In August 2004, CPI inflation-inflation measured by 473-item consumer price index- rose by 9.25 per cent year-on-year, or more than five times the rate of inflation in August 2003.

In July-August 2004, the increase in inflation was even higher__9.29 per cent, or nearly six times the rate of inflation in July-August 2003. In August 2003, CPI inflation was at 1.76 per cent and in July-August 2003 at 1.58 per cent.

Inflation started picking up right at the start of the last fiscal year in July 2003. During July-December 2003 it moved up steadily but slowly. But in January-June 2004,it accelerated at a high pace.

On the other hand, banks' weighted average deposit rate that was at 1.7 per cent in July 2003 gradually fell to 1.21 per cent in April 2004 and remained intact in May and June 2004 also.

The result was this. In July 2003 average deposit rate was 29 basis points higher than marginal inflation that month but in June 2004 it fell 724 basis points below inflation. See Chart I.

More interestingly, in July 2003 banks' average lending rate was 371 basis points higher than marginal inflation that month but in June 2004 it fell 340 basis points below inflation. See Chart II.

Banks' average deposit rate cannot be compared with marginal inflation for a variety of reasons. But if inflation remains much higher than average deposit rate for a considerable period, it certainly discourages savings and compels individuals and businesses to invest money in relatively least or non-documented sectors of the economy.

More importantly, if banks' average lending rate falls far below inflation and stays there for a considerable period, it not only makes containing of inflation progressively difficult but also defeats the very purpose of low lending rates.

That is, when average lending rate is allowed to remain far below inflation, businesses find it easier to seek low-cost fresh loans and retired the old expensive ones.

They also find it more attractive to use low-cost loans for building up inventories or hoarding commodities, purchased or produced, using such loans. Pakistan has witnessed this negative fallout of very low lending rate in case of wheat hoarding last year, that was more to blame for a price-hike in wheat and wheat flour than the actual shortage of the commodity.

The fact that both average lending and deposit rates of banks have stayed far below marginal inflation for months underscores the need for pacing up the efforts to make the interest rates more responsive to rising inflation.

Why high inflation: CPI inflation that stood as low as 1.7 per cent in July 2003 rose gradually to 8.45 per cent in June 2004. And, as stated earlier, in July it peaked at 9.33 per cent before receding to 9.25 per cent in August on the back of growing economy.

Pakistan's economy grew by an estimated 6.4 per cent in fiscal year July-June 2003-04, up from 5.1 per cent in July-June 2002-03. Annualized average inflation rose by 4.57 per cent in FY04, up from 3.1 per cent in FY03. Economic managers say that a higher inflation was the by-product of a handsome economic growth.

That makes sense though independent economists may argue that inflation shot up also due to other reasons including wheat hoarding and a less-than-required response from the central bank in containing inflation.

But instead of debating endlessly on whether inflation could have been contained more effectively in the outgoing fiscal year, let us focus on more important issues at hand.

The issue is whether the economic managers will be able to keep inflation at the targeted level of 5 per cent during this fiscal year to achieve a targeted growth of 6.6 per cent in GDP. And, whether there is a need for introducing any saving and investment scheme offering higher-than-inflation returns. Or in a broader context, should the interest rates in Pakistan be inflation-driven?

Economic growth vs inflation: There is a relationship between the economic growth and inflation and the economic managers keep this in mind while setting growth and inflation targets at the beginning of the fiscal year.

They have set the growth and inflation targets at 6.6 per cent and 5 per cent respectively for this fiscal year. Now, if inflation exceeds the target and the economy also grows at a faster than projected pace, it would appear to be logical.

But if inflation rises beyond five per cent and the rate of economic growth remains within the targeted level of 6.6 per cent, then it will be too difficult for the government to pacify people protesting over it.

It is too difficult to project at this stage whether the economic growth will also surpass the target with the likely breach of the inflation target. But some pointers indicate that even if the economic growth surpasses the target, the additional growth would be lesser than the additional increase in inflation.

When the economic managers had key targets for this fiscal year, they were not aware that the oil prices would shoot up to a record 14-year high and would remain substantially high even afterwards.

New York's reference Light Sweet Crude that was at $30 a barrel at the end of the last fiscal year shot up to $49.40 in mid-August and was being quoted, until recently, at $44-$45 a barrel for October deliveries.

This sharp rise in oil prices will directly fuel inflation in Pakistan, once the government de-freezes domestic oil prices. Unusually high oil prices have already been pushing up the price-line by increasing the imported inflation.

Oil import bill, in the first two months of this fiscal year, has risen by 35 per cent, chiefly due to booming oil prices and, to a lesser extent, due to higher demand for petroleum products in Pakistan's growing economy.

This large increase in oil import bill has been a key factor behind a huge trade deficit of $489 million in July-August 2004. Total trade deficit in the current fiscal year may rise past $4 billion against targeted $3 billion primarily due to high oil prices.

Besides, water scarcity in Sindh that is going to take its toll on agricultural output also threatens to impede the economic growth beyond the targeted 6.6 per cent, or even make the achievement of this target difficult.

As water scarcity issue is quite recent, the economic managers might not have taken this into consideration while setting economic targets. Or, they would not have given it due weight while factoring in its possible dampening impact on GDP.

Based on the above assumptions, it can be said that whereas inflation may rise far beyond the targeted level of five per cent during this fiscal year, the economic growth target of 6.6 per cent cannot be surpassed by a big margin.

In the last fiscal year the situation was quite different. Average inflation had risen by 4.57 per cent against the initial target of 3.9 per cent but the GDP growth was also much higher than targeted, 6.4 per cent against the target of 5.3 per cent.

So, there is a need to ensure that inflation does not cross the level required for achieving 6.6 per cent growth in the changed scenario, amidst booming oil prices and water scarcity in Sindh etc.

If that means keeping inflation at, say, six per cent that is not a big issue. The issue is how the government is going to provide cushion to the general public against rising inflation in the short term even though it is needed for a mid-term high economic growth.

One way of tackling inflation more effectively in the short term is to raise interest rates aggressively. But our economic managers rightly point out that making interest rates inflation-driven at this stage may prove counter-productive in the sense that it can stifle growth, so badly needed for poverty alleviation and creation of jobs in the mid-term.

They believe that once the economy attains an annual growth rate of 8 per cent, required for substantially reducing poverty and joblessness, only then the interest rates could be made inflation-driven.

But at the same time, they do realize the need for increasing interest rates in a measured and gradual manner to keep inflation in check. The State Bank move to raise the weighted average yield on six-month treasury bills by 38 basis points, in one go, to 3 per cent on September 15 reinforces this view.

Inflation-indexed bonds: Now let's assume that for the reasons stated above, there is no room for making the overall interest rates fully responsive to inflation at this stage.

Then, the economic managers must come up with an idea of keeping the yields on savings and investments from falling further below inflation. At present, marginal or year-on-year inflation is so high that the rate of return on even 10-year Defence Saving Certificates is lower than that. Currently inflation is at 9.25 per cent and the return on 10-year DSCs is only 8.15 per cent!

One way of avoiding a real negative return on savings and investments is that the government may introduce inflation-protected or inflation-indexed bonds or bills or certificates of investment or any other mode of saving and investment.

The private sector can also be engaged in this exercise. Some players in the financial sector are just willing to do this. The government can engage them in developing such instruments.

In a series of interviews conducted by Dawn to ascertain the need of inflation-indexed bonds and to see the willingness among financial sector players for designing inflation-protected products, it transpired that the private sector wants the government to take the lead.

Chairman of the Leasing Association of Pakistan Basheer A. Chowdary said: "We can design saving and investment products with inflation as floor for their rates of return. We can issue Certificates of Investment.

In fact, I would be exploring this possibility and engage experts for this purpose." But he and several others including present Karachi Stock Exchange Chairman Arif Habib and past chairman Yasin Lakhani said the government should take the lead.