Monetary Policy: Pragmatism or Obduracy

Economic growth should be the ultimate objective of policymakers along with redistribution of resources among the society to maintain the balance among the distribution of resources. Following such a policy may reduce the gap between rich and poor, hence lesser income inequality.

Nevertheless, talk of the town is not in general, growth but inflation, exchange rate depreciation or forced appreciation, on target and off target tax collections, piling or reducing public debt and these days the most important loss of economy due to dharna and floods. No doubt these are as important as some other indicators such as interest rate, private sector credit, debt servicing, allocation of budget etc. There is a possibility that everyone is thinking about “economic growth” but not explicitly. More importantly, most of us have failed to form a logical link between the above mentioned variables and economic growth.

I and some of my other colleagues and friends always follow theoretical foundations while presenting an argument. Although not everything can be explained by just theory, nonetheless, rigor always remains the core of the debate. In general, during the debate, just to win an argument, someone from the group would stand call other’s argument non-pragmatic. The above argument is important to mention here because when policymakers try to set different indicators in finding the pragmatic versions of debate/story they may divert from the actual target, which is growth. On the other hand while following “just growth” they may follow growth as well as welfare of the society. In my opinion following “just growth” is the pragmatic approach not the other way around.

Going back to traditional growth models investment is core of the economic growth. Investment can be done by utilizing saving or borrowing from the Banks. In Econ 101 we learn that investment is a function of interest rate. Although interest rate is insensitive to investment in the short run but it is not totally redundant. Studies suggest that interest rate investment nexus in the long run is significant therefore, we cannot ridicule it. Moreover, investors have been continuously asking to decrease interest rate since the new government took over the office last year.

Interest rate is the cost or price of borrowing. Nominal price is different than real price of borrowing. When we talk about nominal interest rate then it is nominal price of borrowing while real interest rate is the real price of borrowing. To contain the inflation the State Bank of Pakistan is not decreasing the interest rate. Although inflation is dropped to 7 percent nonetheless fear of higher inflation expectations is preventing the SBP from decreasing the discount rate.

It is evident from the picture that real interest rate is positive which implies real price of borrowing is quite high. Should it be closer to zero or negative?

Positive real interest rate is certainly not good for the investors because no one wants to borrow and high real price. This is one of the reasons private sector credit creation is not picking up along with several constraints and hurdles faced by the investors, which shrinks the profitability of the ventures.  

Question is why are they not decreasing the discount rate? Is it only due to higher inflation expectations? These policies are similar to “sado monetarism”, a term coined by the Nobel laureate Paul Krugman. It is just spoiling the ultimate goal, i.e. growth.

According to the Asian Development Bank, IMF and World Bank Pakistan’s economy is recovering which implies that recessionary trends are going away. Inflation has come down. Exchange rate is at the unreasonable level after forced appreciation. Due to improvement in energy situation, though slightly, and better energy management investors want to invest. Therefore, there is no point in keeping the discount rate at higher level, which is also keeping the real rate higher.

Besides above, we are out of acute stagflation therefore, it is not good to follow conservative central banker’s policies. Since most of the SBP’s policies are governed or in-line with the Ministry of Finance therefore the SBP with the agreement of the MOF should decrease the interest rate so that real interest rate declines and come closer to zero if not negative. This would kick off the investment in various sectors including the services sector which is the most resilient sector, especially during the energy crisis since 2008.

Since rules of the game are not clearly spelled out thus it is also possible that the monetary policy does not follow pragmatic approach instead follows the instinct of the BOSS. If it is true then we should stay away from visceral type monetary policy and move towards objective oriented monetary policy.

Rules of the game are very important before managing any policy. If Central Bank’s task is to control inflation at the socially optimal or minimum possible level or growth enhancing level or monetary stability then it should be followed strictly. Nevertheless, the SBP needs complete operational independence to perform better. If they continue to listen to the Ministry of Finance then it is will be visceral Darnomics. No one knows what is it and what it will be. I hope they formulate the policies pragmatically instead of obduracy.