Control Inflation

There is growing consensus among central bankers that medium- to long-term price stability is the overriding goal of monetary policy.

Research has shown that maintaining low and stable inflation has helped economies to grow, as businesses, households and individual consumers are able to make better investment, savings and wage contract decisions. If inflation gets out of control either due to an over heating of the economy or supply side factors, central banks have generally resorted to monetary tightening as a means to control inflation.

This has the knock on effect of reducing aggregate demand and feeding into slower growth.

The State Bank of Pakistan (SBP)—an independent institution with full autonomy on monetary policy—has delicately balanced two opposing objectives, an anti-inflation policy and a pro-growth policy. There has been an impressive array of reforms in this regard, including the Fiscal Responsibility Act and Debt Limitation Act of June 2003, yet the reform agenda needs to be boosted further in the current macro­ economic environment.

While inflation was not an issue in 2002-2008, the current challenges are more testing. In order to achieve the 7% growth trajectory the SBP needs to keep inflation low.

The recent monetary tightening in response to rising inflation has not been preferred strategy, not only because it is politically unpopular but also because it results in increasing debt servicing and could result in further weakness in the currency and another bout of inflation.

With Pakistan’s high debt to GDP ratio as well as a growing fiscal deficit, control of inflation becomes a pressing priority to induce confidence in the business community and public at large about future price stability. The SBP alone cannot control inflation without the presence of a coordinated fiscal policy which requires support from the Ministry of Finance. The budget announced in June 2010 was a step in the right direction as it signalled a more responsible fiscal stance by the government. This would entail the government sticking to an agenda where unnecessary current expenditures are severely curtailed along with a clear policy for revenue enhancement. Recent indicators suggest that inflation is on the rise. This has been precipitated by the government’s decision to increase electricity tariffs, fuel prices, elimination of food subsidies and the imposition of a new ‘Reformed General Sales Tax’.

Further tariff increases and rises in taxation have been announced by the government, partly driven by the additional 239resources required for rehabilitation and relief for flood affectees. The SBP is also pointing to aggregate demand picking up, led mainly by public sector consumption, while prospects for aggregate supply remain weak due to energy shortages and the poor law and order situation. These developments together with the rising total debt reinforce the need to have renewed efforts to keep inflation and the fiscal deficit under control.

What can be done?

1. The government should announce a ‘Medium Term Financial Strategy’ (MTFS) for the next 5 years.

This will have a coordinated fiscal and monetary policy having a target band for inflation should form a cornerstone of the government’s approach.

Setting an inflation target or a band for inflation would certainly help to engender positive expectations across the economy and help to reinforce a ‘mindset’ that the government is serious about controlling inflation. Given that the vast majority of people are sensitive to rising prices, the very poor and low income groups, as well as business and industry, lose from higher input and capital costs in a rising inflation scenario.

Inflation-targeting is also an appealing choice as it has worked in both developing and advanced countries. It is not an end in itself, but a means to an end, which is achieving price stability that can be defined as low and stable inflation. The real point is to get inflation down to, in line with, or maybe even below its major trading partners and competitors.

If Pakistan can achieve this, then policy-makers will not need to depreciate its nominal exchange rate and play catch-up with the adverse relative inflation differential. Getting that adverse inflation differential down is therefore key. The target range within such a context should be between 5 to 8 per cent over the next five years.

2. This strategy should be supplemented by having a closely aligned industry and trade policy, and a clear policy on raising the level of productivity for capital and labour in key export sectors as well as those sectors where capacity constraints result in price increases of goods and services.

Examples of these sectors would include food, housing and energy which collectively account for over 60 per cent of the consumer price index. In particular, at a time when most nations globally are scrambling for food security, Pakistan’s government would reap significant future dividends if it were to have a strong agricultural policy to encourage investments that enhance agricultural output and productivity. Increased attention to Research and Development would need to be an integral part of a productivity enhancement drive, particularly in agriculture and the SME sectors, which are export oriented.

This is another way of improving competitiveness, which aims at cutting unit costs by raising productivity of capital and labour. To have a stable exchange rate raising productivity in the export sector is the only way to cut costs and increase export profitability. This would not only help to curb inflation but also allow an export surplus which would help in improving long term macroeconomic indicators.

3. The official consumer price index could be reconstituted to reduce the weight of food and energy which are dependent on exogenous factors and a global pricing mechanism which is beyond the control of governments.

This would leave other items in the CPI basket such as wages, rent, medical care, transportation, textile and apparel goods prices intact and would be a more significant monitor of how successful the government is in terms of achieving its inflation target.

4. To reinforce the stable price ‘mindset’, the government could enact an Act of Parliament which compels subsequent governments to adhere to a consistent policy of bringing inflation within the target band.

In the context of an Act of Parliament, caveats can be structured for unexpected natural disasters such as the 2010 floods that produced a sharp increase in the price of food and other necessities, which offset the benefits of an inflation targeting policy.

Conclusion

Despite turbulent economic and political headwinds over the last three decades Pakistan’s economy has not only avoided collapse but has recorded an average growth rate of over 5 per cent per annum. Pakistan’s medium and longer-term future will be driven by key demographic and economic trends. As the focus of much international attention, Pakistan has the opportunity to push ahead on key structural reforms. Couple with a steady flow of loans, assistance and investments, this has the potential to hedge any economic downturn in the short to medium term. The list of things Pakistan needs to do is not new. Yet they are difficult things to achieve and require a clearly defined implementation framework and the full support of government bureaucracy, industry, businesses and the public at large with priority given to those measures that can create jobs to accommodate new people entering the work force each year.

The full extent of damage emanating from the floods in Pakistan is not known at the time of writing this chapter, billions of dollars will be required for rebuilding and reconstruction. Whilst the floods have caused much misery and devastation the disaster can act as a catalyst to formulate a clear economic vision. The need for better governance, for creating social safety nets for the poor and for accelerating growth can become pressing national issues. This, in turn, can force the government in power to become more transparent and accountable to the public.

There are two scenarios that can emerge. The best-case scenario is one where economics prevails over geo-political risks, and a collective will under the leadership of a credible government is created to transform the economic landscape of Pakistan. This can result in a change in perception about Pakistan, trigger an investment cycle targeting growth in infrastructure and propel Pakistan into the 7-8 per cent growth trajectory.

The second scenario is one where future growth is unstable and low. Political and geo-political instability continues to weaken an already fragile economy and investment rates remain low due to the poor internal security situation. In this scenario, Pakistan’s population, instead of being a natural advantage, could turn into a crisis if young people are unable to find economic opportunities and where unmatched expectations result in discontentment, unemployment and growing disparities between the top and bottom end of the social pyramid.

Pakistan’s record in reform and policy implementation to achieve long- term economic development has at best been marked by missed opportunities and failures. The risks of failure are much greater today than at any time in the past, but so too are the rewards of meaningful reform.