In the article
I wrote earlier, I made an attempt to track the trends in inflation figures choosing
2008 as my starting year. Using data from the State Bank inflation reports, I
finally concluded that ‘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 subsides.’
Furthermore, I also pointed to the increase in the minimum support price of
major agricultural commodities (eg. wheat) which consequently increased the
prices of other crops as well.
The above analysis had direct
policy implications. Firstly, any policy which aggressively attempts to control
spurts in inflation – when exogenous shocks are the primary reason – will be
counterproductive. Therefore, monetary policy must take a cautionary approach.
Secondly, inflation will gradually decline as different shocks finally
dissipate in the economy. Both the implications were based on the observation
that excess demand is unlikely to be the driving force underlying inflation
trends. This observation flows from the fact that growth rates of the past few
years have been below the potential. In technical terms used in macroeconomic
models, ‘output gap’ have been negative.
There is indeed evidence that the
economy has not experienced any major price shock in the previous months thus
allowing the inflation to converge to the level consistent with the prevailing
output gap. In addition, recent cut in the prices of CNG by Rs. 30 has
increased the pace of this downward convergence. However, there are two strong
arguments which question the declining trends: one is excessive government
borrowing from the banking system which makes decline in overall inflation to
look paradoxical; and, the other is how much time (time lag) it may take for
the shocks to dissipate in the economy. Both the arguments are interlinked as
is everything in economics and they equally strengthen the notion that
government must have manipulated the numbers to suit their political needs.
However, to me the recent inflation trend appears to follow a pattern which is
dictated by economic logic rather than political motives.
Most economic models are tuned to
considering the shock processes as exogenous. Endogenous shocks have only
recently begun to penetrate in the mainstream models. Therefore, I must accept
that I do not have a sound research study to support the following analysis but
this in itself is not a valid reason to stop me from doing so. Although most of
the shocks are considered to be exogenous but some of them could very well be
endogenous at least in some special circumstances.
The first argument of increase in
the government borrowing has two parts in it. Government may borrow from the
commercial banks or from the State Bank. It is only the latter which significantly
contributes towards inflation by resulting in an increase in the money supply
as a direct consequence of State Bank printing money. This increase in the
money supply is a shock and is mostly treated as exogenous in macroeconomic
models. However for Pakistan, in the special case of last few years, money
supply shock was endogenous to other exogenous shock processes such as floods,
military operation, IDPs, global energy prices which resulted in rising fiscal
needs. It will, therefore, be illogical to analyze its effects independent of
the exogenous shock processes thus overestimating the consequences and
justifying an aggressive monetary policy stance.
The second argument of the ‘time
lag’ is less generic and varies from region to region. The time lag itself
depends on the degree of inflation persistence and also the dynamics
(autocorrelation) of it. Inflation persistence determines the time it takes for
any price shock to dissipate. Knowing inflation persistence is vital for
conducting monetary policy optimally as it guides the monetary authority (State
Bank) on how to adjust the policy instruments in response to shocks (or
deviation from the steady state) so as to achieve the desired targets. Lack of
inflation persistence implies that the impact of monetary policy response to price
shocks will be immediate rather than delayed and gradual.
Recent study by the State Bank showed that
aggregate inflation persistence in Pakistan has only been 0.19 for the period
of 1959-2011 which has become statistically insignificant for the most recent
period of 2001-2011. This means that the impact of the previous shocks has
already been felt at the aggregate level and thus the recent fall in the aggregate
inflation level to 7.66% is justified. On the other hand, inflation persistence
in the core inflation is significant at 0.69 which is why core inflation, which
stands at 10.8%, has still not come down significantly and will take more time
given no bad news hits the economy in the coming months.
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