Sample Mid Questions:

why it isdifficultto control inflation inPakistan?why monetary management in Pakistan is a challenging task?Is inflation good for economy like Pakistan?

What are the main challenges for policy makers in Pakistan?Is SBP an independent central bank?Suggest few policy measures to Governor SBP for controlling inflation?

RANDOM INFORMATION:

WHAT IS INFLATION? DISCUSS ITS TYPES, CAUSES, MEASURES AND EFFECTS.Introduction:Collective increase in the supply of money, in money incomes, or in prices refers to inflation. Inflation is generally thought of as an undue rise in the general level of prices.Definition:Inflation is a situation whereby there is a continuous and persistent rise in the general price level.According to Meyer:An increase in the prices that occurs after full employment has been attained.Situation in Pakistan:Today, inflation is one of the serious problems faced by Pakistan. Rate of inflation in Pakistan is very high. According to economic survey 2009-10, its rate is 13.3 %, while it was 22.3 % in last fiscal year. According to ESP 2011-12, rate of inflation (CPI) is 10.8%.Explanation:All above definitions are showing that inflation is a condition in which prices rise and money value decreases. Due to inflation the real value of money i. e., the purchasing power decreases.TYPES OF INFLATION:Following are the main types of inflation, which are different from one another due to their causes:1)Demand Pull InflationThis is demand side inflation. It simply means that when there is an increase in aggregate demand. Without any corresponding increase in aggregate supply the price level will rise.2)Cost Push InflationIt is supply side inflation. If there is increase in prices it will results in fall in aggregate supply. It is the reason of increase in cost of production.3)Structural InflationSometimes prices rise in an expanding economy because the supply cannot keep up with rising demand because of structural inflexibilities. This is also called the Structuralist Argument for inflation.4)Imported InflationIn such inflation local governments are helpless; it is due to an increase in the prices of imported goods. To control it government may bans the imported items.5)Open InflationIf there is no control over rise in prices, it will be determined by free forces of demand and supply.6)Suppressed InflationIf prices are subject to governmental control then their increase is made by the government action.7)Ex-ante & Ex-post InflationEx-ante inflation is the expected inflation and ex-post is the actual inflation. For example, if people of Pakistan expect an inflation rate of 10% it will Ex-ante inflation but actual inflation is 7 % it will be ex-post.8)Anticipated InflationIf the actual rate of inflation is perfectly in accordance with the peoples expectations it is called anticipated inflation.9)Unanticipated InflationIf the actual rate of inflation is not according to the peoples expectations, it is called unanticipated inflation.10)Profit InflationProfit inflation is the result of the greed of businessmen. It usually occurs in such economy, which are dominated by monopolies.11)Deficit InflationGovernment has to borrow form banks and non-bank & internal and external resources in case of deficit financing. It also caused inflation named as deficit inflation.12)Devaluation InflationDevaluation also leads to inflation. Devaluation decreases the purchasing power of our currency that results in inflation.13)Ceiling InflationInflation that occurs due to various prices ceiling enforced by government. Price ceiling are set by government to maintain prices of certain essential goods at a determined level.14)Income InflationIf there is an increase in income of the people, it will increase the money supply in the country that leads to income inflation.DEGREES OF INFLATION:Inflation contains the following degrees:1)Moderate InflationWhen the rate of inflation is very low, say in the range of 1% to 20%, it is moderate inflation.vIf its rate is less than 5 %, then it iscreeping inflation.vIf its rate is more than 5 %, then it is calledtrotting inflation.2)Galloping InflationWhen the rate of inflation exceeds 20 % it is called galloping inflation. The upper limit of galloping inflation may roughly be defined as 1000 %.3)Hyper InflationIf the rate of inflation is above 1000 %, it can be termed as hyper-inflation.CAUSES OF INFLATION IN PAKISTANCauses of inflation are of two types:A.INCREASE IN DEMAND:1)Increase in Money SupplyThe major cause of increase in the price level is an increase in money supply. It may be due to increase in currency or credit money. Increase in the stock of money induces people to demand more and more of goods and services.2)Increase in Velocity of MoneyAccording to the Fishers Quantity Theory of Money, if there is an increase in the velocity of circulation of money it also leads to inflation.3)More InvestmentInvestments also play an important role in producing inflation. At the moment of investment the economys stock of wealth and money expands and it result is in inflation.4)Non-productive ExpendituresGovernment of Pakistan has to make a lot of non-productive expenditures like defence etc. Such unproductive expenditures lead to the wastage of economys precious resources and also lead to inflation.5)Corruption & Black MoneyCorruption and black money leads to increase in aggregate demand, which is cause of inflation. These evils increase aggregate demand and import volume.6)Deficit FinancingDeficit financing is another cause of inflation. It increases the money supply and leads to inflation.7)Foreign RemittancesIncrease in foreign remittances is increasing the money supply in our country. Increase in money supply leads to inflation.8)Foreign AidsForeign aids are also a source of mobilization of resources form rich countries to poor countries. It is also a cause of inflation in Pakistan.9)Consumption TrendsDue to demonstration effect people of our country want to copy the styles of people of rich countries. In this way there is an increase in consumption trends that leads to inflation.10)Population BombPopulation of Pakistan is increasing day by day. Increasing population is demanding more and it creates inflation.B.DECREASE IN SUPPLY:11)Slow Agricultural DevelopmentLow growth rate of agricultural sector caused in shortage of productivity. It results in low supply and increase in price level.12)Slow Industrial GrowthOur industrial sector is not at developed form due to use of backward techniques of production. Its less production also creates shortage in market and caused in inflation.13)Increase in Wages & SalariesNow labour is demanding more wages and salaries. Increase in wages and salaries leads to increase in cost that increases the prices. On the other hand due to more wages and salaries there is an increase in income and it caused in inflation.14)Increase in Prices of ImportsIncrease in the prices of imports also leads to creation of inflation. If there is an increase in the prices of oil and other imported raw material then it will cause to reduction in supply.15)DevaluationThe value of our currency is decreased due to devaluation. It makes imported goods more expensive and it leads to shortage of supply.16)Indirect TaxesThe imposition of indirect taxes is a reason for increase in prices. Sometimes government imposes taxes on some particular commodities. In this case producer may start to decline the production of those goods.MEASURES TO CONTROL THE INFLATIONFollowing measures are suggested to control high inflation:1)Increase in thegrowth rateof output2)Government should control thesupply of moneythrough effective monetary policy3)Highly increasingunproductive expendituresmust be control4)Government should check thecorruptionfirst to eliminate the inflation5)Control on populationis also necessary to control inflation6)Reduction inbudget surplus7)Reduction inmonetary expansion8)Effectivetax systemwill be helpful to control the inflation9)Improvement inbalance of payment10)Developments ofagricultural and industrialsector will helps to control the inflation.EFFECTS OF INFLATIONFollowing areGOOD EFFECTSof inflation, if rate is 2% to 4%:1)There isincrease in productiondue to inflation.2)Inflation increases theemployment opportunitiesin the country.3)Inflation enhances the process ofeconomic development.4)There ismore investmentin country at the time of inflation.5)Inflation increases the economic activities that may cause toinventions and innovations.6)Profitof the producers also increases when there is normal inflation.Following are theBAD EFFECTSof inflation:1)It is a huge problem foremployees, taking fixed salaries.2)It generatesunfair distributionof income and wealth.3)Inflationreduces the savingof the population.4)It is a cause ofunfavorable balanceof trade and payment.5)Inflation increases therate of interest.6)It creates a lot ofsocial evils.7)It isdifficult for consumersto purchases more goods.8)It generates very bad effects on thepoor labour force.9)Inflation reduces theliving standardandpurchasing powerof people.10)It is harmful forcreditors.11)Inflation reduces thepurchasing power.

Conclusion:Inflation is everywhere in an economy. Its rate is high in developing countries and is low in poor developed counties. Effective operation of monetary and fiscal policy is essential to control the inflation.

The effectiveness of monetary policy in Pakistan

ARTICLE (December 09 2008): Alongside is the text of the speech of the Governor, State Bank of Pakistan, at the Institute of Business Management on December 6. Economic policies aim to increase the welfare of the general public, and monetary policy supports this broad objective by focusing its efforts to promote price stability. Embedded in this objective is the belief that persistent inflation would compromise the long term economic prospects of the country.

The objective of monetary policy in Pakistan, as laid down in the SBP Act of 1956, is to achieve the targets of inflation and growth set annually by the government. In pursuit of this mandate, SBP formulates the country's monetary policy that is consistent with these announced targets. In my remarks today, I plan to provide perspective on:

First, why central banks focus on price stability?

Second, how the monetary policy transmission mechanisms work?

Third, what are the principal features of Pakistan's monetary policy framework?

Fourth, selected thoughts on effectiveness of Pakistan's monetary policy framework

Finally, what measures are needed to improve the effectiveness of the monetary policy framework in Pakistan?

These questions have been a subject of much debate lately, as monetary tightening - an inevitable policy response for regaining macroeconomic stability - has aroused anxiety but better public understanding of this question will help them to appreciate central bank's monetary policy stance.

WHY FOCUS ON PRICE STABILITY?

Before getting into other intricacies of monetary policy, it is useful to bring forth the importance of price stability as an overriding objective of monetary policy. Actual inflation outcome in the economy is driven largely by the level of output gap (the difference between what the economy is demanding and what it can potentially produce) and inflation expectations.

When the output gap widens, the actual output is more than what the economy can sustain in the long run with stable inflation. This reflects excessive demand for available resources in the economy, which pushes up general prices. In order to stem the increase in resource cost and the general price level in the economy, this gap needs to be narrowed or stabilised.

This can be achieved by either reducing the demand in the short run or increasing the productive capacity over the medium to long run. Reducing aggregate demand, however, entails reduction in current output and an increase in the unemployment level in the economy. The famous classical Phillips curve that captures the trade-off between stabilising inflation and controlling unemployment was criticised by Phelps and Friedman in the late 1960s.

They argued that if inflation expectations react to changes in actual inflation, then any trade-off between inflation and unemployment would be short-lived at best. If wages are set once a year and for some reason the output prices increase, then the producers have an incentive to increase their output by hiring more workers.

However it is only possible if workers' expectations of inflation remain Unchanged during the period of increase in output prices. If workers adjust their expectations in accordance with actual inflation and demand higher nominal wages, it leaves relatively little incentive for firms to increase the output.

Therefore the focus has shifted away from this trade-off and new consensus has emerged in the literature that price stability is key to long run growth prospects. Both theory and evidence suggest that monetary stimulus can only affect real economic activity in the short-run.

In the long run, however, there is no conflict between low inflation and full utilisation of economic resources. Ensuring price stability, in turn, requires effective management and anchoring of inflation expectations. With stable prices, economic decisions can be made with less uncertainty and therefore markets can function without concern about unpredictable fluctuations in the purchasing power of money.

On the other hand, high and unanticipated inflation lowers the quality of the signals coming from the price system as producers and consumers find it difficult to distinguish price changes arising from changes in the supply and demand for products from changes arising from the high level of general inflation.

In the market economy, prices represent basic means of transmission of information; the increased noise associated with high inflation lowers the effectiveness of the market system. High and unanticipated inflation makes it impossible to plan for relatively longer outlook, creating incentives for households and firms to shorten their decision horizons and to spend resources in managing inflation risks rather than focusing on the most productive activities.

Ben Bernanke argued that the Fed's mandated goals of price stability and maximum employment are almost entirely complementary: "price stability is an end of monetary policy; it is also o means by which policy con achieve its other objectives." This argument has also been supported by Kenneth Rogoff (1985) who advocated that the central bank should place larger weight on inflation stabilisation, in order to increase the welfare of the society.

Therefore, the competing goals of growth and price stability, which may seem to be at odds with each other, in fact boils down to a single objective ie price stability. In this backdrop, there is no surprise that most of the central banks aim at maintaining low and stable inflation. Central banks place more weight and demonstrate increased willingness on controlling inflation relative to output growth, and financial and exchange rate stability.

It is important to acknowledge, however, that in practical policy making, adhering to revealed preferences is rather difficult. The reason is that central banks do not operate in a vacuum and require co-ordination with other policy making institutions, in particular the fiscal authority. In addition, the social and cultural make-up of a country, and political economy considerations often require central banks to accommodate conflicting policies.

In other words, sticking to an announced rule-based monetary policy can be difficult in practice; 'enlightened discretion' is preferred by most central banks. Thus, SBP's decision to focus on arresting the persistent inflationary trends is tantamount to a pro-growth policy, not a growth retarding one.

MONETARY POLICY TRANSMISSION MECHANISM

The monetary transmission mechanism refers to a process through which monetary policy decisions affect the level of economic activity in the economy and the inflation rate. Understanding the transmission mechanism of monetary policy is crucial for appropriate design and efficient conduct of monetary policy.

As monetary policy actions affect policy variables with a considerable lag and with high degree of variability and uncertainty, it is important to predict the possible impact and extent of monetary policy actions on the real variables.

Thus, by its very nature, monetary policy tends to be forward-looking. It is also important to know which transmission channels are more effective in terms of transmitting changes in monetary policy actions to ultimate policy goals.

Since various financial sector developments particularly regarding introduction of new financial products, technological changes, institutional strengthening, and expectations about future policy, etc can potentially change economic effects of the monetary policy measures, there is a need to regularly update, empirically test and reinterpret monetary policy transmission channels. The impact of monetary policy is perceived to transmit in to the real economic activity through five channels.

The first channel and most widely studied and understood channel of monetary policy transmission relies on the link between changes in the short-term nominal interest rate (induced by changes in the policy rate) and the long-term real interest rate that ultimately affect components of aggregate demand such as consumption and investment in an economy. As such, it is the changes in the long-term real interest rates that have its impact on aggregate consumption, business investment and other components of aggregate demand.

The second channel, known as the credit channel, involves changes in monetary policy that not only affects the ability of firms to borrow money (by affecting their net worth) but also affects the ability of banks to lend money. The strength of this channel depends on the degree to which the central bank has allowed banks to extend loans and the dependence of borrowers on bank loans. These factors are clearly influenced by the structure of the financial system and its regulation.

The third channel of monetary policy transmission focuses on asset prices (other than the interest rate) such as the market value of securities (bonds and equities) and prices of real estate. A policy-induced change in the nominal interest rate affects the price of bonds and stocks that may change the market value of firms relative to the replacement cost of capital, affecting investment. Moreover, a change in the prices of securities entails a change in wealth which can affect the consumption of households.

Fourth, a policy-induced change in the domestic interest rate also affects the exchange rate that in turn affects the foreign financial flows, net exports and thus aggregate demand.

The strength of the exchange rate channel depends on the responsiveness of the exchange rate to monetary shocks, the degree of openness of the economy, sensitivity of foreign private inflows and net exports to exchange rate variations, and the net worth of firms and thus their borrowing capacity if they have taken exposure to foreign currency. Moreover, exchange rate changes lead to changes in the domestic price of imported consumption goods and imported production inputs affecting inflation directly.

Since expectations influence the inflation dynamics, there is a fifth channel that is based on the economic agents' expectations of the future prospects of the economy and likely stance of the monetary policy.

According to this 'expectations channel', most economic variables are determined in a forward-looking manner and are affected by the expected monetary policy actions. Thus, a consistent, credible, and transparent monetary policy can potentially affect the likely path of the economy by simply affecting expectations.

MONETARY POLICY FRAMEWORK IN PAKISTAN

Considering the economic and financial market structure in Pakistan, SBP has for sometime pursued a monetary targeting regime with broad money supply (M2) as a nominal anchor to achieve the objective of controlling inflation without any prejudice to growth.

The process of monetary policy formulation usually begins at the start of the fiscal year when SBP sets a target of M2 growth in line with government's targets of inflation and growth (usually in the month of May) and an estimation of money demand in the economy. The basic idea is to keep the money supply close to its estimated demand level, as both a significant excess and a shortfall may lead to considerable deviations in actual outcomes of inflation and real GDP growth from their respective targets.

Underlying this framework are two strong assumptions: first, there is a strong and reliable relationship between the goal variable (inflation or real GDP) and M2; and second, the SBP can control growth in M2. While containing the M2 growth close to its target level is the key consideration in the current monetary framework, the composition of the money supply does matter and at times requires policy actions even if these actions lead to a deviation in monetary growth from its target level.

To understand this point, it is necessary to know the major components of money supply and their relative importance. Net foreign Assets (NFA) and Net Domestic Assets (NDA) of the banking system are the two major components of money supply.

The NFA is the excess of foreign exchange inflows over outflows to the banking system, or in other terms it is a reflection of underlying trends in the country's external Balance of Payment (BoP) position. It is estimated by the projected values of all major external transactions such trade, workers' remittances; debt servicing, foreign investment, and debt flows etc.

The NDA of the banking system, which primarily consists of credit to the government and the private sector, reflects changes in the fiscal and the real sectors of the economy, If is estimated as a residual of M2 and the NFA. Further break-up of NDA is estimated on the basis of projected credit needs of the government and the private sector.

NOW coming to the importance of these components of the money supply, depletion in NFA is generally considered as an unhealthy development. Sharp NFA depletion reflects worsening BOP position and a pressure on exchange rate. In such a case, a higher NDA growth, though helps in expanding M2 to reach ifs target level, may further deteriorate external accounts, sharper depreciation of local currency, and higher depletion of country's foreign exchange reserves.

Although since FY07, only the indicative M2 growth target is being announced, SBP also takes into consideration the causative factors for monetary expansion while pursing this target. Considering the changes in monetary aggregates and other economic variables, the changes in monetary policy are signalled through adjustments in the policy discount rate (3-day repo rate).

Further, the changes in the policy rate are complemented by appropriate liquidity management mainly through Open Market Operations (OMOs) and if required changes in the Cash Reserve Requirement (CRR) and Statutory Liquid Reserve requirement (SLR) are also made."

EFFECTIVENESS OF MONETARY POLICY IN PAKISTAN

Significance of various channels that transmit the monetary policy shocks in Pakistan to the real economy has been analysed by few economists. Ahmad et al. (2005) found that credit channel is the most 'important conduit for transmitting monetary policy actions to the real economic activity. Evidence confirms transmission through the active asset price channel and exchange rate channel.

According to this study, monetary policy shocks impact real output after a lag of 7 to 11 months. Tasneem and Waheed (2006), on the other hand, investigated whether different sectors of the economy respond differently to monetary shocks.

The presence of sector wise differences in the monetary transmission mechanism has profound implications for macroeconomic management as the central bank then has to weigh the varying consequences of its actions on different sectors. Investigating the transmission of changes in interest rate to seven sub sectors of the economy, the authors found evidence supporting sector-specific variation in the real effects of monetary policy.

They found that the interest rate shock on manufacturing, wholesale and retail trade, and finance and insurance sectors transmit after a lag of 6 to 12 months. On the other hand, monetary policy shocks have negligible impact on agriculture, mining and quarrying, construction and ownership of dwelling sectors.

Generally, historical evidence does reflect that Pakistan has been a high inflation and high interest economy given its inherent structural weaknesses. The role and effectiveness of monetary policy appears more visible in the 2000s when financial sector reforms started bearing fruits in terms of a more market based money and foreign exchange markets.

Entering the 21sf century, the loose monetary policy stance in the face of low inflation, low growth and low twin deficits, along with structural measures to open up the economy and alleviate some first round constraints, triggered the economy on a long-term growth trajectory of above 7 percent.

Monetary policy stance was however altered as the inflationary pressures started to build up in 2005. At the end of the fiscal year, the economy, which had been showing sustained steady growth since FY01, registered a historically high level of growth (9 percent), average inflation rose sharply (9.3 percent) and the external current account balance turned into deficit (-1.4 percent of GDP)

Coinciding with these developments, the fiscal module started to show signs of stress as the fiscal balance was converted into a deficit and the stock of external debt and liabilities, which had been declining since FY00 after the Paris Club rescheduling, began increasing. These indicators largely capture the high and growing aggregate demand in the economy on account of sustained increase in peoples' income.

With the emerging domestic and global price pressures, SBP tightened its monetary policy after a prolonged gap of a few years. The efforts to rein-in inflation, however, proved less effective due to a rebound in international commodity prices and a rise in domestic food prices later on.

The rise in the international commodity prices, particularly oil, exacerbated the fight against inflation. The international oil prices (Arabian Light) rose from US$27.1 at end 2004 to US$50.9 at end 2006, whereas international food prices rose by 24, 24 and 21 percent during 2004, 2005 and 2006 respectively.

Realising the complications of monetary management and adverse global and domestic economic developments, the implementation of SBP monetary policy during FY06 varied significantly from the preceding fiscal years. In addition to the rise in the policy rate, the central bank focused on the short-end of the yield curve, draining excess liquidity from the interbank money market and pushing up short-tenor rates.

Consequently, not only did the overnight rates remain close to the discount rate through most of the year, the volatility in these rates also declined. These tight monetary conditions along with the Government's administrative measures to control food inflation helped in scaling down average inflation from 9.3 percent in FY05 to 7.9 percent in FY06, within the 8.0 percent annual target.

This was certainly an encouraging development, particularly as if was achieved without affecting economic growth as the real GDP growth remained strong at 6.6 percent in FY06.

MONETARY POLICY TIGHTENING WAS STRENGTHENED FURTHER

For FY07, the government set an inflation target of 6.5 percent. To achieve this, a further moderation in aggregate demand during FY07 was required as the core inflation witnessed a relatively smaller decline in FY06, indicating that demand-side inflationary pressures were strong.

In this perspective, SBP further tightened its monetary policy in July 2006 raising the CRR and SLR for the scheduled banks; and its policy rate by 50 basis points (bps) to 9.5 percent. Moreover, proactive liquidity management helped in transmitting the monetary tightening signals to key interest rates in the economy.

For instance, the Karachi Inter Bank Offer Rate (KIBOR) of 6 months tenor increased from 9.6 percent in June 2006 to 10.02 percent at end-June 2007 and the banks' weighted average lending and deposits rates (on outstanding amount) increased by 0.93 percentage points and 1.1 percentage points, respectively, during FY07.

In retrospect, it appears evident that monetary tightening in FY07 did not put any adverse impact on economic growth, as not only was the real GDP growth target of 7.0 percent for FY07 was met, the growth was quite broad based. At the same time, the impact of the monetary tightening was most evident in the continued deceleration in core inflation during FY07.

One measure of core inflation, the non-food non-energy CPI, continued its downtrend from YoY high of 7.8 percent in October 2005, to 6.3 percent at end-FY06, and to 5.1 percent by the end of FY07. However, much of the gains from the tight monetary policy on overall CPI inflation were offset by the unexpected rise in food inflation.

On the downside, however, broad money supply (M2) grew by 19.3 percent during FY07, exceeding the annual target by 5.8 percentage points. Slippages in money supply growth largely stemmed from an expansion in NFA due to the higher than expected foreign exchange inflows. Equally stressful was the impact of Government borrowings from the central bank during the course of the year. The pressure from the fiscal account was due to mismatch in its external budgetary inflows and expenditures.

With the privatisation inflows and the receipts from a sovereign debt offering at end-FY07, the Government managed to end the year with retirement of central bank borrowings, on the margin. By end-FYO7, SBP holdings of government papers were still around Rs 452 billion, despite a net retirement of Rs 56.0 billion during the year.

Another major aberration in FY07 emanated from the high level of SBP refinancing extended, for both working capital and long-term investment, to exporters. Aside from monetary management complexities, these schemes have been distorting the incentive structure in the economy.

FY08 AND BEGINNING OF FY09 WAS EVEN MORE CHALLENGING

FY08 was an exceptionally difficult year. The domestic macroeconomic and political vulnerabilities coupled with a very challenging global environment caused slippages in macroeconomic targets by a wide margin.

AFTER A RELATIVELY LONG PERIOD OF MACROECONOMIC STABILITY AND PROSPERITY, THE GLOBAL ECONOMY FACED MULTIFARIOUS CHALLENGES:(i) hit by the sub prime mortgage crisis in U.S in 2007, the international financial markets had been in turmoil, the impact of which was felt across markets and continents; (ii) rising global commodity prices, with crude oil and food staples prices skyrocketing; and (iii) a gradual slide in the U.S dollar against major currencies.

Combination of these events induced a degree of recessionary tendencies and inflationary pressures across developed and developing countries. Policy-makers were gripped with the dual challenge of slowdown in growth and unprecedented rising inflationary pressures. Central bankers faced a demanding task of weighing the trade-off between growth and price stability.

With the exception of few developed countries, most central banks showed a strong bias towards addressing the risk of inflation and responded with tightening of monetary policies. On the domestic front, the external current account deficit and fiscal deficit widened considerably to unsustainable level (8.4 and 7.4 percent of GDP).

The subsidy payments worth Rs 407 billion by Government, which account for almost half of the fiscal deficit, shielded domestic consumers from high international POL and commodity prices and distorted the natural demand adjustment mechanism. While the government passed on price increase to consumers, the rising international oil and other importable prices continued to take a toll on the economy.

Rising demand has cost the country dearly in terms of foreign exchange spent on importing large volumes of these commodities. Rising fiscal deficit and lower than required financing flows resulted in exceptional recourse of the Government to the highly inflationary central bank borrowing for financing deficit. At the same time the surge in imports persisted.

As a result, inflation accelerated and its expectations strengthened due to pass through of international oil prices to the domestic market, increases in the electricity tariff and the general sales tax, and rising exchange rate depreciation. These developments resulted in a further rise in headline as well as core inflation (20 percent weighted trimmed measure) to 25 percent and 21.7 percent respectively in October 2008.

Considering the size of macroeconomic imbalances and the emerging inflationary pressures, SBP remained committed to achieve price stability over the medium term and thus had to launch steeper monetary tightening to tame the demand pressures and restore macroeconomic stability in FY09. SBP thus increased the policy rate from 13.5 to 15 percent.

WHAT NEEDS TO BE DONE TO IMPROVE THE EFFECTIVENESS OF MONETARY POLICY?

Apart from taking policy measures to address the emerging challenges, SBP also introduced structural changes in the process of monetary policy formulation and conduct to make the monetary policy formulation and implementation more transparent, efficient, and effective. Specifically, during the last couple of years, SBP focused on

Institutionalising the process of policy formulation and conduct,

Stepping up movement towards a more market based credit allocation mechanism,

Developing its analytical and operational capacity,

Improving its capabilities to assess future developments to act proactively, and

Improving upon the communication of policy stance to the general public.

However, the following areas need attention and are key for effective monetary management.

1. Effectiveness of monetary and fiscal co-ordination would be helpful. Section 9A and 9B of the SBP Act (amended in 1994) articulates the institutional mechanism for economic policy making and co-ordination and defines the ground rules for both the process and the policy making. However, the track record of the Monetary and Fiscal Policies Co-ordination Board (MFPCB), established in February 1994 that requires quarterly meetings of the SBP and the government, has been less than satisfactory.

urthermore, the sequencing of economy-wide projections is done in isolation of the budget and monetary policy making process, and the budget making process has not respected the monetary compulsions. With rising spending and stagnating revenues, the budget assumes at the start of the year certain recourse to the central bank rather than treat it as mere ways and means advances.

2. For effective analysis of developments and policy making, timely and quality information is extremely important. However, due to weaknesses in the data collection and reporting mechanism of the various agencies of the country, information is not available with desired frequency and timeliness. Also there are concerns over the quality of data. Unlike many developed and developing countries, data on quarterly GDP, employment and wages, etc is not available in case of Pakistan.

Moreover, the data on key macroeconomic variables (such as government expenditure and revenue, output of large-scale manufacturing, crop estimates, etc) is usually available with substantial lags. This constrains an in-depth analysis of the current economic situation and evolving trends, and hinders the ability of the SBP to develop a forward-looking policy stance.

3. Unlike many countries, both developed and developing, there is no prescribed limit On government borrowing from SBP defined in the SBP Act or the Fiscal Responsibility and Debt Limitation (FRDL) Act 2005. Besides being highly inflationary, government borrowing from SBP also complicates liquidity management.

Borrowing from the central bank injects liquidity in the system through increased currency in circulation and deposits of the government with the banks. In both cases, the impact of tight monetary stance is diluted as this automatic creation of money increases money supply without any prior notice. Moreover, access to potentially unlimited borrowings from the SBP provides little incentives to the government to put the fiscal accounts in order.

Therefore, the foremost task to improve the effectiveness of monetary policy is to prohibit the practice of government borrowings from the SBP. In this regard, appropriate provisions are required to cease or limit government recourse to central bank financing through amendments in the SBP Act and the FRDL Act 2005.

4. Another issue is to make a clear distinction between exchange rate management and monetary management. Currently, there is a general perception that the State Bank is bound to keep the exchange rate at some predefined level and any movement away from this level is then considered as an inefficiency of the SBP.

There is a need to understand that for an open economy, it is impossible to pursue an independent monetary and exchange rate policy as well as allowing capital to move freely across the border. Since the SBP endeavours to achieve price stability through achieving monetary targets by changes in the policy rate, it is not possible to maintain exchange rates at some level with free capital mobility.

This can only be achieved by putting complete restrictions on capital movements, which is not possible. SBP's responsibility is to ensure an environment where foreign exchange flows are driven by economic fundamental and are not misguided by rent seeking speculation. 5. Finally, based on experience particularly gained during the last two months is to differentiate between liquidity management and monetary policy stance.

Recently, when the banking system experienced extraordinary stress due to shallow liquidity in the system, rumour mongering heightened the general public anxiety over few banks' sustainability. Consequently, the SBP had to intervene in the market by injecting ample liquidity through various measures. In some quarters, these changes were deemed as a change in the bank's tight monetary policy stance.

However, this was not the case and the bank had to clearly and repeatedly communicate that the existing stance is being continued. Later on, the bank further tightened its monetary policy. It must be understood that quite often, liquidity management can drive the market interest rates away from the direction desired under the monetary policy stance. However, this has to be temporary and 'the interest rates are bound to move in the policy stance direction.

To resolve this issue, the SBP is studying various options, including the introduction of a "Standing Deposit Facility" to keep the interbank rate within a corridor.

In conclusion, it is imperative that above steps be taken urgently. Over the period, however, this needs to be complemented with much deeper structural reforms to synchronise and reform the medium term planning for the budget and monetary policy formulation process Several studies and technical assistance have provided extensive guidance in this area, but the lack of capacities and short term compulsions have often withheld such reforms.

What is important is to recognise that a medium term development strategy, independently worked out, would help minimise one agency interest which has often been a source of co-ordination difficulties. It would also help the budget making process more rule based than the incrementally driven process to satisfy conflicting demands.

Monetary policy and inflation: MAKING the half-yearly monetary policy statement, State Bank Governor Shamshad Akhtar told a press conference last Thursday that the central bank will maintain its (tight) monetary policy stance while effective administrative measures are needed to control food prices.The SBP appears to be saying it has done as much as it can to control inflation and it is now up to the government to take corrective measures on the administrative or supply-side to bring down food price inflation that has led to Pakistans overall inflation rate to accelerate to a twelve-month high of 8.9 per cent in December. The Governor left the benchmark policy rate (3-day Repo Rate) unchanged at 9.5 per cent.The monetary policy statement of the State Bank of Pakistan (SBP) makes two other important points: (a) inflation remains stubbornly high and is likely to exceed the 6.5 per cent target for the current fiscal year, and (b) the monetary policy continues to be supportive of the economic growth as threshold level of inflation for a stable economic growth. in the range of 4-6 per cent..The assertion that Pakistan, being a developing country, needs a high inflation rate (6 per cent or so) to support a 6-8 per cent GDP growth is seriously questionable and is not supported by hard evidence from the most recent comparable GDP growth and inflation data of some major emerging markets. Pakistan stands out with the highest inflation rate and the only country in the group whose inflation rate (8.9 per cent) is more than its GDP growth rate (6.6 per cent). This suggests that either there is something so unique about the structure of Pakistans economy that the divergence of its GDP growth and inflation data from the norm of even other developing and oil importing countries (leave aside those of the developed markets) has a valid and legitimate reason or the data itself is questionable.However, even if we take data at its face value, the graph shows that most of these developing countries are growing at around six per cent or more while their inflation rate is around four per cent or thereabouts. The only exception is India whose inflation rate is 6.7 per cent but then its current GDP growth rate of 9.2 per cent is also significantly higher than Pakistans 6.6 per cent. The monetary policy statement does acknowledge that the inflation is relatively higher compared to its competitors and trading partners and this higher domestic inflation has offset the gains emanating from nominal depreciation of the rupee against other currencies. Is it making a case for an accelerated depreciation of rupee in the coming months because the monetary policy has failed to achieve the inflation target?When most of major developing countries are recording healthy GDP growth while keeping overall inflation (this includes food and energy inflation) under five per cent, should not the government set five per cent inflation rate as target for the next fiscal year? This assumes additional significance aside from domestic economy and political considerations in an election year since the relatively higher inflation is hurting competitiveness and exports growth instead of supporting the declared policy objective of encouraging economic growth.Still, it is fair to say that the SBP, primarily through open market operations and changes in the reserve ratios, has managed to bring down the overall growth rate in the private sector borrowings. Based on the monthly average loans outstanding of the scheduled banks, the loan growth during the six months to December 2006 was 14.5 per cent compared to 25.3 per cent growth during the previous year.However, the impact of the overall tightening in the credit supply has been somewhat diluted by a Rs34.7 billion increase in loans under Long-term Financing for Export Oriented Projects (LTF-EOP) and R26.8 billion increase in loans under Export Finance Scheme (EFS), both offered at concessional or reduced rates.The combined increase in loans under these financing schemes accounted for 54 per cent of the Reserve Money (M0) growth during the first half of the current fiscal year. Although there may be legitimate reasons for offering export financing at concessional rates, the reports about the abuse of such facilities abound with money being diverted to real estate and stock market investments. Such schemes can offset the benefits of a monetary tightening and derail the progress made in since late 2004. Given their large proportion in overall money supply growth, it is fair to argue that their rapid build-up may have adverse effects on the core function of the monetary policy, that is, achieving low inflation in the next 12-18 months.Notwithstanding this, the impact of the monetary tightening is visible in rising interest rates and a deceleration in the principal indicator of the money supply, that is M2, during the first six months of FY2006-07. The three-month Karachi interbank offered rate (KIBOR) averaged 10.39 per cent during December 2006 compared to 8.98 per cent during January 2006. While raising interest rates is a perfectly legitimate response to building inflationary expectations, there is an other side to it.If real interest rates, that is, nominal interest rates minus inflation, are higher compared to a countrys competitors, they can hurt growth, particularly exports. Some policy makers argue that the local businesses and industrialists should not just look at the lower nominal interest rates in India because Pakistans inflation rate is higher. Simple enough, but a comparison of the real interest rates between Pakistan and India reveals a somewhat different and more complex picture.Graph 2 shows real interest rates in Pakistan and India. The monthly averages of 3-month KIBOR and 3-month MIBOR (Mumbai interbank offered rate) and monthly inflation (CPI) rates were used to calculate the real rates. The graph shows the real interest rates in Pakistan have stayed generally higher during 2006 compared to Indias. Although it is difficult to quantify the impact, higher real interest rates do contribute to higher cost of production and hurt international competitiveness.Moreover, the data has some difficult implications from a monetary policy standpoint. The real interest rates in Pakistan depict a declining trend since mid-2006 while those in India show an upward trend.Declining real interest rates can portend a higher inflationary environment 18 months down the road, as monetary tightening takes at least that long to make a dent in inflation. Here, it is relevant to note that the SBPs last Thursday statement starts with a rather bold assertion that monetary policy measures adopted in July 2006 augmented earlier tightening and reduced core inflation (Non-Food Non-Energy NFNE) to 5.5 per cent by December 2006 from 7.4 per cent a year earlier.Given the widely accepted view, acknowledged even by the SBP Governor, that monetary policy takes 18 months or so to impact inflation rate; it is not clear how the July tightening has caused headline inflation to drop in just 6 months? While this may be excused as a statement made more for public consumption rather than on a serious note, more important issue is the recent and growing trend of emphasising core inflation as opposed to overall inflation that includes food inflation. Maybe it is just a better number to talk about because it looks good.On the other hand, one may argue that core inflation is also followed closely in the developed economies such as the United States. However, there is a major difference between Pakistans inflation (CPI) measure and those of the developed world. Food inflation is the single largest component of Pakistans CPI and constitutes 40 per cent of this index compared to only 17 per cent or so in the U.S. and some other developed markets.Together with energy, food inflation accounts for almost 48 per cent of the CPI or overall inflation in Pakistan. Therefore, in Pakistans context, core inflation (that is, Non-Food Non Energy inflation) is not as meaningful a measure as in some other developed countries. While supply-side factors do play a role in inflation, this should not detract the central bankers from targeting the overall inflation rate as the primary focus of the monetary policy. Monetary tools, such as margin requirements, do play a role in commodity financing and should be used appropriately to respond to the financing needs of essential items.Moreover, while financial deregulation and innovation have made the money supply harder to interpret in the developed markets, domestic money supply control can be a relatively more effective tool of monetary policy in economies like Pakistan where private sector access to foreign borrowing and markets is fairly limited. The fact that a large sector of the economy is undocumented has little to do with the effect of money supply growth on inflation as has been well established in high inflation developing countries like Brazil and Turkey.The SBP maintains it is capable of skilful management of the often difficult and complex objectives of meeting national growth priorities, liquidity and demand management, and controlling inflation. As central bankers around the world know too well from history, it is difficult to manage just one goal low inflation let alone many.Given the propensity of the borrowers in Pakistan to abuse concessional credits and the difficulties in managing multiple and some times conflicting near-term policy objectives, the SBP will be better off to make achieving an inflation rate of five per cent or less as its core target for next 12-18 months. That by itself will facilitate growth and price stability. Failure to achieve low inflation will hurt growth and exports down the road as monetary policy mistakes can take up to 18-24 months to show up in even higher inflation numbers. But by then, elections will be over.

Freeing the state bank:If there is one thing that the current government will strive at all costs to retain, it is control over the State Bank of Pakistan (SBP). And if there is one thing that the International Monetary Fund wants, it is to wrest control of the SBP from political control and create a truly independent entity. To that end, the IMF has dropped the hammer on the federal government and given it two months to get its financial house in order bygiving complete autonomy to the SBP. This is a move that was neither sudden nor unexpected and the government had been ducking and diving on this issue virtually since it took office.

The federal government had proposed an amendment billwhich sought to satisfy the IMF condition of autonomy for the SBP, but the IMF was not satisfied with the proposed amendments that fell far short of what it sought and had a number of structural weaknesses, particularly in relation to autonomy the very thing that the IMF was seeking and the federal government was hoping to avoid. The government is keen to retain control of the SBP because it allows what amounts to interest-free borrowing, the proverbial licence to print money. As things stand, the SBP is subservient to the federal government, and has weak internal governance and controls.The government would be wise to accede to the requirements of the IMF. The devolution of control has been an issue for many years and successive governments have resisted granting autonomy to the SBP simply because it is an immediately accessible source of ready cash in a cash-strapped economy. The IMF favoursthe government borrowingfrom private banks which have rather more stringent terms of business than does an enfeebled SBP. Borrowing in the private sector is also likely to result in greater transparency, something that Pakistans governments are perennially averse to. The federal government now has till the end of August to demonstrate compliance a tight time frame. Our financial managers cannot dodge and weave forever and this looks like the end of this particular road. An independent SBP is maybe not a distant dream after all.

Parliament giveth with one hand and taketh away with the other. Or so it seems from the comments made by members of the parliamentary committee on finance, who two weeks back criticised the State Bank of Pakistan (SBP) for tightening monetary policy. It is somewhat comical that the same legislature that has only this past week taken active measures to curb a loose fiscal policy are now complaining about a monetary policy that is too tight. A parliamentary panel passed a bill last week that would restrict government borrowing from the central bank and would enhance the ability of the SBP to control monetary policy. This action would suggest that they agree with the SBPs central diagnosis that the administrations fiscal policy is flawed and needs to be institutionally kept in check. But on the same day, they decide to criticise the SBP for acting against that very same flawed fiscal policy and moving to protect the integrity of the rupees value. There is an inherent contradiction in those two acts and one that the members of the committee would do well to try and understand.We believe that the SBP was right in its diagnosis of the governments fiscal policy as being overly optimistic. We also believe that the central bank has, first and foremost, a mandate to curb inflation. There are both monetary and fiscal means to do that, though the SBP only controls the former and the finance ministry controls the latter. In this tug of war between the finance ministry and the SBP, the central bank is clearly the more responsible actor. We commend the parliamentary committees approval of proposals to strengthen the central banks independence. But they must understand that the SBPs job, while often unpopular, is necessary. Legislators would serve the country well by not second-guessing a policy that they clearly seem to agree with.