There are three pricing elements which central banks usually evaluate to determine equilibrium by changing one or more to have an impact on the others. These are prices of goods and services – inflation, interest rate and currency exchange rate. The job of the central bank is to maintain equilibrium amongst these measures to stabilize the monetary system.
What SBP is doing lately is determining interest rates based on the inflation outlook while completely ignoring the exchange rate. Even, the premise of lowering interest rates based on low inflation is debatable. The link between inflation and interest rates is driven by demand; if you increase interest rates, demand for money should fall and subsequently, demand-driven inflation is lower and vice versa.
The reason for cutting the policy interest rate by 400 basis points since November 14, 2014; is that inflation has come down significantly and there is a need to spur demand for money through lower interest rates. But the chief reason for subdued inflation is supply-side positive shocks as international commodity prices nose-dived.
The demand side is rather showing a varying picture – monetary aggregates grew by 13.2 percent in FY15 while the nominal GDP growth is around 8.7 percent (4.2% real GDP plus 4.5% CPI). According to the Ministry of Finance numbers, the nominal GDP growth was 7.8 percent. This implies there is an excess demand (4.5-5.4%) and this can fuel inflation. On the other hand, SBP is consistently lowering the interest rates. The relation is not that simple and there is an anomaly in it. Is the monetary policy document explaining it?
The reason could be an overhang of low growth and high inflation era and it takes time for consumers and producers to change behavior. But the central bank should have explained it. The excess demand wasn’t there in FY14 as M2 grew by 12.5 percent while nominal GDP growth was similar (4% real GDP plus 8.6% CPI).
The point is that excessive easing can fuel inflation and the need is to find avenues where excess demand emanates from. The currency in circulation is growing rampantly lately so is it fuelling the informal economy, or there is something else?
The other important factor that is completely ignored by SBP is its own computed real effective exchange rate (REER) which describes the deviation of the nominal exchange rate from its equilibrium value. There are various methodologies used to compute the equilibrium exchange rate. The most widely used are REER. And within REER, there is a number of ways to compute and this article is confined to the calculations by SBP.
REER, as computed by SBP, was at 121.6 in July 2015. The nominal currency depreciated by two percent since then against the USD which may have lowered REER to 119, by now. This is the highest value since 2002, as per the data published by SBP. It ranged in the band of 94-106 during 2002-2013. In February 2014, the REER was 101.7 however it has slipped out of hand since then. As of March of this year, REER jumped to 107 while its last reported reading is 121.6.
Published on September 15, 2015.
