It is plausibly argued that a central bank's principal activity is formulation of monetary policy, which should be broadly aimed at controlling money supply and credit conditions for the purpose of achieving certain economic objectives such as price stability, increased economic growth, stable exchange rate and soundness in the financial sector. Arguably, Pakistan's monetary policy has lost a lot of its gloss due to permanent high fiscal deficit forcing the State Bank of Pakistan to lend directly to the government and also undertake money injections through open market operations (OMOs) to help banks purchase government securities and lubricate the system by providing the markets with required liquidity.
As a consequence, the rise in money supply is way above the nominal growth. The resulting monetary overhang persisted, it has never been corrected in the last five years; nor is there any hope this year. On Friday August 10, 2012, the SBP Governor will issue a monetary policy statement which will provide reasoning for a change in the policy rate, if any, and an insightful commentary on the state of economy. While government borrowing is not interest-rate sensitive; private sector borrowing is! As a consequence the local businesses have all along been pressing SBP to slash its policy rate as they feel that inflation is due to supply-side shortages emanating from a slow rise in GDP compared to the faster pace of demand emanating from population growth. Private sector borrowers feel SBP has an opportunity to slash its policy rate by at least 200 basis points mainly because of 31-month low (9.6 percent) CPI for July. But one needs to go into more depth to ascertain the reasons behind the CPI drop. Is it due to a recent cut in gas and petroleum retail prices which are, incidentally, on the rise once again? CPI captures data of first two weeks in a month.
As such, July figures have not taken into account the rise in Ramazan food prices. If one is to look into core inflation figures, ie non-food/non-energy or trimmed inflation, these are still in double digits for July 2012. NFNE is 11.3 while trimmed is 10.7. NFNE and trimmed are classified as 'core' inflation. By its very definition - volatility is removed, therefore core inflation is never volatile. The reason for an upward trend could be due to recent downward adjustment of the rupee. However, inflation is still 'sticky' despite the fact that inflationary expectations may have softened with the release of Coalition Support Fund and prospects of other expected external inflows have somewhat brightened.
For an energy-deficient country like Pakistan, the key variable which will determine both inflation and balance of payment (BoP) position would be the international price of oil and deficit POL products imported to meet the power and transport needs. Even a five-dollar price change has a significant impact ($600m to $700m) when around 35 percent of country's import bill is on account of POL. And another important variable is food prices as they carry a weight of 34.83 percent in the CPI basket. Drought in India in three years - one of the world's largest producers and consumers - will definitely have a direct bearing on us while drought in the US will have severe repercussion on international food prices. However, one needs to concede that damage caused by flood and rainwater to crops and storage (seen in the last two years in Pakistan) is of immediate consequence while drought as a long period of abnormally low rainfall causes a gradual impact. Both wholesale and retail prices of food have transportation cost as an important component which brings us back to the likely price of oil between now and June 2013. Will it be between $90 and $100 range or more, ie, $100 to $110? Pakistan can benefit hugely if oil drops below $90; it will face a huge pressure if this key commodity averages above $110 a barrel. Protracted economic slowdown in Europe and North America could lower oil prices, while the ongoing turmoil in Syria spilling across its borders could spike oil prices. Although, inflation is an important factor in determining policy rate because it is widely agreed that Monetary Policy can contribute to sustainable growth by maintaining price stability, the weight it gets varies from situation to situation. At times, external sector is given more weight than domestic inflationary expectations. Causes of inflation have to be carefully ascertained; it needs to be examined or probed whether they emanate from supply-side shortages or demand-side. Is anaemic rise in GDP due to persistent electricity and gas shortages or other factors such as the high cost of borrowing? But one thing is very clear: growth in private sector credit is 'flat'. This may be due to crowding-out effect of high government borrowing or little to no appetite in private sector on account of protracted energy shortages or both. It may also be due to banks' overt reluctance to lend to the private sector in an environment of higher risk. The bottom line, however, is that the private sector is getting nothing from the banks. Investment is down while unemployment is up. Political uncertainty due to judiciary-government stand-off has not helped either. With general election to be held within this fiscal year both the businesses as well as the incumbent government are looking for a deep cut in the key policy discount rate. A 50 to 100 bps cut will be seen as a soft option. A higher cut (in one go) may be riskier but could be more helpful in terms of lowering government debt servicing cost and reducing pressure on the budget. Though, a deep cut in interest rate will stoke inflation, it will spur growth. The situation brings to mind the famous remarks of Helmut Schmidt, who served as Chancellor of the then West Germany from 1974 to 1982. According to him, 'five percent inflation is easier to bear than five percent unemployment'.
