Tracking inflation for optimal monetary policy

IN an economy inflation is often considered a monetary phenomenon which can be appropriately dealt with by using interest rates as a policy tool.

Researchers have also suggested and shown that in a general case increasing nominal interest rates by more than one unit for a unit increase in inflation produces reasonably good outcomes on average.

However, the simplicity of such rules often requires that a policymaker be aware of the underlying variables and be mindful of the judgement required on his part.

Fortunately, much more flexible models have evolved which consider variety of factors before suggesting a policy response.

One essential feature of these is the taking into account of various uncertainties or shocks (such as demand and cost shocks) which the economy experiences from time to time.

This brings us to an important step of investigating these shocks in the data followed by reconciling them with the observable events and then proposing a policy framework which may be most appropriate. Here I make a similar attempt in the case of Pakistan.

I have chosen 2008 as my starting year because it is then when international commodity prices touched their peak which was later followed by the global financial crisis. Furthermore, the data from the State Bank shows that inflation in Pakistan started increasing around January 2008 – few months after international oil prices started rising.

A detailed look at the data shows that initially commodity price shock and removal of subsidies led to an increase in food and fuel prices while the non food non energy (NFNE) group inflation did not change by much.

Gradually, with a lag of one quarter (roughly), NFNE inflation increased (due to rising marginal cost) up to 18.9 per cent in January 2009. By this time food and fuel inflation had already started declining from its peak of more than 25 per cent and had come down to around 21 per cent. Keeping in mind the earlier lag effect, NFNE inflation started declining from February 2009 onwards. In 2010 floods came and food inflation shot back up to 20 per cent while the NFNE inflation remained stable. With the
effect of floods subsiding, inflation declined subsequently.

From 13.9 per cent in Jan 2011 to 10.1 per cent in Jan 2012, year- on- year inflation has declined further. Much of the decline in the later year can be attributed to decrease in inflation for the food group (from 20.2 to 9.2 per cent over the same period) due to better crop production and sufficient levels of buffer stock. Considerable decline is also due to fall in the global food prices which saw an year-on-year increase of 29.9 per cent in January 2011 but declined by 10.7 per cent in January 2012.

Most of the fluctuations in various inflation indexes can be traced back either to the global trends in commodity prices or domestic shocks such as due to floods, energy shortages or elimination of subsidies. Other shocks are also in the form of government increasing the minimum price of major crops (such as wheat) which consequently lead to increase in prices of other crops as well. Owing to this uncertainty which underlay these events, the optimal monetary response should therefore be a cautionary one. Any attempt to aggressively reduce fluctuations in inflation under the given scenario will push the level of output further below its natural level and therefore reduce the overall social welfare.

In developing countries where equity markets are by and large underdeveloped, businesses rely on loans to expand and run themselves. In Pakistan not even a fraction of businesses are listed on the stock exchange. Under an environment with high interest rates, likelihood of default increases for businesses as they are now required to pay huge amounts to their creditors (banks).

Moreover, the risk of default also increases as investors are now forced to pursue riskier projects in an attempt to earn higher
returns required for paying back the high interest bearing loans. Banks, anticipating this increase in the risk of default, keep the interest rates at the level which may not clear the market but maximise the banks’ profits. In other words, not everyone is able to get the loan even if one is willing to pay a higher price – credit rationing.

Higher interest rates coupled with other factors has resulted in a decline in gross capital formation (an investment indicator) from 22 per cent of GDP in 2008 to 15 per cent in 2010 (World Bank data). Economic Survey 2011-12 has shown private investment declining from 15 per cent of GDP in 2007-08 to 10.2 per cent in 2009-10. The provisional estimate for 2011-12 show that the private investment has further declined to 7.9 per cent of the GDP.

Despite excessive government borrowing, public investment has also failed to keep the investment demand stable and that, on the contrary, has declined from 5.4 per cent to three per cent over the same period. However, the World Bank estimates show that the gross savings rate has declined by less and has remained close 20 per cent of the GDP. With savings running ahead of investment, it is likely that the output growth will fall over the medium run if the trend in investment is not reversed with the help higher public investment and lower interest rates.

Having looked at the trends in inflation indexes and highlighted some of the costs associated with a high interest rate policy, I now return to the question under investigation – what is an optimal monetary policy? When the benefits of any policy are not clear while the costs associated with it are obvious, ‘caution’ becomes a virtue.

As long as the process of elimination of subsidies does not get completed and sufficient electricity is not produced to allow businesses to achieve economies of scale, it will not be appropriate to target a pre-crisis level of inflation rate. Additionally, an optimal monetary response to changes in inflation must adopt a cautionary approach if the underlying factors influencing the changes in price are supply or cost shocks.

First Published in Dawn (18th June 2012)

http://dawn.com/2012/06/18/tracking-inflation-for-optimal-monetary-policy/