The implications of inflation targeting

One of the most pressing issues confronting the PTI government is inflation that has pushed millions of people below the poverty line since 2018.

The government blames mafias - cartels, hoarders, and extortionists - for creating an artificial shortage of edibles to fetch high prices. In recent months we saw wheat, sugar, and petrol vanished from markets.

Later, all three commodities were sold at premium prices under the very nose of the government, which after letting the mafias strip people of their hard-earned money, appointed commissions to probe the market distortion. Despite the investigation, the hoarders are far from being convicted, and neither the prices of essential commodities have come down.

The question arises: who is responsible for stabilising prices?

Fundamentally, it is the responsibility of the central banks which, by managing the supply of money and interest rates, achieve a range of other objectives such as price stabilisation, economic growth, employment and financial stability. In the real world, it is not possible to achieve all these objectives simultaneously. When one is targeted, the other suffers. Therefore, banks pick objectives that best serve their country's prevailing interest.

Since 1980, central banks world over have been consistently focused on achieving price stabilisation through adjustments in interest rate. This theory - inflation targeting - holds that if the interest rate is raised, it brings inflation down. Inflation targeting had been first practised by the central bank of New Zealand in 1980. No sooner did every other country from the US to Japan to England and Canada adopt it as gospel truth to control inflation, despite experiencing stunted economic growth and high unemployment. Over time, first during the 2008 economic crisis and later with the coronavirus-induced economic disruptions, many central banks concentrated on economic growth rather than striving to keep inflation at a minimum range.

Interest rates were dramatically lowered to pump money into the market, and contrary to common belief, low interest rates did not translate into high inflation. In the UK in 2019, the interest rate was 0.7%, and the rate of inflation was 1.8%.

During the coronavirus, the UK's inflation rate moved further down to settle at 0.4%. In crux, the Bank of England and many central banks of developed countries practise quantitative easing rather than inflation targeting to achieve economic growth.

While the government in Pakistan focuses on mafias to vent its failure to control inflation, it has been deflecting on its role to direct the state bank to devise a monetary policy that favours an ordinary person.

High interest rates only go so far in reducing inflation as it dissuades people from buying luxury items such as cars, etc. However, it does not reduce the demand for commodities used on a daily basis. In reality, high interest rates increase inflation because of supply-side market disruptions. It also raises the cost of debt a government borrows to meet its expenses but fails to return in a given time frame.

Many countries borrow debt from their commercial banks. These debts are usually of the short-term period to be paid off within one day or one year. Usually, governments fail to have sufficient money to pay off debt; therefore, they borrow more to repay interest.

This debt is borrowed on the current interest rate. In simple words, short-term debts are impacted every three to six months by a new interest rate. For instance, the PML-N government in 2018 had allocated Rs1,391 billion to pay interest on a Rs16,200 billion debt. At that time, the interest rate was 6%. When the PTI government was preparing its first budget in 2019, the government debt had increased to Rs18,500 billion, which was 14% higher than the 2018 debt.

To pay off the interest on this debt, the PTI government allocated Rs2,531 billion in the budget, which was 82% higher than the previous year's interest. This differential was due to the policy rate that had risen to 11% in one year. If the interest rate had remained constant, there would have been a corresponding 14% increase in the interest.

The additional 68% amounting to Rs960 billion was borne because of inflation targeting.