Monetary Policy Tightening –Is this the ONLY solution?

The economy has witnessed increase of 175 base points hike since Jan -18. Many would argue the step as mandatory (no choice basis) response to inflation figures. Was inflation demand driven or cost pushed? I would choose the later. If one analyzes the inflation breakup released by SBP for the month of Jun/Jul, inflation has been directly or indirectly caused by rise in energy prices and education. These sectors are main drivers in inching up the headline inflation. These local energy prices have been driven up due to both international and weakening of rupee. It is important to understand cause of inflation rather than reacting to the effects of inflation. For any economy, ideal scenario is to increase the supply and demand at the same rate.

Oil prices have gone up by 40-50% and rupee lost its value of 30% against the greenback in the last nine months.

Petroleum Products – Consumption pattern

Pakistan consumes 550,000 bpd(approx.) and it causes $550,000 excessive import bill daily for every $1 per barrel increase. Based on various statistics, 45% of the imported oil is utilized by non-transportation activities. Structural imbalance in power sector is the main culprit in creating adverse ripple effects in the economy. Policy measures should consider oil consumption as 650,000 bpd mainly owing to growth in demand of petroleum products. Below graph clearly depicts inverse relationship between crude oil prices and Pakistan’ GDP growth rate.

Currency Devaluation

Value of rupee eroded by 30% in the last nine months pushing the cost of imported and commodity products upwards. In my opinion, natural aggregate demand has never exceeding national aggregate supply but the currency depreciation becomes a single largest factor in pushing the cost of products upwards. Abrupt rupee losses only occurs if the value of currency is artificially held.

High Interest Rates – high budget deficits

The hike in interest rates is partially responsible for fall in stock market and other alternate investments, distortion the projections of corporate endeavors and above all it has increased debt servicing for both private and government. The target of the central bank should be to keep the real interest rates around 3.25% with inflation at creeping levels. Expansion projects will go on halt/ and future jobs are at stake.

Below mentioned table has been extracted from ‘Inflation Monitor’ released by the central bank in July and it clearly exhibits upswing in ‘Transportation’ by 50% month of month basis. CPI chart consists of necessary items and has inelastic demand. Distribution - Composition of CPI basket – 37% food and 63 % non-food.

Pakistan economy is not integrated to the level of consumer to affect demand due to increase/decrease in interest rates. Bear in mind that interest rate is also one of the key components that constitutes the cost structure of items in CPI basket.  Pakistan economy was textbook example of Phillips curve in 2008-10 as unemployment peaked with historic high interest rates.  Demographics of Pakistan have changed significantly since 2008-10 and the effect of unemployment will be much deeper this time.

Money Supply – M2

It is evident from the below mentioned graph that higher inflation is not demand driven as M2 in the economy is increasing at regular pace. Slope of the M2 growth is not any steeper in 2018. Growth rate in M2 recorded is around 8.5% in 2018. Demand side inflation is only ascertained if money supply(M2) grows faster than GDP.

Limited Consumer Credit

It holds true in the economies where personal credit be in the form of mortgage, personal loan and any other forms of loan in disseminated instantly.

Short Term Approach – In my opinion, resorting to stabilise the short term interest rates through calibration in reining supply side cost management. Fundamentally, stabilising the petroleum product prices and seeking less reliance on import of oil are the only two problems which needs utmost attention by policy makers in the first six to eight quarters. Interest rate only reins demand side of inflated price formation but we suffer supply side problem. Pakistan should develop strategy to fundamentally predict and correct supply side economics. India has addressed this problem in 2017 when the country has decided to calculate the price of petroleum products on daily basis as hike in petroleum is daily absorbed and is saved from abrupt fluctuation.  Pakistan should align formation of oil prices with monetary policy announcements to narrow the response lags.

Long Term Approach – Independence of our country from oil driven production (be in the form of transportation or vital activity like energy mix). If the results of this long term initiative are achieved, the central bank will be able to utilize monetary policy tools for other objectives and goals beyond mere inflation management. Since the inception of the SBP, it has never performed proactively for the growth of exports and alleviation of poverty and growth in consumption. SBP always had reactionary stance to economic situations.  Real sustainable growth lies in rise of consumer spending but unfortunately governments of third world countries eagerly concentrate on government spending(G) to spur growth and resultantly run into fiscal deficits. This in turn increases borrowings (bilateral and public) and press them deeper to service the debt cost. The borrowings by government by banking sector create the ‘crowding out effect’ and keeps lending institutions shy from extending credit to common man.  The government should strive to increase the consumer spending and spur growth and adopt counter measures to keep the inflation at creeping levels. One can safely argue that increasing interest rates in response to inflation number especially when it is not demand driven is not the effective strategy and it is counter-productive. In my opinion, keeping the oil prices intact or passing equivalent subsidiary to manufacturing(production) can have mitigating effect on cost push inflation.

Loans to Private Sector Loans to private sector have registered increase of 18% in the calendar year 2018 mostly due to expansionary projects by corporations. Private credit can be controlled through other monetary policy tools (Reserve ratio and Open market operations-OMO).

Can revenue be sacrificed for economic growth? These are two vital questions to set future growth trajectory for Pakistan and are we ready to deal this with unorthodox measures? It is high time to integrate fiscal and monetary policy tools to kick start much needed sustainable growth.

God bless and long live Pakistan.