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Inflation and SBP: Bringing knife to a gun fight

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November 9, 2020 (MLN): It’s usually in Macroeconomics 101 that freshmen students learn about central banks’ mandate of maintaining price level stability, which they often do through the interest rate channel that in turn affects money supply and inflation.

But as is often the case with macroeconomics, much of the classical theory in this context only explains a fraction of the ground realities in emerging markets. Take the current food crisis grappling the country for instance, which has forced the government to import wheat one batch after another.

Unlike the advanced countries, food prices exert more volatility in the emerging markets and has been particularly the case in Pakistan of late. Year-on-year food inflation has consistently exceeded general price levels (in the range of 1.1 to 7.5 percentage points) in the urban areas every month since August 2019 while for rural, the situation dates further back to March of the same year.

That takes us to the question: how the central bank can achieve price stability when it doesn’t have much control over its biggest driver (these days), food inflation. After all, that comes under the National Price Monitoring Committee.

The latest crisis is a result of supply side issues, where the targeting of local crop and import comes under the Economic Coordination Committee with the Ministry of National Food Security and Research also playing a role. This leaves little room for the SBP, considering that its tools are targeted towards the demand.

However, even on the demand side, the scope is limited as is usually the case in emerging markets in general, but even more so in Pakistan. Influencing inflation through the use of interest rate channels in a country where financial inclusion is pathetically low – with the number of bank accounts below 55 million by FY20 – can only be so effective. The country’s record in terms of borrowing is well below the regional average, pointing to how the masses are still locked out from financial services. It’s generally the big companies that actively look for opportunities based on the prevailing monetary policy, allocating their investments accordingly. Not like banks are anyway very willing otherwise to go out to the mass market and bring people into the net, when they can simply park money in treasuries.

What must be done then? Should the SBP be allowed a greater role that equips it to manage food inflation better? That’s not only an unfeasible but also a risky idea. Supply side issues to ensure price stability in food will have adverse impact on the central bank independence, considering that it’s the government which would be answerable to its electorate for the rising food prices and would surely try to manipulate the central bank into taking more populist measures.

In order to ensure that the demand and supply sides are on the same plane at least, there is a Monetary and Fiscal Policies Coordination Board where representatives from the central bank, government and bureaucracy sit together even though it’s not really a decision-making body.

All of this isn’t to say that classical macroeconomics is completely inept in the context of countries like Pakistan. Despite the underdeveloped financial markets that limits the role of interest rates, higher inflation can still feed into the expectations channel which in turn further raises the price level.

Furthermore, even if only a few companies directly alter their investments and savings decisions based on the interest rate changes, they generally happen to be the price makers. Hence, whatever effect gets translated into their pricing as well as supply chains, it gets further passed on to the smaller and other ancillary players. Think of the FMCGs here and how they shape the local (especially urban) markets. 

Back to the food crisis, it’s pretty much a recurring cycle where the pattern keeps repeating every few years and the same statements are repeated but to no result. To understand all of this better, the political economy can better explain the situation than macroeconomics ever will.

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Posted on: 2020-11-09T10:26:00+05:00