For two years, economy in grip of stagflation

Ask anyone what’s been troubling them the most lately, and at least nine out of ten will say it’s the relentless price rise. The last financial year (FY24) ended with an average CPI inflation of 23.41%, compared to 29.18% in FY23 and 12.15% in FY22. Simultaneously, the economy grew by 2.4% in FY24, contracted by 0.2% in FY23, and grew by 6.2% in FY22. These indicators unmistakably show that the country has been in the grip of stagflation—a combination of high prices and low growth rates—for the past two years. A mix of domestic and external factors has pushed the economy into this dire situation.

In recent years, several economies, both developed and developing, have faced stagflation, though for shorter periods. The issue began with the COVID-19 pandemic, which severely restricted the movement of people and goods, stalling economic growth worldwide. According to the International Monetary Fund (IMF), in 2020, the year the pandemic emerged, advanced economies contracted by an average of 3.9%, including a 2.2% contraction in the US and a 10.4% contraction in the UK. Similarly, developing and emerging (D&E) economies contracted by an average of 1.8%, with Pakistan shrinking by 0.9% and India by 5.8%.

Due to the low-base effect in 2020, 2021 saw economies around the world rebounding with healthy growth rates: advanced economies grew by an average of 5.7%, and D&E economies by 7%. The UK and the US grew by 8.7% and 5.8%, respectively, while Pakistan and India grew by 5.8% and 9.7%, respectively.

In 2022, growth rates moderated as the pandemic’s impact subsided, primarily due to the high base effect. Advanced and D&E economies grew by 2.6% and 4.1%, respectively. In the UK, US, and India, growth rates decreased to 4.3%, 1.9%, and 7%, respectively. Surprisingly, Pakistan’s growth rate increased to 6.2%, the highest in recent years. This high growth rate was driven by increased consumption expenditure, reflected in record-high imports of $80.17 billion.

In 2022, prices surged globally. In advanced economies, inflation rose to 7.3% from 5.3% in 2021, while D&E economies saw inflation climb to 10.1% from 7.1% in 2021. In Pakistan, inflation skyrocketed to 21.3% from 9.7% in 2021. A common factor was the monetary policy of the Federal Reserve (Fed) in the US. To address the economic contraction, job losses, and increased social safety expenditure in 2020, the Fed adopted a loose monetary policy, printing more currency. Consequently, US inflation ballooned from 1.6% in 2020 to 7.4% in 2021. To curb inflation, the Fed tightened monetary policy by raising the benchmark interest rates, implementing 11 rate hikes between March 2022 and July 2023.

Given the size of the US economy and the widespread use of the dollar in international transactions, the appreciation of the greenback has led to the depreciation of other currencies, including the PKR. In Pakistan’s case, domestic factors have also contributed to this decline. In an import-dependent economy like Pakistan’s, currency depreciation either drives up prices or, if the government imposes import-compression measures, hampers economic growth.

In Pakistan, stagflation has been driven by a mix of international and domestic factors that have compounded each other. The war in Ukraine increased food and oil prices, which are significant items on Pakistan’s import bill. In FY22, during a period of relatively high growth, the country imported petroleum and food products worth $23.32 billion and $9.01 billion, respectively, totalling 40.33% of the overall imports of $80.17 billion. Additionally, the massive floods in the second half of 2022 (FY23) caused economic losses exceeding $15 billion, leading to a dramatic slump in growth from 6.2% in FY22 to just 0.2% in FY23.

The import-compression measures initially yielded results, with imports falling to $55.20 billion in FY23 and further to $54.73 billion. However, this came at the expense of exacerbating inflation and slowing down the economy. The high inflation forced the State Bank of Pakistan (SBP) to maintain elevated interest rates, a typical response from central banks in such situations, which further contributed to the economic slowdown. Another significant factor was the ‘rationalisation’ of energy and utility prices, alongside an increase in the GST rate from 17% to 18% as part of efforts to reduce the fiscal deficit and secure an IMF bailout package.

Stagflation, characterised by supply-side inflation as opposed to demand-side inflation, fundamentally represents a problem of falling output. Growth recession implies that less output is available relative to demand. With the gap between domestic demand and domestic output filled by imports. In the case of Pakistan, the reduction in imports, combined with steep currency depreciation and periodic increases in utility prices, has led to rising prices.

It is important to note that exchange rate management, which allowed the domestic currency to depreciate, and monetary policy, which aimed to strengthen the domestic currency through higher interest rates, were in conflict. Consequently, the potential reduction in inflation from contractionary monetary policy was offset by the inflationary spike induced by currency depreciation. As always, contractionary monetary policy contributed to reducing real output and thus to stagflation.

Stagflation is particularly challenging to manage. The standard approach to addressing low growth is fiscal and monetary expansion, while high inflation typically calls for fiscal and monetary contraction. However, stagflation undermines both strategies. Expansionary policies can exacerbate inflation when prices are rising, while contractionary policies can further depress growth when it is already weak.

The primary step in addressing stagflation is for the government or central bank to focus on either reducing low growth or high inflation. The government appears to have chosen to target inflation, given its diminishing political capital due to soaring prices. However, the long-term solution to stagflation involves increasing the productivity of factors of production. This approach ensures that efforts to boost growth do not result in a surge in imports, which would compel the government to implement import-compression measures that could further slow down economic growth.

THE WRITER IS AN ISLAMABAD-BASED COLUMNIST