Many commentators have been touting the monetarist belief that increased money supply through SBP’s Open Market Operations (OMOs) will continue to stoke inflation. It’s a belief I’ve held too but it is not true as circumstances have changed.
Money supply has been rising steadily over the years with an uptick since 2021. Monetarists would tell you this has been the true cause of inflation in Pakistan while quoting Milton Friedman: “Inflation is always and everywhere a monetary phenomenon”.
(Source: State Bank of Pakistan)
This belief stems from the fundamental monetarist equation MV=PY (where M stands for Money Supply, V for Velocity of Money, P for Price Level and Y for Real GDP). A monetarist will tell you that if you hold V and Y constant, the only cause of inflation would be money supply growth. Thus, curtailing money supply would curtail inflation. Meaning, money supply growth and inflation (price level growth) follow a one-to-one relationship.
Generally, this has been true as money supply (M2) growth has largely tracked inflation in Pakistan. However, there has been a differential between the two much of the time. This is because the monetarist assumption of Y (and V) being constant does not always hold.
(Source: IMF)
For instance, most of the 2000s and early 2010s were a period of positive supply shocks marked by low commodity prices, thus helping generate lower inflation than as predicted by M2 growth. But this can work in the opposite direction too as the severe import restrictions and commodity price shocks in 2008-2009 and 2022-2023 led to inflation spiking beyond M2 growth.
Nonetheless, a general trend between money supply growth and inflation can be inferred. So even if we take the monetarist belief as the rule and these slight divergences as the exception, how does SBP create money?
For one, SBP can circulate more notes and coins to increase money supply. This is generally done to meet demand for money. A standard example is that during Ramadan/Eid, money demand spikes so the SBP caters to this demand in order to keep interest rates the same. And also, to not curtail real activity in the economy. After all, money is there to facilitate real transactions.
But the more sophisticated approach to creating money involves open market operations. Outright open market operations generally entail the SBP buying or selling bonds to vary money supply. Generally-speaking, when SBP buys bonds, the money supply goes up as the public has more cash while SBP selling bonds does the reverse. Note, broad money supply is defined generally defined as currency in circulation plus short-term deposits (current and savings account for instance).
The transaction involves SBP buying bonds from financial institutions and crediting the accounts of those institutions. Now, ideally banks would use that credit to lend it out to borrowers as they do under normal circumstances. Those borrowers would keep their loans in the bank (as deposits), thus creating money and having an impact on the real economy. Note, in this process, it is the banks that are actually creating money through their choice to lend or not although SBP began the initial process of credit.
However, when economic conditions worsen, banks generally tend to lend to the government or simply hold excess reserves. So greater credit (monetary base) does not translate to greater money supply. Hence, understanding how government borrowing is facilitated and how that money is spent can help unravel inflationary trends.
When the government is short of cash, SBP performs what is known as reverse repos (another kind of OMO). In a reverse repo, SBP will buy T-bills or PIBs from banks with the agreement to purchase it at a higher price at a future date. The difference between the future purchase price and current sale price is determined by the interest rate. Meanwhile, the future purchase date depends on the tenor set by the SBP which usually ranges from 7 to 28 days.
Now, when the government needs cash, SBP will perform these reverse repos so that banks have more cash. So, when the SBP holds auctions for government securities (to raise cash for the government), the banks will fund it with the cash received from the reverse repo. This is the great monetary settlement between the SBP, the government and the commercial banks.
But hang on a second, how does this cause inflation or affect the real economy? Well, when the government receives that money from the auctions, it chooses to spend it on goods and services. So, let’s say the government buys wheat from flour mills for a new subsidy program. The flour mills receive that cash and choose to spend a portion of it (or hold a portion as deposits). That spending leads to an income for someone else and this cycle continues ad infinitum.
This is precisely how SBP’s reverse repos lead to inflation. But implicit in this example is that the government is spending that cash on goods which affects the real economy. As in, it is running a primary deficit which it generally has for most recent years.
However, this financial year, the government is actually running a primary surplus. Meaning, it is not really spending that reserve repo cash on goods. So where is that cash going? Well, it’s not really going anywhere; it’s just being circled around.
Essentially, that cash is being spent on debt servicing. So, the SBP is still handing cash to the banks which are buying government securities at auctions and giving the government that cash but only to retire or service old debt. So really, the money is not being spent anywhere – not making its way into the real economy or increasing the number of deposits.
In this scenario, OMOs really do not cause inflation. An interesting example or parallel in monetary history to this would be the German MEFO bills of the Nazi-era.
During the Nazi-era, the German government needed a lot of cash to reinflate the economy. Naturally that would cause inflation, so Hjalmar Schadt (the German Central Bank President) introduced an ingenious security called MEFO bills.
MEFO bills were promissory notes that served as bills for payment by the German government to manufacturers. They were convertible to the German currency but a higher interest rate on them was offered to entice manufacturers to hold those notes. Meanwhile, the maturity on these notes would continually to be extended so as to avoid conversion of these notes to the currency – to avoid increasing money supply.
So, what’s the lesson here? Greater credit does not always mean greater money supply or inflation. Consequently, OMOs (credit creation) do not always cause inflation. At least, they are not causing inflation in the present circumstances.
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