After the coronavirus struck, central banks took the driving seat and gave economic policy responses in view of the pandemic. Expansionary monetary policies, particularly during the lockdowns, became the “the only game in town”. Policy rates were immediately slashed. Quantitative easing was practiced as if there was no tomorrow.

The State Bank of Pakistan (SBP) also followed suit. Loans were repriced downward; the policy rate was cut down by 625 base points to 7 percent from 13.25 percent in less than three months. Concessional finance of Rs435.7 was approved for businesses, under the Temporary Economic Relief facility (TERF). Debts were rescheduled.

While these and other similar programmes were crucial in stabilising economies and financial markets during the lockdown, in order to control the spread of Covid-19, central banking and monetary policy in a shifting world now requires rethinking at a more fundamental level.

Social footprint of central bank policies, particularly that of monetary policy, is getting serious attention. Central banks, going beyond the formal mandate of price stability, are paying increasing attention to poverty, inequality, climate change, and other issues.

The debate, however, remains largely missing in Pakistan. It is time for the SBP to consider that its decisions and actions affect poverty, inequality and other social outcomes. Alternative types of monetary policy interventions that have the same aggregate effect – for example, increasing inflation – impact different population groups differently.

Take for example, reducing the interest rate or increasing the money supply. Both lead to higher inflation. The latter, however, will affect the poor relatively more. As the poor generally hold their money in the form of cash, an increase in currency supply in countries like Pakistan will generate an excess supply of cash predominantly among them. This will lead to a relatively higher level of inflation in the prices of commodities consumed by the poor, which essentially include food commodities, resulting in food inflation.

This, in turn, can disturb household expenditure patterns, as low-income households spend a major share of their income on food. A recent study showed that due to a surge in food inflation, low-income households spent 46 percent of their income on food in April 2021, compared to 30 percent in March 2020.

Consequently, households may have to borrow to meet other needs, such as health spending and education of children. A recent study from SDPI suggests that half of poor households in Pakistan are under debt. Most importantly, about 80 percent of these households defaulted on repaying their loans.

Higher food inflation can increase borrowing on the one hand, while further weakening the capacity to repay debt, on the other. Similarly, monetary policy decisions affect income, wealth and consumption inequality through several channels; difference in sources of income, portfolio composition, the sector and occupation of work, and the role of the credit market, such as savers and borrowers.

The Global Future Council of World Economic Forum on the New Agenda for Fiscal and Monetary Policy identified three policy ways to advance social agenda in macroeconomic policies. First and foremost is “bridging inequalities”.

The council concluded that “while current monetary policy tools might be effective at maintaining liquidity, they might not encourage the structural transformation towards fairer, more equitable and sustainable economies”. Research of the IMF concluded that inequality should factor into the decisions of central banks. An IMF working paper, published in September 2020, recommends that tackling inequality should be an explicit target of monetary policy.

Researchers and policymakers are finding increasing evidence that monetary policy actions affect socio-economic indicators like poverty, inequality, unemployment. 

The distributional impacts, which are perceived to be short term in nature for developed countries, may create long-term structural inequalities in access to education, health and skill development in developing countries. They can particularly have long-term effects in countries like Pakistan, which have lower financial inclusion, poor social-spending and an overwhelmingly informal economy. Together, these characteristics can convert an otherwise short-term distributional impact, into long-term structural inequalities.

With some exceptions, most of the existing research in Pakistan has largely ignored the possible social implications of monetary policy interventions. To some extent, the available literature explores the aggregate impact of inflation on wages and employment. But questions such as how day-to-day monetary policy actions affect the poor, poverty and inequality, remain largely neglected.

This has worked to delink monetary policy from the common man. In fact, research guiding post-Covid monetary policy is particularly lacking in this regard. Interestingly, the terms ‘inequality’ and ‘poverty’ do not appear in the title of any of the SBP’s 107 working papers published over the last 20 years.

The formulation of welfare-enhancing short-term monetary policy must be informed by its social effects. Contrary to common belief, that monetary variables like money supply and interest rates do not have any real influence on the economy, researchers and policymakers are finding increasing evidence that monetary policy actions affect socio-economic indicators like poverty, inequality, unemployment.

Opponents to this idea generally argue that fighting inequality and reducing poverty is not the goal of monetary policy. Any proposal to reconsider the agenda of monetary policies is, therefore, unwarranted. It is important to note here that the new agenda in no way asks to replace price stability with poverty and inequality reduction. It simply suggests that monetary policy, like any other policy, must be considerate of the socio-economic impacts of its actions. Furthermore, recent research by the IMF suggests that inequality distorts the transmission of monetary policy and hurts its effectiveness. It must, therefore, factor into monetary policy decisions.

The inequality footprint of monetary policy is particularly more relevant for the SBP now as it aims to ensure greater autonomy. A working paper from the World Bank, published in January 2021, identified three channels through which central bank independence (CBI), if left unchecked, can result in higher inequality. First, central bank independence indirectly constrains fiscal policy and weakens a government’s ability to engage in redistribution. Second, central bank independence incentivizes governments to deregulate financial markets, which generates a boom in asset values. These assets are predominantly in the hands of wealthier segments of the population. Third, to contain inflationary pressures, governments actively promote policies that weaken the bargaining power of workers.

These inequality-increasing channels of CBI are likely to be stronger at the initial phase of independence – as in the case of the SBP, as the institutional capacity, monetary policy framework and monetary instruments do not match with the newly adopted regime of inflation targeting. However, this proposition in no way means that CBI is bad. In fact, it actually advises that a more independent central bank has a larger role to play in fighting inequality, and that the existing framework, monetary policy actions, and instruments must be considerate of their social implications.

It is, therefore, high time to focus on social outcomes at the very onset of transition towards a more independent SBP adopting inflation targeting. The SBP must expand its research agenda to explore how its decisions and actions can affect social outcomes such as poverty and inequality. It must then work towards minimising these adverse impacts. At a later stage, the SBP must work towards calibrating decisions-making processes to refine monetary policy actions and instruments accordingly.

Central banking and monetary policy, which is considerate of the social implications can improve Pakistan’s progress towards social and economic development. At the same time, it can help the SBP to communicate the importance of the SBP and monetary policy to the general public. It can help broaden and deepen the SBP’s outreach, leading to the improved effectiveness of its monetary and other policies.

The writer is a research fellow and heads Policy Solutions Lab at Sustainable Development Policy Institute (SDPI), Islamabad. He tweets @sajidaminjaved