No doubt the State Bank enjoys autonomy, but now a situation of fiscal dominance is being faced. As such, instead of sucking out excess liquidity from the banking system, the State Bank is pumping out liquidity directly into the economy

IN recent years, industrialized countries and some of the transitional economies have recognized ‘inflation targeting’ as a most effective tool to control inflationary pressure.

Inflation target for achieving price stability are set on annual basis. And the central bank is accountable for meeting the target.

This mechanism has been in practice since early 90’s starting mostly with developed countries and by some of the high income developing countries.

The explicit target setting mechanism provides an anchor for private market expectations apart from assisting central banks to have effective control on money supply to ensure sustained economic growth.

Among the countries who have chosen to enter inflation targeting regime, one finds a lot of diversity of institutional and operational features of their central banks, but the main aim is to maintain low and stable inflation. It is a focused objective of their monetary policy.

The rationale of this emphasis has long-term repercussions on the economy by sustaining high economic growth rate and employment level. Actually monetary policy is formulated within some sort of conceptual framework and this framework is needed to be explicit on all counts.

It is inflation targeting, which provides coherent framework for thinking about monetary policy choices, which in turn involves access of public opinion. For the success of inflation targeting strategy, central banks need to have total autonomy. The best practice inflation targeting is based on communication strategy, which a central bank adopts for communicating with political authorities, financial markets and general public.

The success of inflation targeting, if taken as main component of monetary policy by a central bank, depends on nature of political institutions. It has been established through experience that countries having long established political institutional pattern are more likely to succeed as generally high inflation is the outcome of political instability as is the case with majority of low and middle- income developing countries.

Economies of low-income developing countries including Pakistan are faced with fiscal burden, rising trade deficit and continuous government intervention to seek funds from central banks to bridge fiscal deficit, thus adversely impacting monetary situation. This gives rise to speculative activities, which is the main cause of persistent high inflationary pressure.

Pakistan in particular, apart from fiscal difficulties and rising trade deficit is presently faced with rising inflation primarily due to rising oil prices and more importantly owing to strong hold of informal market causing hoarding and speculative activity in special consumer items market, which despite concerted efforts of economic managers to bring down inflation to five per cent level in 2003 and 2004 has made the core inflation flare up to a level of eight per cent again since last eighteen months.

Inflation targeting applied in crude form to bring down consumer price index (CPI) to a manageable level have totally failed. Due to hoarding and speculative activity going on unabated, profits earned by food and other consumer items suppliers have mounted since last 18 months or so.

No doubt the State Bank of Pakistan enjoys autonomy, but now a situation of fiscal dominance is being faced. As such, instead of sucking out excess liquidity from the banking system, the State Bank is pumping out liquidity directly into the economy.

According to recent reports, the figure of Rs515 billion pertaining to Treasury Bills (T-Bill) appearing on central bank’s balance sheet does not entirely account for T-bills sold to banks. This includes a sizable portion provided to the government.

Since this money is spent on public works undertaken by government, this comes back to banking sector, thus enabling the banks to lend to private sector. As a result advances to deposit ratio has steeply risen to 77 per cent lately, no doubt causing monetary growth, but at the same time steep rise in inflation.

Further, the growing trend is towards monopolization and forming cartels is yet another hitch towards controlling abrupt and unjustified rise in prices of essential items of consumption. Accordingly under present scenario of fiscal dominance and unethical business trends, inflation targeting strategy can not work effectively.

The same applies to other low income developing economies where central banks have to undertake deficit financing strategies as a matter of routine to meet revenue shortfalls of their governments. The best practice monetary policy is designed to achieve inflation reduction target with emphasis on promoting real economic growth.