- The agreement with the IMF needs revision
Inflation in Pakistan– just like in developing countries in general– is at least equally a fiscal phenomenon. The basket of goods and services in this context is driven mostly by variables that feed into cost of production- or input cost.
This means that unlike in developed countries, where the role of finance and especially mortgage finance feeds is significant in terms of feeding into demand-pull inflation, whereby the role of tight monetary policy– basically increasing policy rate– becomes highly relevant in reducing inflation; through squeezing the aggregate demand.
On the contrary in developing countries, where the inputs for production are mostly imported given the lack of development of the country, and therefore, firstly, the channel of exchange rate pass-through significantly determines the landed prices of these goods.
Time for change in policy to tackle inflation, therefore, is indeed overdue. The government should remember that the main opposition party may not after all be in the parliament currently, but in the shape of an increasing mass of disgruntled people being affected by high inflation
Secondly, many developing countries like Pakistan are net-importers of oil, and therefore price changes in global market for oil– and sometimes the sudden spikes at the back of political/strategic environment, like the Mideast tensions brewing for some time now, in turn affecting oil supplies– significantly impact inflation rate in the importing country.
A rise here means that many of the goods and services in the basket of CPI all see a telling increase in their prices. The July CPI inflation figures, seeing a year-on-year increase of 10.3 per cent, and up by 1.4 per cent from the previous month, are mostly positively impacted by increases in prices of commodities that feed into the production process in terms of higher costs, and not because there has been increase in the demand for these commodities. This is because most of the commercial bank lending goes to government– to basically service the high amount of debt-servicing at hand- which does not create demand for commodities consumed by households.
At the same time, it is not that many months of high growth have created a lot of jobs, which has allowed more people with capacity to make additional spending. In fact, poverty rates have remained quite high and stubborn, and are likely to rise if inflation is not controlled with a correct policy approach.
In the meantime, the future expected inflation would rise even further, in line with SBP thinking whereby anticipated average inflation would likely to be around 11-12 per cent in FY20; higher than where it stands currently. Yet this will happen because of excessive demand; since a low-growth scenario will reduce employment and with it lead to diminishing aggregate demand. Moreover, it is not that the median wages have increased in any drastic manner or are likely to rise, given the low-growth equilibrium in which Pakistan has been stuck for many months now.
So clearly, inflation is not being caused by demand-pull factors, or will most probably be caused through this channel. But the frustrating part of policy being adopted by the central bank for over a year now is that they have not realised that squeezing aggregate demand has not and therefore, will not, reduce inflation in any consistent way. Let’s look at the numbers.
State Bank of Pakistan (SBP) in its last monetary policy statement, released in July 2019, increased the policy rate by 1 per cent in one go to take it to 13.25 per cent. In April 2018- more than a year ago- the policy rate stood at 6 per cent, and CPI (consumer price index) inflation rate was 3.7 per cent. Hence, During April-July 2018/19 the policy rate saw an average monthly increase of 0.5 per cent, from 6 per cent to the current 13.25 per cent; rising by 7.25 per cent in turn.
At the same time, for these 15 months, inflation only decreased in five of these months and that too in a scattered and paltry way– in September by 0.7 per cent, in November and December each by 0.3 per cent respectively, in April by 0.6 per cent, and in June by 0.2 per cent. Moreover, the lacklustre impact of policy rate on inflation took place, even when the real interest rate on average was 2.3 per cent.
The above clearly indicates that there is a lack of negative correlation between policy rate and inflation. Squeezing the demand-side for over a year now– and the central bank of the country becoming the one adopting the tightest monetary policy in Asia– has only negatively impacted economic growth rate. Hence, even after 15 months, during which tight monetary policy led to more than doubling of the policy rate, inflation increased for 10 of these months; where in five of those months it increased by one per cent or more.
It clearly indicates that inflation is a supply-sided phenomenon in the country, and therefore, requires fiscal and governance policies that help reduce the input cost of goods and services. Given the two main channels of oil prices and exchange rate, it therefore means that greater government intervention is needed to reduce the domestic price-enhancing impacts of these two channels.
For this the government will have to ask the central bank, and take on board the International Monetary Fund (IMF) to induce policy towards a more active manage-float exchange rate regime. Surely, the negotiated programme should be taken as a somewhat flexible document at least, since an economy functions in a dynamic way and the policy document should be open to absorbing the changing realities of the economic environment.
The policy and the IMF-negotiated document should therefore remain on the learning curve. The argument in the most recent monetary policy statement, whereby it indicates, ‘The decision takes into account upside inflationary pressures from exchange rate depreciation… the likely increase in near term inflation from the one-off impact of recent adjustments in utility prices and other measures in the FY20 budget’ is naive and over-simplistic in terms of inflation-inducing causes at hand.
Similarly, oil prices feed into prices of many commodities in the CPI inflation-related basket of goods and services, and therefore the prices should be smoothed through a tax-rationalisation programme. Currently, the landed oil product prices contain a significant proportion combined of petroleum levy, margins and indirect taxation. This should be reduced altogether if possible. In addition, a well-targeted subsidy programme is also to be launched to raise the usage ceiling for lifeline consumers.
Inflation reduction would require reducing market failures through better governance of markets, lowering the role of information asymmetry, and the high level of transaction costs.
Inflation needs to be controlled if the government wishes to enhance the level of investment in the country. The current policy will most-likely not cause inflation to reduce and remain low sustainably. This would mean that purchasing power will remain low and that will be a disincentive for foreign investment given lower demand possibilities.
A high inflation rate would also mean that people will have less saving capacity– less is left from disposable income after meeting higher consumption costs, especially when real wages have hardly risen for some time now– even if the increasing policy rate means higher savings rate.
Portfolio investment anyways is ‘hot money’, and in an environment of weak regulations would mean it can fly out anytime the risk level rises; so is undependable in building official reserves. So even if induced by keeping policy rate on the higher side, portfolio investment will remain volatile.
Time for change in policy to tackle inflation, therefore, is indeed overdue. The government should remember that the main opposition party may not after all be in the parliament currently, but in the shape of an increasing mass of disgruntled people being affected by high inflation. While people may– and rather should– understand that the government received a difficult economic situation, following a wrong policy is only pushing them to the wall of unbearable misery. Their pain should find a vent into policy corridors; otherwise they might erupt like a volcano on the future of this government.
