In Pakistan, The Policy Interest Rate Is Ineffective In Containing Inflation

In the 1970s, economists believed in unabashed monetarism, which espouses the notion that inflation was primarily caused by too much money chasing too few goods in the economy. They contended that the only way to control inflation was to keep the economy's money supply under control. Following the same neoclassical convention and theoretical rationale, the State Bank of Pakistan (SBP) has been raising the policy interest rate on a regular basis to limit the supply of money and control inflation expectations.

During the past year, from March 2022 to March 2023, the interest rate has increased from 11.37% to 20%, representing a substantial increase of 75.9%. However, inflation during the same period soared from 12.70% to 31.5% or a staggering 148%.  Like the previous year, Pakistan has left behind all regional countries and peer economies by introducing a phenomenal increase in interest rates.

Despite a significant rise in interest rates, inflation remains stubbornly high, which raises the question of the effectiveness of monetary policy in taming inflation.

Firstly, raising the interest rate may not be an effective policy measure to control inflation, since the current inflation is largely being caused by global supply chain shocks. Covid-19 has disrupted global supply chains and the market equilibrium, which is further exacerbated by recent sanctions on Russia, a major energy and agricultural producer, leading to a further shortage of goods for consumers. Therefore, the inflation we are experiencing currently is cost-push inflation, and monetary policy is not an appropriate way to cope with this kind of price surge.

Secondly, imported inflation is another factor fueling rises in prices. Throughout the preceding decade or so, the government's heavy borrowing from commercial banks, as well as international lending agencies have been placing pressure on our external sector, leading to the depletion of foreign currency reserves, and further devaluation of the rupee. As a result, even though energy prices have remained relatively stable on the world market in recent months, the devalued rupee relative to the US dollar has made the same volume of petroleum is now more expensive, triggering inflation.

Thirdly, Pakistan’s informal economy, which makes up 40% of the country’s regulated economy, raises concerns about the effectiveness of the policy rate. Moreover, Pakistan's economy is very tenuously tied to the financial sector, with just 7% of businesses accessing funds via conventional credit lending institutions. This is far lower than comparable countries like India (21%), China (25%), and Bangladesh (34%).

The ineffectiveness of policy rates in achieving economic stability has serious repercussions for the government of Pakistan, which is a significant borrower from commercial banks. The bulk of interest payments is made on a floating rate. The government's interest payments for the fiscal year 2022-23 were initially estimated to be Rs 3,950 billion. Nevertheless, interest rates have lately been drastically hiked, and payments at the current 20% interest rate have risen to Rs. 5,400 billion, accounting for 56.8% of government expenditure for the current fiscal year. The interest rate may increase further to anchor inflation expectations, which may exacerbate government expenditures via higher interest payments. As a corollary, additional taxes are projected to be levied in order to make budgetary adjustments, which would further exacerbate inflation. The country will stay locked in a vicious spiral until fundamental structural reforms are implemented.

The rescheduling of the State Banks’ Monitory Policy Committee (MPC) meeting to meet the IMF conditionality raises serious concerns about the sovereignty of the State Bank of Pakistan and its ability to make independent decisions per the requirements of Pakistan’s economy. Additionally, in the MPC statement, the next policy meeting is scheduled to be held on April 4^th, 2023, and due to prevailing inflationary pressure, a further hike in interest rate is predicted.

The current policy rate of 20%, with the corresponding KIBOR rate ranging from 22% to 23%, poses a significant challenge for businessmen to generate at least a profit of 25%. Several sectors that import raw materials for production will face significantly increased costs as a consequence of tighter monetary policy and currency depreciation. The price effect will be passed on to the general public, and rising inflation is envisaged.

In the short term, the government must focus on regulating prices and improving governance. Surprisingly, food inflation which is a major contributor to the consumer price index is higher in rural areas as compared to urban areas despite the former being source regions for food.  Improved governance and market regulation by checking on hoarding, artificial supply shocks, and cross-border smuggling can potentially bring down the volatility in the goods markets, and hence can offer some relief to desperate masses.

Pakistan is expecting financial aid from friendly countries, which will relieve strain on the foreign account. Key products are awaiting clearance at ports, and it will require between $4 and $5 billion to import trade-related commodities. Acquiring funding from friendly nations will increase food stores and necessary supplies, and hence reduce inflation.