Pakistan’s central bank must act ahead to curb inflation
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Rising inflation, which until recently was under control in major developed economies, has become a cause for concern for central bankers globally. A US Federal Reserve Board of Governors member, Lael Brainard, has stated “Inflation is too high, and working people around the country are concerned how far their paychecks will go,” and added that bringing inflation back to 2 percent from a 40-year high of 7 percent in the US “is the most important task.” In Pakistan, the sentiment was echoed by the State Bank of Pakistan (SBP) Governor, Reza Baqr, who considers curbing inflation one of the key challenges facing the economy.
As reported by the Pakistan Bureau of Statistics, the Consumer Price Index jumped to 12.96 percent in January year on year, making it the highest in nearly two years. Sharply increasing prices of important essentials, including food, not only takes a toll on the purchasing power of consumers, especially the most indigent sections of society, but also inhibits economic growth prospects. High inflation rate and increased volatility negatively impacts the level of confidence in profitability individuals and businesses can expect from investments, which in turn dampens risk taking appetite of investors, and therefore, economic activity.
Although a large part of the recent rise in inflationary pressure can be attributed to expansionary monetary policies and huge fiscal stimulus adopted by developed economies in response to the Covid-19 pandemic, the domestic price volatility is also due to the pro-cyclical stimulus adopted by the government in order to boost growth. Much like developed economy central banks appear to have misread early signs of inflationary pressures building up in the system, and treated upward spikes in prices as transitory, the SBP was also slow in taking corrective measures to curb demand. The delayed response helped bolster inflation expectations, which SBP must now ensure is not entrenched.
This is especially pertinent now that SBP has been granted autonomy by the parliament with the primary mandate of inflation targeting – a necessary step in enabling the central bank to independently conduct monetary policy. This should ensure that fiscal policy considerations do not dictate monetary policy. While it must be emphasized that the central bank is owned by and accountable to the government of Pakistan, SBP can now independently determine the instruments it chooses to apply to achieve the inflation target.
If SBP succeeds in delivering price stability and anchoring inflation expectations, it will not only alleviate the hardships of the poor, but also boost business confidence and long-term economic growth prospects.
Javed Hassan
It is incumbent on the central bank to establish its credibility by taking bold steps and raising policy interest rates ahead of the curve if it is to avoid having to take difficult corrective measures in the future. It must clearly signal its monetary policy framework of “inflation targeting” that demonstrates its ability and will to combat inflation decisively. In order to do so, the central bank will need to have the requisite expertise and methodology to forecast with a high degree of confidence the future path of inflation that will guide the monetary policy adjustments to hit the target.
Most countries, including developing economies, have set inflation targets in the low single digits, and there is little reason for Pakistan not to follow suit and set a target lower than the historical average inflation rate of 7.85 percent. Those countries that have adopted inflation targeting have generally succeeded in anchoring lower inflation rates than the historical average. It is vital that precise numerical targets for inflation for a specific number of periods ahead is set and these markers inform monetary policy decisions. Not only must the medium-term inflation target be unambiguously communicated to the public, the central bank must be held accountable for meeting it.
Although inflation targeting does not require hitting the target at all times and most central banks achieve the target over a two to three-year horizon, given its recent history of high inflation and volatility, SBP should avoid allowing for above-target inflation other than for very short periods in the event of external shocks. Monetary policy adjustments taken by SBP that account for forward estimates of inflation have to be accompanied by prudent fiscal policies by the government to clearly signal to markets that all arms of the state are acting in lockstep. These measures will help the central bank avoid having to tighten conditions more sharply to reverse inflation expectations than would be necessary if fiscal discipline were perceived to be missing.
Empirical evidence from countries where central banks have adopted inflation targeting, including those in developing economies, indicates that it has been more effective in delivering low inflation and lowering inflation volatility than alternative monetary policy frameworks. Moreover, these have been achieved without adversely impacting long-term economic growth. If SBP similarly succeeds in delivering price stability and anchoring inflation expectations, it will not only alleviate the hardships the poor people in the country are facing, but also boost business confidence and long-term economic growth prospects.
- Javed Hassan has worked in senior executive positions both in the profit and non-profit sector in Pakistan and internationally. He’s an investment banker by training.
Twitter: @javedhassan
