Global Uncertainty and Monetary Policy Effectiveness in Pakistan

Inayat U. Mangla Professor of Finance, Lahore School of Economics

And

Professor of Finance EmeritusDepartment of Finance & Commercial Law

Haworth College of Business, Western Michigan University

Syed Kalim HyderSenior Economist

Monetary Policy Department, State Bank of Pakistan

1

Outline

• Summary

• Introduction

• Literature review

• Stylized facts

• External flows to Pakistan

• Methodology

• Results

• Conclusions and Policy implications

2

Motivation

“There is only one difference between a bad economist and a good one: the bad economist confines himself/herself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.” Fredric Bastiat, 19th century French economist

Granger Causality + RE Model (Rational Expectation) in late 1970s

3

Summary • Paul Volker’s disinflation episode has useful / greater

insight for effective monetary policy• Monetary Policy effectiveness in the developed World

has implications for EM• Aftermath of GFC• Spillovers of global development after GFC• Monetary policy effectiveness in Pakistan

– External factors– Domestic Changes

• Easy monetary policy is biased in favor of capital and less for labor

• Fiscal and monetary policy Coordination is needed

4

Four Major Global Financial Crises

1. The slump of 1930s (Great Depression), which followed the Wall Street crash of 1929.

2. The stagnation of Japanese economy, which followed their stock market crash of 1990 and continuous occurrence of recessions in last twenty five years in Japan.

3. The Global Financial Crisis (GFC 2008) and economic weakness that followed sharp falls in financial asset and house prices-leading to a Great Recession.

4. The ‘Severe Recession’ of 1981 (also known as Volcker deflation).

5

Monetary Policy Effectiveness

• Era of effective monetary Policy (1980 - 2008)

– Credibility, independence and transparency

– Effective management of Inflation expectations

• Limitations and Asymmetries in monetary policy effectiveness

– Low bound interest rates

– Effectiveness in Recessions and Expansions

– International developments

6

Implications for monetary policy in PakistanConventional Scenario

• Fed rate hike will hit the global economy in several ways;

• One interest rate hike in 2015 was a tweak (not of D. Trump)

• A second on March 15, 2017 is a step towards normalization.

• The third looks like a whole rising interest rates cycle

A Caveat;

• While everyone screams about a rising interest rate and

normalization of yields, few seem to realize what is required

for that to happen

• You cannot normalize yields unless you normalize growth and

inflation expectations. Period.7

Five Big Trends to Watch

1. Super Cheap Money

2. Inflation Uncertainties

3. Expect Saving Rate to rise

4. Huge Budget Pressures on the governments

5. Expect Trade War (Specific US and EU, Est vs East)

8

The Second Scenario

• The other scenario as being suggested by the US Bond and Stock markets implies a Fed rate hike + low growth= recession

• Near-zero rates have been the most important factor in the global economy for a decade.

• They have changed the way F. assets are priced, dictated saving rates and allowed governments to borrow

• BOTH scenarios will bring pressure for PAK external account and uncertainty for monetary policy

• Message for financial manager (SBP and MOF); Buckle up!!- greater uncertainty ahead

9

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Australia Canada EU Japan UK US

Average Policy Rates of Major Economies

1991-2000 2000-2010 2010-2015 July 2016

10

International Developments – Stylized Facts

-7-6-5-4-3-2-101234

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Real Economic growth (YoY)

OECD-34 OECD-EU OECD-7

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Inflation (YoY)

OECD-34 OECD-EU OECD-7

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GFC and Pakistan

• Aftermath of GFC

– Low interest rates

– Depreciating currencies

– Outflow of Capital

– Declining prices of commodities

• International oil Prices

• Spillovers of these developments to Pakistan

12

Average Foreign Direct Investment inflows to Selected Countries (Mil. US$)

-5000

0

5000

10000

15000

20000

Pakistan Indonesia, Malaysia & Philippines Bangladesh, India &Thailand

13

Methodology - Specification

• Supply Shock– International Oil Price inflation,

• Global Demand Shock– US industrial Production Growth

• Monetary Policy– Real Policy Rate

• Domestic Factors– Real Exchange Rate– Domestic industrial Production– Inflation in Consumer Prices

14

Methods and Robustness

• Reduced form Recursive Structural VAR -(Ahmed 2003, Ahmed et al 2006)

• Local Projections - Jordà (2005)

• Long and short run Restrictions

• Robustness

• Structural Changes

• Sample 1991-2016

15

Impact of External Uncertainty

• Impulse response Analysis

– External Shocks

• Oil Prices shock

• US Production Shock

– Monetary Policy Response to external shocks

– Exchange rate Response to external shocks

– Domestic Economic Growth implications

– Response of Domestic Consumer Price

16

Monetary Policy Effectiveness in Pakistan

• Monetary Policy Effectiveness

– Exchange rate depreciation Shock

– Inflation shock

– Economic Growth surge

• Response of Exchange rate to domestic Shocks

– Monetary Policy Changes

– Inflation shock

– Economic Growth surge

17

Policy impact assessment Behavior of Most Endogenous variables

• Real Economic Growth

– Response to Policy rate Shock

– Response to Exchange rate Shock

• Inflation in Consumer price Response to

– Policy rate adjustments

– Exchange rate depreciations

18

Conclusions

• International developments

– Effectiveness of monetary policy

– Spillovers of QE

• Policy response and implications of global uncertainties

• Effectiveness of monetary policy in Pakistan

• Do Asymmetries exists?

19

Policy Implications

• More independence to Central Bank?

• Fiscal and Monetary Policy Coordination

– Fiscal dominance

– Monetary dominance

– Balanced coordination

• Need to increase the scope of monetary Policy

20

21

-0.8

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Real Policy Rate – Oil price and US growth increase

-.3

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0 2 4 6 8 10 12 14 16 18 20 22 24 26

Policy rate response to Oil price Shock Policy rate response to US Growth Shock

Real Exchange Rate – Oil price and US growth increase

22Back

-.4

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0 2 4 6 8 10 12 14 16 18 20 22 24 26

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Exchange rate response to Oil price Shock Exchange rate response to US Growth Shock

Domestic Growth– Oil price and US growth increase

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Domestic growth - Oil price Shock Domestic growth – US growth Shock

Inflation and external Uncertainties

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-.15

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Inflation response to Oil price Shock Inflation response to US growth Shock

Monetary Policy Effectiveness

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Policy rate – Exchange rate Shock Policy rate – Domestic Growth Shock

Policy rate Response -Inflation Shock

Response of Exchange rate – domestic Shocks

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-.4

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Exchange rate - Policy rate Shock Exchange rate – Domestic Growth Shock

Exchange rate Response -Inflation Shock

Economic Growth Response

27Back

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Economic Growth – Real Policy rate Shock Economic Growth – Real Exchange rate Shock

Response of Consumer Prices- Inflation

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-.5

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Inflation – Real Policy rate Shock Inflation– Real Exchange rate Shock