THERE is considerable acceptance in the economic literature that some degree of inflation is inevitable for an economy to grow.
Traditional Philips Curve traces the inflation and unemployment nexus and proves that inflation has negative relationship with unemployment. Inflation is like a lubricant which is essential to sustains the momentum of economic growth and is harmful only when it rises beyond a certain threshold level that varies from economy to economy.
In Pakistan, inflation remained below the threshold level of five per cent during 2000 to 2004. In this period, the economic growth was also lower. The inflation data for fiscal year 2004-05 showed a weak response to monetary tightening whereas economy continued to grow strongly. Real GDP growth at 8.6 per cent was substantially higher in FY 2004-05 than the targeted 6.6 per cent, thereby, raising pressures on productive capacity of the economy and leading to a surge in imports.
The rising capacity utilization, high energy costs and shortages of foodstuff substantially added to inflationary pressures. All these factors originated from supply-side and thus CPI inflation averaged 9.3 per cent in FY2004-05, substantially above the five per cent target.
The gradual monetary tightening was warranted only to keep demand side pressure under control. However, a pro-active monetary tightening was least desirable option which could derail the growth momentum in the economy. The higher inflation of 2004-05 was only culmination of rise in support price of wheat and its sympathy effect.
In short, it was only petroleum and wheat and monetary tightening was not prescribed for containing prices of any one of them. It was smoothing of oil prices and better wheat supply management that brought inflation down by 1.4 percentage points. The evidence is sharp fall in food inflation.
The policy induced component of the inflation i.e core inflation remained stable in a narrow band of 6-8 per cent for the last three years. It means it is not monetary tightening but better supply management which brought inflation below target.
The government and the SBP have so far avoided heavy handed response to tame inflation that could derail the ongoing economic upturn. The SBP avoided a sledgehammer policy response in the wake of rising inflation during the last two years and preferred to strike a balance between sustaining the growth momentum and containing inflation.
Real GDP growth target of seven per cent for the current fiscal year 2006-07 demands investment rate of 20 per cent of GDP. The investment in capacity expansion and new capital spending would be discouraged by monetary tightening. This would be detrimental to growth.
At a time, when the government is providing fiscal stimulus for growth and investment, the monetary policy runs counter to fiscal policy targets. The government needs to finance its huge current account and fiscal deficits.
The worst affected by the interest rate hike would be the government. Inflation can only be controlled by administrative measures to curb extra market forces which exploit poor consumers. Competition law could take care of this problem.
The SBP itself admits that, “In contrast, the distinct feature of restraining inflation to 6.5 per cent during FY07 together with accelerating GDP growth to seven per cent makes the conduct of monetary policy difficult. Moreover, growth promoting fiscal stance render the monetary policy environment even more challenging going forward”.
On the fiscal policy side, the government has shown greater tolerance to fiscal deficit for the last two years because of its higher spending on social and physical infrastructural development.
This would jeopardise the prudent public debt management of the government which received its first ever jerk on August 02 T-bill auction. In this auction, the commercial banks stayed away from the ring and the government was not able to mobilise desired level of resources.
Now, under the changed parameters, like higher financing requirement by the government, discount rate is adjusted upward by 50 basis points and CRR and SLR are also adjusted with the objective to provide relief to the depositors. However, this may adversely affect debt management objectives of the government.
The rising lending rates have yielded positive rate of return to the bankers but as they are rising after entry into double digit, it will impact negatively on access the credit.
On the other hand, the poor depositors are getting negative rate of return on their deposits. SBP should serve the interest, both of depositors and the banker because both stakeholders are important market players in the financial business. Being watch-dog of the banking sector, SBP has the responsibility of taking care of all stakeholders.
The current monetary stance would adversely affect the current growth momentum, prudence in public debt management and investment. This is definitely not the right time to check inflation when it is sliding downwards. The core inflation which is more relevant to the monetary policy is in the stable zone.
Monetary expansion is close to nominal GDP growth. It is not the right time to make impact of fiscal stimulus null and void. What the government wants to achieve through fiscal stimulus is likely to be lost by pro-active monetary stance. The SBP should make monetary policy supportive of growth and aligned with overall macroeconomic framework and fiscal expansionary context.
While the inflation is under control, credit to the private sector is slowing down, the economy badly needs investment in new capacity and public sector development programme is expansionary, the current monetary stance is likely to hurt the government finances more than any other sector.