Interest rate hike: bold and correct

We know economists seldom agree with each other so I was surprised when my economist friends were in unanimous agreement over what the State Bank of Pakistan (SBP) should do in its monetary policy review. The bank did the bold and correct thing.

A viable macroeconomic policy stance is all about maintaining balance and consistency between instruments and policy objectives. If there are fiscal slippages, monetary policy needs to take up the slack. If monetary policy is loose and accommodative, fiscal policy should play a dampening counter-cyclical role. Ideally, fiscal policy should be held tight and monetary policy allowed the room and flexibility to adjust interest rates and other instruments at its command. This is not what we have in Pakistan today where the situation is reversed.  As we all know, there have been recurring slippages on the fiscal side. When all the data is in, the fiscal outturn for the year just ended could well be 6.5-6.7 per cent of GDP, far in excess of the original target, signifying that a strong positive fiscal impulse has been injected into the economy. If we add the quasi-fiscal deficits of our loss-making public enterprises, the broader measure of the public sector deficit is probably closer to eight to nine per cent of GDP — a staggering figure. Not surprisingly, inflation, which had started to come down nicely and briefly touched single digits, has gone back up again. Ramazan is around the corner so we can expect another price-push from the hoarders and profiteers. The provinces, in the wake of the much-trumpeted NFC award, demonstrated a striking lack of fiscal discipline that has unfortunately rendered the entire macroeconomic framework for 2010-2011 irrelevant.

At this critical juncture, what was needed was for the SBP to step in and restore a measure of discipline. It needed to counter the excess demand pressures coming from the fiscal side. Given the state of the economy there was certainly no room to cut interest rates. The SBP policy rate was barely positive in “real” (inflation-adjusted) terms so one could argue that monetary policy was not tight enough to begin with. Of course, some will say that we should not be looking at present inflation but expected inflation to judge whether monetary policy is tight enough, should be tighter, or whether it needs to loosen. While that is technically correct, the path of expected inflation at this moment is highly uncertain. As noted above, the macroeconomic framework has been thrown off-track. The consolidated (federal and provincial) fiscal deficit for this year could be headed towards 6 per cent of GDP rather than the desirable four per cent of GDP because that four per cent figure assumed that the provinces would deliver a combined fiscal surplus of 1.5 per cent of GDP. This year’s inflation target of 9.5 per cent – disappointingly un-ambitious to begin with – was consistent with the four per cent deficit target. What might be the likely rate of inflation this year that would follow from a consolidated fiscal deficit out-turn of six per cent of GDP or more?

Given the evident disarray in the macro framework and the heightened uncertainty about the future path of inflation, there was a compelling reason for a pro-active tightening of monetary policy. If the SBP had not acted as they did, it would have run the risk of falling behind the policymaking curve and be forced to play catch-up. Our recent experience with very high inflation should tell us that falling behind can be painful and costly because once it is entrenched, inflation is very hard to subdue. The degree of tightening is small but it sends a strong signal to markets that the SBP is determined to restore some balance in the economy and is committed to bearing down hard on inflation, get it to single digits and keep it there.

The SBP has done the right thing with this decision. The wasteful and unnecessary 17-member delegation going to Washington may think they are ready to face the IMF. They had better be. Not only with their new exotic concoction called the ‘reformed GST’ but with a credible plan of fiscal consolidation that reins in the free-spending provinces.

Published in The Express Tribune, August 2^nd, 2010.