State Bank: Failure in Monetary Policy

 

The State Bank (SBP) has taken interest rates from 7% to 22% in less than two years. But counterintuitively, inflation has skyrocketed from 9% to a maximum of 38% within that same period, only falling to 29% just last month.

SBP was way ahead of the curve in raising interest rates and was far more hawkish than other central banks. Yet, its monetary policy has yielded negative returns. What gives?

To understand this, one must first realize the sources of inflation. Generally speaking, there are three sources of inflation: prices of domestic goods, prices of foreign goods and the exchange rate. In Pakistan’s case, the prices of domestic goods are heavily influenced by prices of foreign goods and exchange rates due to a heavy reliance on import of raw materials in manufacturing. Add high pricing power of businesses to this mix and prices of foreign goods and exchange rates become the dominating factor in Pakistan’s inflation story.

The prices of key foreign goods have fallen significantly since last year. For instance, the price of brent crude has slid from $105 in July 2022 to $75 in July 2023. Other commodities like wheat and natural gas (LNG) have seen similar downtrends. On the other hand, the rupee has depreciated heavily relative to the dollar – Rs 207/$ in July 2022 to the current Rs 277/$. That represents a 34% decline in the purchasing power of the rupee.

Consequently, the prices of foreign goods have fallen but so has the value of the rupee – a cancelling out effect. So why has inflation been rising? Well, it has a lot to do with administrative control of prices and a phenomenon called ‘base effect’.

The government controls domestic prices of a few key goods & services including petrol, gas, electricity, and agricultural commodities. It hiked the prices of these goods and services only in 2022 although the prices of these goods had risen internationally a year earlier. This hike occurred partly due to the IMF’s conditions under the 8^th review. Since prices were too low in 2021 and suddenly rose in 2022, base effect kicked in to show a significant increase in inflation.

The above are some of the statistical or supply factors for inflation. But what about the demand side of inflation? The side of inflation which the SBP can control.

To understand the demand side of inflation, one has to start at the monetary base. The monetary base is the amount of currency in circulation and bank reserves within an economy. It is important because it is the initial source for the creation of money and credit. Through the multiplier process, we arrive at money supply. Although there are many different kinds of money supply, M2 money supply is usually a good reference point for money supply in an economy.

As seen in the graph above, monetary base has risen steadily since SBP started hiking interest rates in 2021. This has undoubtedly translated into a rise in money supply as we see below with the M2 money supply graph.

Both the above graphs are puzzling, especially given the SBP’s aggressive interest rate hikes over the past couple of years. What really happened and why is SBP failing to curb the money supply?

The purpose of hiking interest rates is to rein in credit demand which would help reduce demand in the economy. The transmission channel of monetary policy usually involves higher interest rates reducing credit demand for both consumption and investment. Hence, both consumption and investment fall in an economy leading to lower aggregate demand or output (note: Y=C+I+G+NX as taught in a standard macroeconomics class).

This monetary policy transmission works effectively in Western economies where both consumption and investment are heavily fueled by lending. However, this is not the case in Pakistan. In Pakistan the biggest borrower is neither businesses nor consumers. It is in fact the government which spends and borrows as much as it likes or wants.

From July 2022 to April 2023, the private sector borrowed just Rs 220 billion, while the government borrowed Rs 3.06 trillion. Although private sector borrowing was just over Rs 1 trillion in the same period a year ago, it is still peanuts compared to the government’s borrowing binge. So, while higher interest rates have reduced credit demand in the private sector, monetary policy has been ineffective due to the weak link between interest rates and investment/consumption in Pakistan.

But hiking interest rates has another effect: it induces consumers to save for the future rather than spend now. As a consequence, hiking interest rates can still reduce demand in an economy. But for this effect to really kick in, real interest rates must turn positive. The dividends from this can currently be seen in Latin America where positive real interest rates have reduced inflation. In Pakistan, real interest rates still stand at -7%.

If SBP can turn real interest rates positive, it would also cause appreciation of the rupee which would further lower inflation. How? Well currently, Pakistanis have high investment demand for foreign currencies due to the plummeting value of the rupee. By turning real interest rates positive, higher returns on saving domestically will reduce this investment demand for foreign currencies while foreign investors would also look to invest in Pakistan to take advantage of this scenario. But yet again, this transmission channel is weak and usually the flow of hot money from foreign investors dissipates or reverses after a while.

So, the puzzle still remains unresolved; why doesn’t SBP just target and reduce money supply instead? Well, money supply targeting is incredibly tough for three crucial reasons. For one, SBP cannot control how much banks lend to borrowers. Secondly, SBP cannot control how much money consumers choose to park in deposit institutions which affects the money multiplier process. Lastly, SBP has no control over money itself as money can take various forms and expand itself ad infinitum.

Despite these limitations, SBP does have control of some part of the monetary base and money supply – currency in circulation. Pakistan has a large informal, cash-based economy so cash in circulation (CIC) has a drastic impact on demand within the economy. Since SBP chooses to issue or retire currency notes and coins, it can directly influence CIC. However, it has chosen to expand CIC by increasing it 10% YoY. This is a questionable policy given that the SBP is hiking interest rates on the one hand while increasing CIC on the other – essentially making its monetary policy efforts less effective.

To make matters worse, SBP has lost its independence by caving into the government’s demand for borrowing. Since the government’s demand for credit is not being met naturally, SBP is lending to banks via open market operations so that they can further lend it to the government via T-bill and PIB auctions. This way, the government is happy that its credit demand is satisfied while banks earn a quick and easy spread on such transactions.

Both these factors explain the inexplicable rise in money supply despite the increase in interest rates. The end result is that the private sector is squeezed to the edge while the government continues spending lavishly. In other words, resources are being allocated away from the private sector and towards the public sector – a disaster in the making.

State Bank urgently needs to restore its independence and build its credibility. It must realize that government borrowing is a source of inflation. Furthermore, SBP must not let CIC grow further or curtail it if possible. Lastly, raising interest rates is completely futile at this point. Its effect on credit demand is nearly negligible. SBP has to wake up to these realities or the suffering will continue.