- Exploring SBP’s role in inflation control, currency stability and financial confidence
Introduction
It was a usual sultry and humid evening in October. We all were back home after a hectic day and fighting with Karachi’s Monday evening frantic traffic. After the casual chat, we were having dinner and on TV there was news about SBP’s Monetary Policy. We came to know that the Monetary Policy Committee (MPC) of the State Bank of Pakistan (SBP) has decided to cut the key interest rate by 250 basis points (bps) to 15.0 per cent from the previous rate of 19.5 per cent.
My daughter, a clinical psychologist and lecturer at a private university, brusquely asked what this monetary policy is all about and what impact it has on the common man as well as on the country’s economy. During the course of conversation, I felt it was quite cumbersome to explain the impact of monetary policy on the common man and that too in simple non-technical language. This triggers me to reminisce information about the monetary policy.
Monetary policy refers to the actions undertaken by a nation’s central bank to control the money supply, manage interest rates, and achieve macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. Central banks, like the Federal Reserve in the United States and the European Central Bank in the eurozone, use monetary policy to steer the economy towards desired outcomes. Central banks are national financial institutions that are typically responsible for implementing a country’s monetary policy. National governments typically retain responsibility for setting monetary policy objectives, with the role of the central bank being to act as the government’s agent and use the policy tools available to it to try and meet these objectives.
The key task central banks are given responsibility for is normally the pursuit of price stability, which is expressed by achieving a target for a measure of inflation, such as the consumer price index (CPI), or a local equivalent. However, central banks can also be tasked with things such as supporting government efforts to maximise economic growth, promoting full employment and targeting a certain level for the exchange rate. Clearly, not all of these objectives are mutually exclusive and meeting one of them can sometimes only be achieved at the expense of missing another.
Why do central banks have monetary policy?
Control inflation: One of the primary goals of monetary policy is to maintain price stability. High inflation erodes purchasing power and can lead to economic instability. By adjusting interest rates and controlling the money supply, central banks aim to keep inflation within a target range.
Manage employment levels: Central banks use monetary policy to influence employment levels. Lower interest rates can stimulate borrowing and investment, leading to job creation. Conversely, higher interest rates can cool down an overheating economy and prevent excessive inflation.
Stabilise the financial system: Central banks play a crucial role in ensuring the stability of the financial system. Through monetary policy, they can provide liquidity to banks, prevent financial crises, and maintain confidence in the financial system.
Promote economic growth: By influencing credit conditions and the availability of money, monetary policy can stimulate economic growth. Central banks can lower interest rates to encourage borrowing and investment, leading to increased economic activity.
Role of SBP in announcing monetary policy
The State Bank of Pakistan (SBP) is the central bank of Pakistan and plays a crucial role in formulating and implementing the country’s monetary policy. The key functions of SBP in this regard include:
Formulating monetary policy: SBP formulates the monetary policy to achieve macroeconomic objectives such as controlling inflation, stabilising the currency, and promoting economic growth. This involves setting the policy interest rates, such as the Discount Rate and the Policy Rate, which influence the overall economic activity.
Regulating money supply: SBP controls the money supply in the economy through various tools, including open market operations, reserve requirements, and the issuance of government securities. This helps in managing liquidity and ensuring financial stability.
Inflation targeting: One of the primary goals of SBP’s monetary policy is to maintain price stability. By adjusting interest rates and using other monetary tools, SBP aims to keep inflation within a target range, thereby protecting the purchasing power of the currency.
Exchange rate management: SBP also plays a role in managing the exchange rate of the Pakistani Rupee. Through interventions in the foreign exchange market, SBP can influence the value of the currency, which affects trade and investment flows.
Financial stability: Ensuring the stability of the financial system is another critical function of SBP. By providing liquidity to banks and regulating financial institutions, SBP helps maintain confidence in the financial system and prevents crises.
Impact on economy
Interest rates and borrowing costs: The policy rates set by SBP directly influence the interest rates in the economy. Lower interest rates reduce borrowing costs for businesses and consumers, encouraging investment and spending. Conversely, higher interest rates can help control inflation but may also slow down economic activity.
Inflation control: By managing the money supply and interest rates, SBP can influence inflation levels. A tight monetary policy with higher interest rates can help control high inflation, while a more accommodative policy can support economic activity during periods of low inflation or deflation.
Economic growth: SBP’s monetary policy can stimulate economic growth by making credit more affordable and encouraging investment. Lower interest rates can lead to increased business expansion, job creation, and higher consumer spending, boosting overall economic activity.
Exchange rate stability: SBP’s interventions in the foreign exchange market can help stabilize the Pakistani Rupee. A stable exchange rate can enhance investor confidence, support export competitiveness, and reduce the cost of imported goods and services.
Employment levels: By influencing economic growth and investment, SBP’s monetary policy can impact employment levels. Lower interest rates can lead to job creation as businesses expand, while higher rates might slow down job growth in an effort to control inflation.
Financial market confidence: Effective monetary policy by SBP can enhance confidence in the financial markets. By ensuring liquidity and stability, SBP helps maintain trust in the banking system and financial institutions, which is crucial for economic stability.
In summary, the State Bank of Pakistan plays a vital role in shaping the country’s monetary policy, which has significant implications for the economy. Through its actions, SBP aims to achieve a balance between controlling inflation, fostering economic growth, and maintaining financial stability. The impact of these policies is felt across various sectors of the economy, influencing everything from borrowing costs and investment levels to inflation rates and employment.
Effects on the common man
Interest rates: When the central bank changes interest rates, it impacts how much it costs to borrow money or how much you earn on savings. Lower interest rates make loans cheaper, encouraging spending and investment, while higher rates make borrowing more expensive, encouraging saving.
Inflation: By controlling the money supply, monetary policy can influence inflation. High inflation means prices for goods and services rise, which can reduce purchasing power. Low inflation keeps prices stable, making it easier to plan and save.
Employment: Monetary policy can affect job creation. Lower interest rates can stimulate business investment and hiring, reducing unemployment. Conversely, higher rates can slow down the economy and potentially increase unemployment.
Economic stability: Effective monetary policy can help maintain economic stability, reducing the likelihood of extreme economic fluctuations, which benefits everyone by creating a more predictable economic environment.
Interest rates vs discount rates: Interest rates are the cost of borrowing money or the reward for saving money. For example, if you take out a loan from a bank, you will have to pay back the loan amount plus an additional percentage, which is the interest. Similarly, if you save money in a bank account, the bank will pay you an extra amount, which is the interest, for keeping your money with them. Whereas the Discount Rate is the interest rate charged by a central bank when it lends money to commercial banks. This rate influences the interest rates that banks charge their customers. When the central bank lowers the discount rate, it becomes cheaper for banks to borrow money, and they might lower the interest rates they charge their customers. Conversely, when the discount rate is high, borrowing becomes more expensive for banks, which can lead to higher interest rates for customers.
Difference: The key interest rates encompass a range of different rates that the SBP sets, while the policy rate is a specific rate within this range that serves as a primary instrument for monetary policy. Essentially, the policy rate is a type of key interest rate, but not all key interest rates are policy rates.
Relationship between gold reserves, dollar reserves and currency notes
Gold Reserves:
- Central banks hold gold reserves as a store of value and a hedge against currency fluctuations.
- When central banks purchase gold, it affects the supply and demand of their domestic currency.
- The act of buying gold often leads to an increase in the money supply because central banks print more money to acquire gold.
Dollar Reserves:
- Countries aim to hold ample reserves in US dollars to meet their dollar-denominated liabilities.
- The US dollar is widely used in global transactions and is considered stable and reliable.
- Dollar reserves include not only physical currency but also other dollar-denominated assets like US Treasury bonds.
Currency notes printing:
- The State Bank of Pakistan (SBP) manages currency issuance and circulation.
- The demand for banknotes is estimated based on economic growth, expected inflation, soiled note replacement, and other factors.
- The liabilities of the SBP’s Issue Department are the total amount of banknotes in circulation.
A million-dollar question. Can we print more currency notes to pay back our loans of the IMF and WB?
No, we cannot simply print more currency notes to pay back our loans Here’s why:
Inflation: Printing more money without an increase in economic output leads to inflation. This means that the value of the currency decreases, and prices for goods and services increase, making everyday life more expensive for everyone.
Currency devaluation: Excessive printing of money can devalue the currency on the international market. This makes imports more expensive and can lead to a loss of foreign investor confidence.
International obligations: Loans from the IMF and WB are often in foreign currencies. Printing more local currency does not generate the foreign currency needed to repay these loans. Instead, it can lead to a situation where more local currency is required to buy the foreign currency needed for repayment, worsening the debt situation.
Economic stability: Printing more money can lead to economic instability. It can undermine the credibility of the central bank and the government, leading to a loss of trust among both domestic and international stakeholders.
Increasing the supply of currency notes to reduce inflation is a common misconception.
Quantity Theory of Money:
- According to the Quantity Theory of Money, inflation occurs when the money supply grows faster than the economy’s real output.
- Simply printing more currency notes without a corresponding increase in goods and services won’t address the root cause of inflation.
- It might temporarily boost spending, but it won’t lead to sustained economic growth or price stability.
Demand-pull inflation:
- Inflation often results from excess demand relative to supply.
- If more money is injected into the economy, people may bid up prices for goods and services, leading to inflation.
- Printing more notes doesn’t address the underlying demand-supply imbalance.
Cost-push inflation:
- Cost-push inflation occurs when production costs rise (e.g., due to higher raw material prices or wages).
- Printing more money won’t mitigate these cost pressures; it might worsen them by devaluing the currency.
Confidence and expectations:
- Inflation expectations matter. If people anticipate higher inflation, they adjust their behavior (e.g., demanding higher wages).
- Excessive money printing erodes confidence in the currency, leading to hyperinflation in extreme cases.
Central Bank independence:
- Central banks (like the State Bank of Pakistan) manage money supply to achieve price stability.
- They consider various factors (economic growth, employment, etc.) and use tools like interest rates to control inflation.
- Printing more notes without a strategic plan undermines central bank independence.
Conclusion
Monetary policy is a critical tool used by central banks to manage the economy. By controlling the money supply and interest rates, central banks aim to achieve macroeconomic stability, control inflation, promote employment, and foster economic growth. The impact of monetary policy on a country’s economy is profound, influencing everything from consumer spending and investment to currency exchange rates and employment levels. Effective monetary policy is essential for maintaining a stable and healthy economy.
The author, Nazir Ahmed Shaikh, is a freelance writer, columnist, blogger, and motivational speaker. He writes articles on diversified topics. He can be reached at nazir_shaikh86@hotmail.com