Pakistan’s economy under severe stress in recent years caused by external factors beyond the country’s economic managers’ control and internal pandemic-related losses, the impact of natural disasters like floods causing devastation to all sectors of the economy and growing political turmoil since last three years has brought down the economic growth to the lowest ebb. Growing external debt and worsening fiscal and trade deficit impacting budgetary position has changed the external world outlook towards Pakistan.
According to Nobel Laureate James Tobin price, financial and macroeconomic stability places a strict joint requirement on budgetary and monetary policy. Central banks must pursue price stabilizing mechanisms in medium and long-term strategies. Fiscal authorities must guarantee debt sustainability, adjusting their policies consistent with the inflation objectives of the central banks.
During the nineties of the last century, industrialized countries and some of the transitional economies recognized ‘inflation targeting’ as the most effective tool to control inflationary pressure on their economies. Inflation targeting implies achieving price stability through the mechanism of fixing a target normally on an annual basis to bring down inflation to a certain level. However, this is achievable through institutional commitment and arrangements with the understanding that the central bank is accountable for meeting the target.
Prior to that Central Banks had an emphasis on managing money supply and making use of the Exchange Rate Mechanism to control inflation, but despite these regulatory measures, even highly industrialized countries encountered periods of price level flare up very frequently. In reality, it is impracticable for central banks to play their pivotal role of controlling inflation and ensuring a high economic growth rate simultaneously only through conventional tools of regulating money supply through interest rate mechanisms.
Quite a number of emerging market countries/transitional economies like Brazil, Israel, Mexico, Magnolia, Poland and Botswana etc and Thailand alone in South East Asia have started making use of inflation targeting strategies to arrest frequent bubbles in their Consumer Price Index (CPI) and to achieve long-lasting price stability, culminating into sustained high economic growth rate and employment level. In this regard consumer price index is the most common choice. However certain items, which show a reverse trend with the increase/decrease in interest rate for managing money supply need to be excluded from CPI while setting inflation reduction targets.
Bank of England excludes housing-related costs from CPI as an increase in interest rate for tightening money flow causes a rise in mortgage interest rates. Similarly, quite a number of central banks of the countries where inflation targeting is practiced exclude such commodities, price changing trends of which are beyond the control like oil prices, which are now totally unpredictable due to rapidly changing political scenes.
After making all such adjustments to CPI a target is set for bringing down the price level within the specified time period, which is normally a year.
The explicit target-setting mechanism provides an anchor for private market expectations apart from assisting central banks to have effective control of the money supply in the country to ensure sustained economic growth.
Among the countries who have chosen to enter an inflation-targeting regime, one finds a lot of diversity of institutional and operational features of their central banks, but the main aim is to maintain low and stable inflation as much focused objective of their monetary policy. The rationale of this emphasis has long-term repercussions on the economy by sustaining a high economic growth rate and employment level.
Actually, monetary policy is formulated within some sort of conceptual framework and this framework is needed to be explicit on all counts. It is inflation targeting, which provides a coherent framework for thinking about monetary policy choices, which in turn involves access to public opinion. For the success of the inflation targeting strategy, central banks need to have total autonomy. The best practice of inflation targeting is based on a communication strategy, which a central bank adopts for communicating with political authorities, financial markets and the general public.
In this regard Mr. Donald. T. Broost, Governor Reserve Bank of New Zealand, states that ‘there should be a public announcement about monetary policy objectives relating to inflation, open discussion of the bank policy framework and public release of central bank’s forecast on evaluation of the economy. Accordingly, the inflation targeting process, for its creditability presumes total transparency and effective communication with financial markets and the general public for their awareness, which in turn facilitates the accomplishment of set targets with the least social cost.
The success of inflation targeting if taken as the main component of monetary policy by a central bank, depends on the nature of the political institutions of the country concerned. It has been established through experience that countries having long-lived political institution patterns are more likely to succeed as generally high inflation is the outcome of political instability as is the case with the majority of low and middle-income developing countries. In the case of a non-democratic government where there is a strong executive setup, ensuring good governance, inflation targeting strategy can work effectively. It has also been observed that countries despite having democratic institutions in place could not control inflation due to rising social unrest/tension. Hence for the success of inflation targeting the presence of a stable political climate is a must.
So far inflation targeting regime is in force mainly in industrialized countries and some of the transitional economies and high-income developing countries as mentioned above have also successfully practiced this important tool to obtain a congenial monetary climate.
Since economic climate and traditions differ from country to country and decisions about how best to go about with monetary policy must be taken in light of the economic and political scenario of the country concerned. Here question arises whether inflation targeting can be effective in low-income developing countries also. It is the general belief that in low-income developing countries, fiscal objectives override monetary goals and central banks of these countries are primarily concerned with assisting their governments to meet the fiscal deficit. Hence central bank’s funding/credit has high leverage on the total revenue needs of such countries.
Accordingly, it becomes difficult for the central bank to curb the money supply by raising interest rates, indulge in deficit financing and promote economic growth simultaneously in other words it becomes difficult to coordinate fiscal, monetary and foreign exchange policies.
Economies of low-income developing countries including Pakistan are faced with fiscal burden, rising trade deficit and continuous government intervention to seek funds from central banks to bridge fiscal deficit, thus adversely impacting the monetary situation in the country. This gives rise to speculative activities, which is the main cause of persistent high inflationary pressure in these countries. Pakistan in particular, apart from fiscal difficulties and the rising trade deficit is presently faced with rising inflation primarily due to rising oil prices and more importantly, persisting political turmoil combined with a strong hold of the informal market causing hoarding and speculative activity in special consumer items market, which despite concerted efforts of economic managers to bring down inflation.
Inflation targeting applied in crude form to bring down Consumer Price Index (CPI) to a manageable level has totally failed. Due to hoarding and speculative activity going on unabated profits earned by food and other consumer items suppliers have mounted to a frivolous level for the last eighteen months or so.
No doubt State Bank of Pakistan enjoys total autonomy, but lately a situation of fiscal dominance is being faced. As such State Bank instead of sucking out excess liquidity from the banking system is pumping out liquidity directly into the economy. This includes a sizable portion provided to the government. Since this money is spent on public works undertaken by the government, this comes back to the banking sector, thus enabling the banks to lend to the private sector. As a result during the last four years advances to deposit ratio to certain sectors have steeply risen particularly to the housing sector no doubt causing monetary growth, but at the same time steep rise in inflation.
Further, a growing trend among various industries towards monopolization and forming cartels is yet another hitch towards controlling the abrupt and unjustified rise in prices of essential items of consumption. Accordingly under a present scenario of fiscal dominance and unethical business trends inflation targeting strategy cannot work effectively in Pakistan. The same applies to other low-income developing economies where central banks have to undertake deficit financing strategies as a matter of routine to meet revenue shortfalls of their governments.
However as a best practice monetary policy of developing countries should not only be used just to achieve an inflation reduction target, but also it must have an emphasis on promoting real economic growth and maintaining a competitive real exchange rate. Monetary policy if prudently formed with these objectives in mind and implemented in letter and spirit can stimulate demand and boost economic activity. However for that strong political and institutional commitment is a must, which unfortunately is rare in low-income developing economies.