After a period of monetary relaxation in 2020, central banking, particularly monetary policy, was in turbulent waters in 2021. It faced serious choices in balancing the short-term needs of fighting the pandemic and the long-term constraints and challenges. As 2021 is coming to an end, central banks are confronted with the hangover of the pandemic, uncertain economic outlooks, unintended distributional effects of policies and rising inflation.

Monetary policy in Pakistan faced even more serious choices this year. The second half of 2021, June to December, was particularly difficult for the State Bank of Pakistan (SBP), mainly on account of three related challenges. First, the inflation, unstoppable throughout the year, picked up sharply. It rose to 11.5 percent in November, from 9.2 percent in October. This was the highest month-on-month jump in a decade and put the SBP under pressure.

Second, the current account deficit started ballooning, setting new records every month. As noted in monetary policy statement (MPS) of December 2021, the SBP projected deficit “at around 4 percent of the GDP — somewhat higher than earlier projected”.

Independent experts, however, expect the deficit to be more than 5 percent of the GDP. Monetary policy had to press the pedal on policy rate to control the deficit. But this intervention comes with a high cost; the slowdown in the economy can further distort the poverty and unemployment picture. Third, rupee continued to slip throughout the year. Historically high trade deficits each month kept the rupee under pressure, rendering friendly deposits less helpful.

Towards the second half of 2021, the SBP, therefore, had to make tough decisions. While the businesses needed an accommodative monetary policy, a lower policy rate, widening deficit, depreciating rupee and rising inflation required the opposite. The SBP decided to align with the latter. After an increase of 25 bps in September, the SBP decided to surprise everyone. It raised the rate by 150 bps in November, followed by another 100-bps increase in December. The policy rate now stands at 9.75 percent, one of the highest in the region. Despite the hike, inflation continues to rise. An economic slowdown, however, is on the cards.

While the SBP has been very proactive in terms of putting in place policies to mitigate the impact of Covid-19, the major challenges of monetary policy persisted in 2021. It faced serious problems in keeping the inflation under control. Actually, for more than three years inflation has been above the medium-term target of 5-7 percent. Price stability is the first assessment of monetary policy of any central bank. The control seems to be loose. The SBP has raised the outlook for inflation to average 9–11 percent this fiscal year from the initial expectations of 7-9 percent.

Most importantly, monetary policy is trying to do what it cannot. The MPS of December 2021 reads that “[t]he goal of this decision [rate hike] is to counter inflationary pressures and ensure that growth remains sustainable”. Clearly, monetary policy is mixing stability with sustainability.

Controlling the deficits by managing aggregate demand is stabilisation of growth, not sustainability. Stabilisation of growth here refers to a growth level that comes with manageable trade and current account deficits. Historically, this combination is available at low growth levels, particularly around 3 percent GDP growth.

Rate hikes can do this. At a heavy cost though; unemployment and poverty. We have seen this in 2018 and 2019 when GDP growth dropped from 5.48 percent to 1.9 percent in 2019 as policy rate increased from 6.25 percent in 2017 to 13.25 percent in 2019. We can do it again. This, however, is ad hoc stabilisation. It goes as we re-enter higher growth. This forced stabilisation by slowing down the economy appears to have come at a wrong time.

Even if one ignores some notable communication errors of 2021, effective communication of monetary policy and other SBP decisions has emerged or resurfaced as a major challenge. While one agrees that there has to be an increase in the frequency and tools of communication, it is coming with a noise that is disturbing the policy signals. Despite issues related to nature and drivers of inflation in Pakistan, there is a growing consensus that the SBP was unable to communicate clearly to anchor the inflation expectations of the people and the confidence of businesses.

The central banks have increasingly relied on various communication strategies in their conduct of monetary policy. As monetary policy in Pakistan is expected to move towards an inflation-targetting regime, effective communication will be the most important tool. For clear signals about the path of policy rate, the noise needs to go. The MPS and other forms of communications need to be focused and to the point. Technical jargons, open and adjectives-loaded statements need to be avoided.

To reduce uncertainty in the market, the SBP for the first time gave forward guidance in 2021. But two important points need consideration going forward. Forward guidance may not work when inflation expectations are not anchored or are loosely anchored. That is what happened here. Unanchored inflation expectations pushed the SBP to tighten the belt and slow down the economy to control inflation.

It is important to note that monetary policy in Pakistan had its limitations and challenges in 2021 which are different from peer economies. Pakistan was under an IMF programme when Covid-19 hit it.

Monetary policy had to deliver some priors, including rate hike. The country was going through a serious balance of payment crisis when Covid-19 arrived. The economy was slowing down; the GDP growth had already dropped to 1.9 percent in 2018-19. Pakistan is again facing a serious balance of payments crisis while the world is planning for a sustainable recovery, and tight fiscal and monetary policies are back.

The year 2021 also brought some fundamental shift in central banking. The SBP gave forward guidance, increased the number of Monetary Policy Committee (MPC) meetings to eight from six a year. The most notable development in the monetary policy of the country, however, was the introduction of the SBP Amendment Act 2021 to modernise central banking in Pakistan.

Primarily, the Act proposes structural revisions in three key areas: i) redefining and clearly laying out monetary policy objectives, ii) the procedures of appointment and terms of offices, and iii) indemnity from accountability from all public sector agencies of the country for actions undertaken in good faith.

Overall, the purpose of the Act seems to be moving towards an inflation targetting regime and focusing on price stability. The Act, however, received strong resistance. While there is debate on the relevance and feasibility of inflation-targetting regime for Pakistan, most of the debate has revolved around the SBP’s perceived “absolute autonomy from the government” with little accountability.

There are multiple reasons for the emergence of the heated debate, mostly against the proposals. The way the Act was presented triggered resistance. The Act was presented to the cabinet in haste without any broad-based discussions. A debate around the proposed amendments in a more open way could have helped avoid most of the backlash.

Further, the perception of a “forced autonomy” pushed by the IMF as a condition for the Extended Fund Facility (EFF) caused some ripples. The IMF and the SBP must understand that the approval of the SBP Act 2021 under pressure will create credibility issues and hurt the monetary policy of the country. The SBP (Amendment) Act 2021 must be made available to the public and openly debated within and outside the parliament before approval.

The SBP must be made independent of any political influences but with strong transparency, accountability and foresight mechanisms in place. The ultimate right to accountability and foresight belongs to the government and the parliament.

Overall, 2021 marked a year full of challenges for monetary policy across the world. At the same time, it opened a window to new opportunities. It brought monetary policy into the limelight more than ever. More people are thus talking about monetary policy than ever. This has provided the SBP an opportunity to broaden and deepen the outreach of its monetary policy.

To take advantage of the opportunity, however, the SBP has to be more robust in its assessments; more open to debate and discussion; and clearly focused on price stability. While there is much to do, two things require serious and immediate attention: a renewed commitment to deliver price stability at a lower level of inflation and communication with greater clarity to send a clear message to businesses and to people to anchor inflation expectations. Otherwise, 2022 will further step up these challenges.

The writer heads the Policy Solutions Lab. He tweets @sajidaminjaved