Inflation: causes and cure - Dr Muhammad Yaqub - Tuesday, December 21, 2010

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For the first time in Pakistan’s history, double digit inflation has become a norm. The official price statistics, including GDP deflator, wholesale price index and consumer price index, showed an average annual rate of inflation of more than 15 per cent in the last four years but we all know from experience that prices are rising at a much faster rate than what the official statistics tell us. Inflationary expectations seem to have taken root creating a momentum for price increases. The country has thus entered a vicious circle in which actual price pressures and inflationary expectations have begun to feed each other. The ravages of high inflation are well known and those include deeper income inequality and poverty, falling saving and rising consumption, widespread speculation, hoarding and black marketing, balance of payment vulnerability, social tensions and political instability.

Some economic policy circles blame international prices, natural disasters and factors beyond government control as the main contributory factors. Such explanations are meant to confuse rather than enlighten people about the causes of inflation in Pakistan. While world prices and natural disasters do have temporary influence on prices, their weight remains limited and impact transitory. Inflation is principally a man-made and home-grown phenomenon in Pakistan. Unless the government and the State Bank of Pakistan take full responsibility for its causes and consequences, policymakers will continue to defer serious policy actions to arrest the rising trend in prices. A government that depends excessively and persistently on printing of notes and indirect taxes to finance its mostly unproductive expenditure and a central bank that can not restrict monetary expansion within the limits dictated by the rate of output growth will fail to contain inflation within safe limits.

If exorbitant money creation had not become a contributory factor for inflation, the rate of inflation would have remained in a moderate range of four to seven per cent per year in Pakistan. Even such a rise in prices may appear excessive, but should be expected in a developing economy exposed to the global environment. Pakistan can expect a two to three per cent annual rise in prices due to the process of development itself that involves mobility of the factors of production and structural shifts in production generating a rise in overall prices due to relative price adjustments. Another one to two percent rise in prices may represent the impact of changes in world prices of commodities that are used and imported into Pakistan. Price reforms within the country could be responsible for another one to two per cent rise in the overall price index.

The high double digit inflation being faced by the country represents the impact of the high rate of money creation resulting from imprudent fiscal and monetary policies. Unless this fact is recognised containment of inflation within a reasonable range of four to seven per cent per annum will remain elusive.

Containment of money supply within the safe limits is the responsibility of SBP. For this purpose, it was given autonomy in 1997 not only for the regulation of credit to the private sector but also to set limits on government borrowing from the banking sector and enforce them through the instruments at its disposal. The SBP failed to exercise the legal power given to it in 1997 to contain government borrowings from SBP within safe limits, and in fact it gave an open general license to the government to engage in wasteful expenditures financed by printing notes by the SBP. A central bank is created not to act as a printing press for currency notes for the government but to act as a custodian of monetary stability in a country.

Excessive government borrowing from the central bank generated high powered money into the banking system in the form of excess reserves which could not be dried up by applying brakes on commercial bank lending to the private sector and by raising lending rates to the private sector. In fact, it is not even prudent policy to penalise the private sector by increasing interest rates and lowering credit availability to offset the expansionary impact of an irresponsible fiscal policy. That kind of approach only encouraged the government to be more wasteful and reckless in its expenditures.

The SBP has to measure up to its critical responsibility in the fight against inflation. First, it needs to apply firm brakes on expansion in money in the next two to three years to drain out the hangover of liquidity created in the system by an expansionary fiscal and monetary policy in the last several years. Once that excessive liquidity is drained out by keeping money growth rate below the growth rate of the economy, prices will stabilise and with a lag of 18-24 months begin to fall.

To achieve monetary restraint, the SBP must convince or compel the government to completely stop borrowing from the SBP for budgetary support. At the same time, credit demand of public sector entities running huge deficits in their operational budgets must be eliminated through their reform and/or privatisation. There are preconditions to be fulfilled by the government in order for the SBP to adopt a policy for the private sector that meets its genuine credit requirements at reasonable level of interest rates. On interest rates, the SBP must use its regulatory authority to reduce the spread between average deposit and the average lending rate that is kept at a very high level by the cartel of large banks. Failure by the SBP to contain monetary expansion and reduce the interest spread will prove very costly for the country.

The writer was Governor of the State Bank from 1993-99.

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