Monetary policy and growth

The monetary policy is a key element of macroeconomic management and its effectiveness is an important issue in economic policy analysis.

In the context of Pakistan, monetary policy management is one of the primary roles of the State Bank of Pakistan (SBP). In line with SBP Act, the monetary policy has to be supportive of the dual objective of promoting economic growth and price stability. The SBP conducts monetary policy by using money supply (M2) as an intermediate target. The SBP uses short-term interest rate as an instrument of monetary policy to control inflation. It pursues a monetary target regime with broad money supply (M2) as a nominal anchor to achieve the objective of price stability.

The SBP also sets a target of M2 growth in line with the government’s targets of inflation and growth. This framework is based on two key 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.

In its meeting on November 22, 2019, the Monetary Policy Committee (MPC) of the State Bank decided to leave the policy rate unchanged at 13.25 percent for the next two months because of obstinately high inflation caused by increases in food prices.

According to the SBP projection, average inflation for FY20 remained broadly unchanged at 11-12 percent. The monetary policy mainly relies on the interest rate channel. Therefore, the critical question is the effectiveness of the interest rate channel as a transmission mechanism. Judging the effectiveness of the monetary policy is difficult because it is not always easy to isolate all the other happenings in the economy, such as fiscal policy, external shocks, market idiosyncrasies, in order to come up with a causal relationship between a monetary policy instrument and an objective.

In developed countries, which have more sophisticated financial systems, there is a general consensus on the use of indirect instrument, particularly a short-term interest rate to effect the monetary policy. Indeed, widespread empirical evidence has shown that in those countries, the short-term interest rate is an effective tool for controlling inflation and influencing output growth.

In developing economies, the transmission of the monetary policy operates differently because of weak institutional frameworks and shallow financial markets. The conventional view is that the monetary policy is ineffective in developing countries, largely because of weak institutions, underdeveloped financial markets, and uncompetitive banking systems.

The tight monetary policy stance has become under fire from the business community and many interested observers. It is argued that the monetary policy has failed to curb inflation on the one side and has stymied economic growth on the other. While there is a certain element of truth in these arguments, policy measures taken to subdue the twin deficits had a profound impact on economic activity during the FY19 (SBP). Real GDP growth slowed to 3.29 percent in FY19 as compared to target of 5.4 percent. Agriculture and industrial output slowed to 0.85 and 1.4 percent as compared to target of 3.7 and 5.8 respectively.

The fallout for the industrial sector was quite severe and similarly the agriculture sector fared poorly as a whole. There are clear signs that in the foreseeable future the economy will witness low economic growth and high double digit inflation – classical characteristics of an economy in stagflation. The supply shock may have partially contributed in the stagflation among other factors. The SBP has acknowledged that a high discount rate has a negative impact on credit to the private sector which further worsens the supply bottleneck.

Higher interest rate increases the cost of borrowing for the private sector which discourages the demand for private sector credit. When the demand for private sector credit decreases, the level of private investment falls – which adversely affects economic growth and employment. Since a major source of stagflation appears to be supply shocks, part of the solution may lie in boosting supply by removing the supply side bottleneck.

The other important concern in this regard is government borrowing from the SBP at a high interest rate. The question is whether the increase in interest rate acts as a deterrent to increased government borrowing from the SBP. The answer to that is: no. During the FY19, government net borrowing from the SBP increased from Rs3691.6 billion in July 2018 to Rs6679 billion in June 2019 which is 81 percent. Borrowing from the SBP injects liquidity in the system through increased currency in circulation. The impact, therefore, of a tight monetary policy stance is diluted with this automatic creation of money which increases the money supply. The high interest rate would cause high interest payments on government debt which would cause an even higher fiscal deficit.

The SBP acknowledged in its monetary policy statement that food prices are behind inflation outturns. According to the ‘Inflation Monitor’ September 2019 issue, the weighted contribution of food and energy (housing, water, electricity, gas & other fuel) group in overall inflation is 72.7 percent. These are essential items and demand for these items may not be curtailed due to high interest rate.

In the current situation, it seems that high interest rate is neither slowing down inflation nor appears to act as a deterrent to government borrowing from the SBP but only adversely affecting the private sector. In this scenario, the possible reason for high interest rate might be the stabilization of the exchange rate. If this is the case, then it is important to make a clear distinction between exchange rate management and monetary policy management. It is now well established that it is not possible to simultaneously achieve exchange rate stability, monetary independence and free movement of capital.

In summary, the economy continues to be bedevilled by supply shocks while macroeconomic stability remain elusive. The current monetary policy stance has not been helpful in either ensuring macroeconomic stability or reviving growth in the economy. Indeed, it only further squeezes the private sector and discourages private investment which is already facing an extremely difficult situation. In the current scenario, the appropriate approach is prudent monetary management to spark private sector revival.

The writer is a seniorresearch economist at the Pakistan Institute of Development Economics (PIDE).

Email: javid@pide.org.pk