SBP’s strategy: hawkish or dovish?

Since the Covid-19 outbreak, developing countries have been in a perplexing situation and have had to make various hard choices, whether in terms of enforcing lockdowns, protecting vulnerable sectors, or promoting economic growth. At present, a major dilemma faced by emerging markets is whether to increase the interest rate to control inflation or maintain a low rate to spur economic recovery. According to the FAO Food Price Index (FFPI), the present global food price hike is the highest in the decade, and there has been a 40% increase in global food commodity prices from May 2020 to August 2021.

In response to these market conditions, the central banks of emerging economies can be divided into inflationary doves or hawks. A dovish approach for a central bank would be to lower the interest rate and ignore other crucial factors such as the rise in inflation, as doves believe that inflation is an inevitable phenomenon and economic growth should be the priority. On the other side, a hawkish approach of the central bank would be to keep the interest rate high in order to control inflation, as they perceive an overheating economy to be a bigger risk.

An example of a dove is Poland where the central bank aims to ‘support economic growth’ and has kept the interest rate at 0.1%. In an interview, Central Bank Governor Adam Glapinski reiterated his view that “it was still too risky to raise rates”. At present, Poland’s inflation rate is 5.4%, the highest in the last ten years.

On the other hand, Turkey is an example where President Recep Tayyip Erdogan has a dovish approach but Central Bank of the Republic of Turkey (CRBT) has a hawkish one. The CRBT has kept the policy rate higher than inflation, and President Erdogan is an opponent of this decision, arguing that a rise in the interest rate results in slow economic growth and contributes to inflation. His argument regarding increase in prices contradicts the central bank’s logic which is that an increased interest rate decreases borrowing, which reduces consumer spending behaviour, and curbs inflation in turn.

In contrast, countries such as Brazil and Russia are inflationary hawks, as they are applying a higher interest rate to control rising inflation. When we talk about Russia, its current inflation rate is 6.74%, and in response to this, the central bank has increased the interest rate slightly above the inflation rate at 6.75%. Similarly, the Brazilian Central Bank (BCB) responded to control an inflation rate of 9.7% by increasing the interest rate from 4.25% to 5.25%. The BCB indicated an expected increase in the interest rate in the coming months, mainly due to the “evolution of the Covid-19 Delta variant”, which is an additional risk to economic recovery.

In the light of this background, let us explore where Pakistan — a former emerging market which has recently moved to the frontier market category — stands in this context. Recently, the State Bank of Pakistan (SBP) announced an increase in the interest rate from 7% to 7.25%. The central bank justified this readjustment based on the argument that the ‘rising demand pressures’ and ‘higher imported inflation’ could amplify inflation rates ‘later in the fiscal year’. Although there has been a decline in the inflation rate from June 9.7% to 8.4% in July and August (2021), it is crucial to examine that the month-on-month price momentum has a remained high at 1.3% in July and 0.6% in August (2021).

Moreover, the fall of Kabul has had economic spillover effects on Pakistan. These effects include pressure on the Pakistani rupee due to inability of the Afghan government to access their foreign exchange reserves which are under US control. Furthermore, smuggling of US dollars to Afghan traders from Pakistan continues through various carriers, such as agents and truck drivers. There is an element of IMF pressure involved here, as experts see Pakistan pursuing a more contractionary policy under this pressure.

The SBP needs to monitor the financial system holistically, ensuring stable economic growth while also considering the risk of inflation on the economy. It is crucial to assess domestic demand pressures and the rise in international commodity prices. Policymakers and advisers must consider the consequences of monetary policy readjustments. What would be worse — increase in instability due to inflation (dove) or stagnation due to slow economic growth (hawk)? In Pakistan’s case, the SBP’s decision suggests that the stakes are higher if inflation gets out of control.

Finance Minister Shaukat Tarin’s statement regarding enforcing restrictive policies to ‘cool down’ the overheating economy and the SBP monetary policy statement is evidence of a hawkish direction. Furthermore, the Finance Minister acknowledges how weaknesses of the external sector were exposed sooner than anticipated. Therefore, the SBP and the government, in response to inflation fears, have emerged as hawks using tight monetary and fiscal policy.

Published in The Express Tribune, November 2^nd, 2021.

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