KARACHI: “An economist is an expert who will tell you tomorrow why the things he predicted yesterday did not happen today”. Economic managers in our country are no exception. They are telling us now why inflation is rising at double the pace they had predicted. And, they are also predicting that it will start falling from the next fiscal year.

In the last fiscal year, when our economy grew 6.4 per cent, we saw inflation of 4.6 per cent, slightly above the target of 3.9 per cent. In April 2005, the 10th month of this fiscal year, inflation shot up to 11.1 per cent over April 2004. The average full fiscal year inflation is expected to be a little less — around 10 per cent or two times the initial target of five per cent.

When we talk about 11.1 per cent inflation in the last month, it simply means that one needed Rs11,110 in April 2005 to buy the same goods and services that he bought in April last year for Rs10,000. Or conversely, the real purchasing value of the Rs10,000 one had earned in April 2004 fell to Rs8,890 in April 2005.

For poorer people, whose earnings are so small that they have to spend most of it on food and clothing, the impact is even harsher. Consider this.

In April 2005, a poor person needed Rs1,134 in place of Rs1,000 to purchase the same goods and services that he bought in April 2004. That is, the real purchasing value of the Rs1,000 he held in April last year fell to Rs866 last month.

The reason for faster erosion in the real purchasing value of a poor man’s earning is that the rate of inflation for the poor is higher than the normal inflation rate. The rate of inflation measured by Sensitive Price Index covering 53 essential items of daily use has been higher than the rate of inflation determined by changes in average prices of the 374-item Consumer Price Index.

In April 2005, SPI inflation showed an annual increase of about 13.4 per cent and CPI inflation reflected a rise of 11.1 per cent. Inflation has been rising faster than projected for a host of reasons. The key factors are: higher-than-targeted growth in the economy; expansion in money supply; low lending rates that prevailed until the end of the last fiscal year and only inched up in three quarters of this fiscal year; artificial or real shortage of food items; business malpractices including cartel-making and hoarding; increase in inflationary expectations for various reasons; delayed and ineffective responses of the government to control inflation through administrative and fiscal measures and; too little and too late tightening of monetary policy by the State Bank in three quarters of the current fiscal year.

The SBP started tightening interest right from the beginning of this fiscal year in July 2004 and made only slight upward adjustments till March 2005. In April, however, it got more serious about containing inflation and raised its discount rate by one-and-a-half percentage points to nine per cent and then let the treasury bills rates rise in successive auctions by big margins.

Some economists say the SBP should have started tightening the monetary policy a bit earlier and in a more aggressive manner. They believe that had the SBP done so, it would have kept inflationary expectations from rising too much and effectively checked inflation.

But SBP Economic Adviser Riaz Riazuddin disagrees with this view.

He says that the SBP followed a gradual tightening of monetary policy to ensure adequate supply of bank credit to the private sector, especially in the crucial cyclical credit period of our economy, i.e. October to April. “Due to record credit expansion...not only large-scale manufacturing performed better but almost all the sub-sectors recorded exceptional growth.”

“Had we drastically tightened (interest rates) earlier, higher level of production would not have taken place. This would have resulted in more adverse consequences on inflation than we are actually witnessing now.”

“It is quite clear that the primary pressure on inflation is coming from the food and oil group, although non-food items like house rent are also contributing. In this situation, any hindrance to the growth momentum would have proved very unfortunate.”

“Having deliberately added to reserve money expansion up to January 2005, the SBP is very consciously, and as planned much earlier, working to drain excess liquidity from the system to decelerate CPI inflation. This deceleration will continue in 2005-06 that will see the inflation rate come down to seven per cent.”

Mr Riazuddin also disagrees with the view that higher inflation is a by-product of faster-than-estimated expansion in the private sector credit. In first 10 months of this fiscal year, the private sector’s borrowings from the banking system reached Rs363 billion, exceeding the upward revised target of Rs350 billion for the entire fiscal year.

“It is indeed true that private sector credit is a sub-component of money supply. However, it is not necessary for every sub-component of money supply to be linked with inflation,” he says.

“In fact there are cogent reasons to surmise that more expansion in credit to the private sector (that is being used productively) leads to more supply that, in turn, eases inflationary pressures.”

One needs to read this quote carefully to get to the bottom of the issue. The SBP official is right in saying that expansion in the private sector credit actually eases inflation if it is used productively. But the problem in our context is that because of delayed and slow-paced tightening of interest rates by the central bank, part of the private sector credit was misused for speculative purposes — ranging from hoarding of food items like wheat and sugar to delayed delivery of cars to unnecessary inventory building — that fuelled inflation.

That the SBP’s hesitation in increasing interest rates aggressively every month or twice a month contributed to higher inflation is evident from the fact that not only overall inflation but core inflation too has been on the rise. In April 2005 when overall CPI inflation was 11.1 per cent year-on-year, core inflation was at 8.4 per cent, substantially higher than even the overall full year inflation target of five per cent.

What is more important is that in each of 10 months — between July 2004 and April 2005 — core inflation remained above six per cent, ranging between 6.1 and 8.5 per cent. Core inflation or non-oil, non-food inflation can be contained through timely and adequate tightening of interest rates. If the real lending rates remain negative, as has been the case in Pakistan, this is bound to increase core inflation, by making it easier for businesses to misuse cheaper bank credit for speculating in stocks and real estate and indulging in hoarding commodities.

During three quarters of this fiscal year, the weighted average lending rate of banks remained below inflation - or negative in real terms - and may remain so in this quarter as well.

One way to check inflation more effectively is to let the SBP target price stability as the prime objective of its monetary policy. Those who advocate this idea argue that the benefits of higher economic growth are not evenly passed on to the poorer people - so inflation must be kept low to minimize their financial woes.

But Riaz Riazuddin challenges this idea.

“If inflation targeting countries are examined alone, the performance improved, on average, between the period before and after the targeting periods. However, in the same period the countries that did not adopt inflation targeting also experienced improvement,” he says. “This finding suggests that better performance resulted from something other than targeting.”

An important pre-requisite for inflation targeting is that the inflation target will not be subordinated to other objectives such as short-term economic growth, exchange rate stability, financial stability, etc. “This mainly requires well developed financial and external sectors.”

“Further, economic growth, both in the short and long-term, is also very important at this stage of development.” On top of all, under the State Bank Act of 1956, the central bank is supposed not only to check inflation but also to ensure that the economic growth target is met.