Monetary policy: chasing vs. targeting inflation


The statement by SBP Acting Governor Dr. Murtaza Syed that monetary policy “will not risk creating an economic recession to bring inflation down and a positive real interest rate can be achieved in the longer term” is an important step in the right direction.

With headline inflation soaring rapidly and the SBP expecting it to remain at as high as 18% to 20% in the current fiscal year, markets feared that further policy tightening does not lead to an economic recession.

The global economy is going through a period of extreme turbulence with international commodity prices at record highs and the prospect of another global recession looming in 2022-2023.

Pakistan, like other emerging economies, is facing severe headwinds with rising inflation and a marked slowdown in economic activity. Headline inflation accelerated sharply to 25% in July, with an SPI of 39%, compared to 8.4% in the same period last year.

There are clear signs of a slowing economy, which is certainly a worrying prognosis for an economy with a young and growing population. Consequently, rising poverty and unemployment could lead to social and political unrest.

The standard textbook prescriptions, which can perhaps be employed in the majority of countries around the world, used by our policy makers to deal with similar economic challenges in the past have not yielded the desired results and may warrant change.

Each country has its own particularities and requires tailor-made solutions based on the realities on the ground. The one-size-fits-all concept is certainly not suitable for complex countries, such as Pakistan. In today’s article, I want to highlight alternative solutions on the management of monetary policy.

Inflation is now the main objective of the SBP, after the adoption of the amendments to the SBP 2022 law. Previously, the SBP had a dual objective of monetary stability and growth.

However, to date, the SBP has not defined an inflation targeting mechanism, at least nothing has been shared with the public. The current monetary and exchange rate frameworks, two key anchors for managing inflation and achieving the primary objective, are vague and lack explicitly defined targets. According to SBP, the current monetary policy is a “light inflation targeting regime”.

Instead, SBP uses an “inflation forecast range”. For example, in the last fiscal year, SBP had to change its inflation forecast range three times.

At the beginning of the fiscal year in July the target was 7% to 9%, it was then revised in December to 9% to 11%, then in May the inflation forecast was raised again to “slightly more than 11%”.

The lack of an anchor to manage inflation expectations leads to market volatility, and the market charges a higher premium to borrowers. The government’s cost of borrowing on short-term paper (three-month Treasury bills) is currently 15.6%, a premium of 60 basis points above the policy rate of 15%. Previously, the premium reached 150 basis points.

According to the 2020 SBP Working Paper titled “Estimated Medium-Term Inflation Target for Pakistan”, the recommended inflation target range is 5% to 7%. This is based on historical trends and lessons from other emerging economies.

However, data from the past 10 years shows that headline inflation has exceeded or exceeded the inflation target range of 5% to 7% in seven of the past 10 years.

On the other hand, core inflation (non-food and non-energy) has ended within the inflation target range eight times over the past 10 years.

By definition, the core inflation index is more stable than the headline inflation index because it excludes high volatility commodities, including energy and food products, from the basket, which is particularly more pronounced lately with the commodity super cycle and supply chain issues around the world. after the Russian-Ukrainian war.

According to the Central Bank of Canada, measures of headline inflation are inherently noisy (due to one-time or temporary supply shocks) and often do not reflect changes in the underlying inflation rate, the rate at which headline inflation is likely to stabilize and that monetary policy may affect.

Although monetary policy is able to control headline inflation over the long term, it lacks the ability to control relative price movements such as those of food and energy.

We must come to terms with the fact that monetary measures alone cannot solve the economic problems in their entirety, they can only support the budgetary and structural reforms which are the real tools for solving the economic problems.

The fact is that fiscal and structural reforms could be targeted; however, monetary measures are secular in nature, therefore, they should not be used in isolation and handled with extreme caution with the most appropriate peg to a more stable inflationary number.

Core inflation measures attempt to eliminate or smooth volatile changes in certain prices in order to distinguish the inflation signal from transient noise. Thus, compared to changes in measures of headline inflation, changes in core measures are much less likely to be reversed, provide a clearer picture of underlying inflationary pressures, and thus serve as a better guide to knowing where headline inflation itself is headed.

More importantly, if something that has a real impact on currency stocks is underlying inflation; headline inflation remains largely off limits, especially in our case where utility prices, food support prices, etc., remain administratively managed.

Therefore, when headline inflation has a large transitory component, a focus on fundamental measures can help avoid monetary policy errors.

A focus on underlying inflation rather than headline inflation – and clear communication with the public about this – can have another benefit, namely that it can help anchor inflation expectations. when headline inflation temporarily increases but core inflation remains essentially unchanged.

If the public understands that the central bank uses core inflation in formulating monetary policy, they will realize that the central bank need not react aggressively to a surge in headline inflation ( due to imported inflation or changes in administered prices for political reasons or otherwise) to keep inflation under control; thus, bringing more certainty and calm to the market.

Thus, the benefits of moving towards an inflation targeting framework focused on underlying inflation will further benefit the economy holistically.

Markets will benefit from greater transparency and greater confidence in the political actions of the SBP. Government borrowing costs will decline as the premium between the policy rate and Treasury bill rates declines, which is one of the fundamental catalysts for fueling inflation in the economy.

Now is the perfect time to move in this direction given that the gap between headline inflation and core inflation is perhaps the widest, with headline inflation at 25%, more than double underlying inflation of 12%.

The discrepancy between the two measures reflects the impact of rising commodity prices with higher administrative prices and imported inflation.

Therefore, looking to headline inflation figures to determine policy rates to achieve desired results may be overkill, as the acting governor also alluded to in his recent statement.

This is something I had always advocated when I was involved in monetary policy decisions as a board member of the State Bank of Pakistan for over three and a half years between 2013 and 2016 and this approach produced the optimal results for the economy as a whole.

The author is the Chairman and CEO of Bank of Punjab, former Chairman of the Publications Review Committee of the Board of Directors of SBP and a member of the Monetary Policy Committee (MPC)

Published in The Express Tribune, August 8e2022.

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