On tackling inflation | Pakistan Today

When the State Bank of Pakistan (SBP) raised its policy rate to 22% (effective March 27, 2023), the CPI inflation rate was 35.4%. Since then, inflation has generally continued to decline, albeit slowly, but in February this year, inflation was above the policy rate of 22% (where the policy rate has remained since it was raised to that level last year), with the CPI at 23.1%.

Having said that, the policy rate was cut three months later, on June 10, by only 150 basis points to 20.5%, while inflation had already fallen sharply to 11.8% in May. While CPI inflation rose slightly to 12.6% in June, it fell to 11.1% in July, and the policy rate was cut only once more, but by a small amount, to 19.5% on July 29. Therefore, there is still a huge gap of 8.4% between the policy rate and inflation.

Although conventional economics holds that real interest rates should be slightly positive, i.e. nominal interest rates slightly above the inflation rate, the current positive real interest rate is 8.4%. This is unacceptable even from the perspective of conventional economics, not to mention that there is little reason to achieve positive real interest rates, especially in developing countries, because inflation in developing countries has traditionally been at least a fiscal phenomenon, not just a monetary one.

Controlling excessive monetary tightening in turn requires greater government involvement in the central bank’s monetary policy committee and overall efforts to reduce the central bank’s excessive independence, so as not to overuse the policy interest rate to control inflation; this policy has caused unnecessary sacrifices in economic growth and exacerbated debt difficulties; not to mention the rise in cost-push inflation and imported inflation caused by this policy.

Moreover, the practice of using policy interest rates primarily as a tool to control inflation has lost its relevance after the global supply shocks caused by the COVID-19 pandemic and geopolitical conflicts. Moreover, supply-side policies have become more important even in developed countries anyway, not only because of the pandemic-related supply shocks, but also because of the structural transformation of the global economy after major rapidly developing existential threats and the digital reorientation of the global economy caused by the rapid development of artificial intelligence in recent years. Therefore, in order to control inflation, developed countries must raise their inflation targets to 2-3%, and developing countries cannot have positive real interest rates.

Nobel Prize-winning economist Joseph Stiglitz told ABC News (Australia), “First of all, let me say where the 2% to 3% number comes from. It’s made up. There is no scientific basis. Now it has become an accepted convention. But in fact, economic research shows that when the economy goes through a transformation, and we are going through a transformation – a green economy, a digital economy, a post-COVID-19 economy – you may want the inflation target rate to be higher. … I certainly don’t think there is any danger of inflation reaching 4% or 5%, or even above that level for a short period of time. You know, people don’t want inflation to get out of control, but there is little evidence that inflation rising to 4% or 5% will lead to out-of-control inflation.”

Renowned economist Berry Eichengreen expressed similar thoughts in an interview published in the Financial Times (FT) on August 9 titled “Barry Eichengreen: ‘The Fed operates in a fog,'” noting that “the Fed is operating in a fog. Several financial anchors that they relied on in the period of relative calm before the pandemic have subsequently begun to drag. For example, there is controversy over what the underlying equilibrium real interest rate is, and whether it has changed significantly as a result of changes in the structure of the global economy and debt levels. As a result, there is considerable uncertainty about the level of interest rates that the Fed should be targeting (the so-called neutral rate of interest).”

Controlling excessive monetary tightening requires greater government involvement in the central bank’s monetary policy committee and a general reduction in the central bank’s excessive independence to avoid excessive use of the policy rate to control inflation; this policy has produced unnecessary sacrifices in economic growth and exacerbated debt difficulties; not to mention the rise in cost-push and imported inflation that this policy has triggered.

Project Syndicate (PS) recently published an article titled “The Limits of Central Bank Independence” which states that “Central bank independence is often seen as a panacea for the high and persistent inflation of the 1970s and early 1980s. To many, it looks like a free lunch: deflation and long-term price stability without any adverse effects on growth and unemployment. But defenders of central bank independence almost certainly overestimate its role as a guarantor of low inflation. Consider a counterfactual: Since the introduction of its monetary policy framework in the early 1980s, the Monetary Authority of Singapore has averaged inflation of close to 2%. Few central banks can match this stellar record, but with four government ministers on the Monetary Authority of Singapore’s board, there is no doubt that the Singapore government can control monetary policy if it chooses. Singapore has achieved persistently low and stable inflation without a strong system of central bank independence.”