Choice between a Hawk and a Dove

Global Misperceptions

Dr. Muhammad Shahid

Monetary Policy Committee of the State Bank of Pakistan has increased the policy rate by 300 basis points to 20 percent. State Bank, in its earlier monetary policy statements had highlighted near-term risks to the inflation outlook from external and fiscal adjustments. Most of these risks have materialized and are partially reflected in the inflation outturns for February. The latest monetary policy statement indicates that inflation has surged to 31.5 percent on year on year basis, while core inflation rose to 17.1 percent in urban and 21.5 percent in rural basket in February 2023.

SBP in its monetary policy statement revealed that recent fiscal adjustments and exchange rate depreciation have led to a significant deterioration in the near term inflation outlook and a further upward drift in inflation expectations. SBP is expecting further surge in inflation in the months ahead. The impact of these adjustments would contribute and rise inflation before it begins to fall.

Why there is so much deviation in the inflation forecast? Several recent reports have shown inflation accelerated more than forecasts made in the previous month. The average inflation this year is now expected in the range of 27 and 29 percent against the November 2022 projection of 21 and 23 percent. The deviation of inflation from the forecasts strikingly illustrates the intersection of multiple factors including politics, economics, and other considerations. Policymakers with eyes on the next election find it difficult to offer political capital, invest the time, and energies to address the abstract possibility of a future crisis.

Keeping in perspective the high inflationary pressure, the monetary policy committee emphasized that anchoring inflation expectations is critical. We need to increase interest rate because anchoring inflation expectations warrants a strong policy response. But at the same time, we also need to understand the difficult politics of cooperation between fiscal and monetary policy because the lack of cooperation makes everyone worse off.The policy response to internal and external vulnerabilities has continued to be tempered by political realities. Furthermore, policymakers are under intense pressure from their constituents.

Every government faces tough decisions to have appropriate policy responses in addressing the complex nature of economic problems including inflation and slow growth.Significant improvement has been observed on the external side in response to the policy decisions. In January 2023, the current account deficit fell to 242 million dollars, the lowest level since March 2021. Cumulatively, the current account deficit remained at 3.8 billion dollar in Jul-Jan FY23 which is 67 percent down compared to the same period last year. However, the uncertain environment at the global level and the declining reserves pose additional risks. We know that despite a substantial reduction in the current account deficit, vulnerabilities continue to persist. The accumulation of domestic and external vulnerabilities, scheduled debt repayments and a decline in financial inflows amid rising global interest rates and domestic uncertainties, continue to exert pressure on foreign exchange reserves and the exchange rate. These vulnerabilities pose a significant threat to improvement in the current account deficit.

The monetary policy committee of the SBP is of the view that coordinated and concerted efforts are needed to arrest the decline in foreign exchange reserves. The MPC noted that foreign reserves remain low and concerted efforts are needed to improve the external position. Finalization of talks with IMF will help address near-term external sector challenges. Furthermore, the monetary policy statement indicates that measures for energy conservation are urgently needed. This will allow the government to alleviate pressure on the external account and meet the import requirements of other sectors.

The introduction of additional revenue measures in the form of mini budget including an increase in GST and excise duties, reduction in subsidies, adjustments in energy prices, and the austerity driveare expected to help contain the otherwise widening fiscal and primary deficits. These fiscal consolidation measures are critical for economic stability and will complement the ongoing monetary tightening in bringing down inflation over the medium-term. The absence of fiscal consolidation and any significant fiscal slippages will undermine monetary policy effectiveness in the context of achieving the price stability objective.

How State Bank of Pakistan can get inflation back to target without generating a significant slowdown in the economy? The recent upward push to the policy rate has led to the debate over the effectiveness of monetary policy. People in SBP are becoming more hawkish and are assigning higher weight to inflation, focussed on increased interest rates while killing growth. SBP is of the view that the short-term costs of bringing down inflation are lower than the long-term costs of allowing it to become more entrenched.

The debate between beating inflation and avoiding job losses is crucial for understanding the political economy of monetary policy. SBP declares itself independent of politics, but it’s getting harder to stay completely separated from the political influence. The prevailing inflation suggests that interest rates will need to increase further and stay elevated into next year to curb inflation which is showing few signs of abating. But what are then the implications for growth, employment and poverty.

Inflation above 30 percent forced SBP officials to be laser-focused on bringing down inflation in the economy. I agree, somehow, with the argument that it takes a while for monetary tightening to really work and arrest inflation but this jumbo-sized 300 basis point hikes in one go is a source of great concern. The hawkish SBP approach will not allow tighter policy to filter through the economy and bring any balance between aggregate supply and aggregate demand and thus will not lower inflation. Inflation will come down with an ease of the global commodity price and improvement in supply chain. We can only make a request to the member of the monetary policy committee to vote for the smaller raise in policy rate at the time of announcing monetary policy.

The author has a PhD Degree in Economics from PIDE and has 17 years’ experience as a journalist in economic reporting. He also teaches Public Policy, Governance, Poverty andDevelopment, Gender and Political Economy.