Why the discount rate hike?
The State Bank of Pakistan (SBP) has increased the discount rate by 50 basis points (0.5 per cent) to 14 per cent with effect from Nov 30. Was this increase justified? While announcing its monetary policy, the SBP justified it as a move counterbalancing "the rapid expansion in reserve money and arrest the rising inflation expectations." The persistent increase in inflation can be attributed to relentless government borrowing from the SBP to finance fiscal deficit, says the Bank.
Monetary policy is an important instrument of stabilisation policy. It has been found to be an effective instrument in controlling aggregate demand, and therefore inflation. There are at least three reasons for tightening of monetary policy. First, it helps to control the persistent rise in price level. Second, it curtails aggregate demand with a view to improving external balance of payments and reducing inflation. Third, it discourages the government from borrowing from the SBP to finance fiscal deficit.
Let me deal with the first issue first. Inflation averaged 14.2 per cent in the first four months of the current fiscal year (July-October), compared to the same period last year. Inflation in October stood at 15.3 per cent. The principal contributor to the recent surge in inflation has been the sharp increase in food inflation. Food inflation averaged 13.7 per cent from November 2009 to July 10, but rose sharply to an average of 19 per cent during August-October 2010.
Food inflation was up 20.1 per cent in October. Fuel and lighting and transport and communication also remained elevated at 21.2 per cent and 18.5 per cent, respectively. A cursory look at the inflation figures would show that food inflation alone contributed 55 per cent in the rise of overall inflation. Fuel and lighting and transport and communication contributed 11.3 per cent and 9.1 per cent, respectively.
Crop damages and supply disruption as a result of the unprecedented floods played important roles in the surge of food prices. Government-administered increases in fuel prices and power tariff also contributed to the increase in the general price level. Thus, food, fuel and transport and communication together contributed 75 per cent to the recent surge in general prices. Should we believe that the rise in the discount rate the prices of food items will come down and the government will stop increasing fuel prices and power tariff? Perhaps the governor of the SBP thinks so.
Central banks around the world target core inflation in the conduct of monetary policy, not headline inflation. Nonfood, non-energy inflation (core inflation) is on the decline since June and was 9.3 per cent in October, as opposed to the headline inflation of 15.3 percent. This clearly suggests that the current increase in inflation is due to the rise in food and fuel prices and transport charges, for which the monetary policy is not an effective instrument to control the situation. Second, one of the objectives of tightening monetary policy is curtailment of aggregate demand and restoration of balance in the economy. Excessive aggregate demand will be reflected through the widening of current-account deficit. Current-account deficit was down by 55 per cent in the first four months of the current fiscal year. In fact, current account remained in surplus during the months of September and October. A sharp reduction in currentaccount deficit suggests significant reduction in imbalances and absence of excessive demand. This can also be corroborated by sales-tax collection from domestic economic activity which was up 8.0 per cent during the first four months of the current fiscal year despite a 1.0-percentage-point increase in the sales tax rate and 15 per cent inflation. Was a further hike in the discount rate justified in the wake of the collapse in aggregate demand? Perhaps the governor of the SBP thinks so.
Third, yet another objective of tightening monetary policy is to discourage the government from borrowing heavily from the SBP to finance fiscal deficit. Government borrowing from the SBP is the main source of the surge in reserve money growth. During the last four-and-a-half-months, the government has borrowed Rs265 billion, against Rs16 billion in the corresponding period last year. As a result, reserve money has grown by 18.4 per cent, against 9.7 percent last year. Perhaps the SBP believes that a rise in discount rate will discourage the government from borrowing from the central bank. The SBP has forgotten that by raising the discount rate by 100 basis points in the current fiscal year, it has increased the interest payment of the government by almost Rs50 billion. Thus, everything being held constant, the budget deficit will increase by Rs50 billion. Hence, more deficit, more borrowing, a further hike in the discount rate, further increase in interest payment, and further increase in budget deficit. Do we want to create a vicious circle?
Perhaps the SBP believes that by increasing the discount rate it will encourage commercial banks to participate actively in auction of government debt. In other words, it will shift government borrowings from the SBP to scheduled banks. Government borrowings from the scheduled banks stood at Rs76 billion, against Rs164 billion in the same period last year. Perhaps the scheduled banks are deliberately avoiding participation in the auction to the extent they should have been.