On May 22, the State Bank of Pakistan announced policy measures to facilitate the process of correction in the macroeconomic imbalances accumulated over the past few years. This worrisome macroeconomic situation can be attributed to the domestic policy slippages and worsening international environment.

An ever widening current account deficit (trade gap) mainly due to relatively inelastic import demand and abnormal price increases in commodities like crude oil exerted extra pressure on the balance of payment (BOP), the foreign exchange reserves and exchange rate. While the stagnating revenue resources and dwindling external inflows necessitated higher borrowings by the government from SBP to meet the financing gap of expansionary fiscal policy.

The deteriorating twin deficit further aggravated the existing macroeconomic imbalances. Inflation surged to unbearable level, particularly for the poor.

Over the last two years, the SBP gradually tightened its policy stance for chocking inflationary pressures. Time and again, the central bank also conveyed its concern over the deteriorating fiscal position and financing of the budgetary deficit from SBP borrowings which raised inflationary expectations. The SBP efforts, however, were met with little success and high prices remained one of the major concerns.

In this scenario, the SBP stepped in on May 22 to further tighten the monetary policy. It jacked up the policy rate (discount rate) by 150 bps, 100 bps increase in CRR/SLR rate on deposits of less than one year to weekly average of nine and 19 per cent respectively and imposed 35 per cent cash margin on opening all import LCs except the specified 47 basic commodities/items. The SBP efforts to rein in inflationary expectations were made in the light of “Taylor Principle” as explained later in this article.

The economy where inflation expectations are very high, will most likely suffer from serious destabilisation, if policy steps are delayed for taming such expectations. Such delays both on fiscal and monetary policy fronts can already be observed.

Fiscal policy delays may be exemplified with the government’s current absorption of high international oil prices and its partial pass through to domestic consumers. Such delays burden the budget as financing needs are met through banking system which crowd out the needs of productive sectors.

On the other hand, delays in monetary response mostly occur due to unavailability of fiscal data to monetary authorities. Fiscal plans envisage various sources of financing of fiscal deficit. At times, it is almost impossible to anticipate delays in financing from these sources.

These shortfalls, supposed to be temporary, are met by borrowing from the SBP delaying the tightening mode. Such delays in the short-run might provide some political expediency, however in the medium to long-term they prove damaging for the economy. For this reason, the “Taylor Principle” asserts that when inflationary expectations accelerate there is a strong case to raise higher interest rates.

Looking at the inflation data, one can see that it oscillated around an average annual year-over-year (YoY) growth of 7.5 per cent for a considerable period of time till August 2007, thereafter; recording some very prominent spikes and virtually getting out of control. [see Figure-1].

More important, in the light of surging global oil prices, the inflationary expectations are getting further strengthened.

The difference between short-term interest rate (which is considered to be controlled by the central bank) and expected inflation is the short-term real rate, which can only be delivered if the increase in the latter is matched by the increase in the earlier case.

In the last decade, a new idea sprang up in monetary economics, called “the Taylor Principle”. It asserts that when there is a 100-basis-point increase in expected inflation, the central bank must increase interest rates by more than 100 basis points. If and only if this is done, then the monetary policy is acting to stabilise GDP. If this is not done, then the monetary policy is destabilising. The “Taylor Principle” stands for a hawkish monetary policy stance when there is a rise in expected inflation. The basic intuition underlying the “Taylor Principle” is as follows.

Supposing that there is a 100-basis-point increase in expected inflation and the central bank responds with only 50 basis points increase in its policy rate , the real rate goes down by 50 basis points. When expansionary forces are acting on the economy, monetary policy is additionally expansionary. When times are good, monetary policy acts to make them better.

In reverse, supposing that there is a 100 bps point drop in expected inflation, and the central bank responds with a drop in its policy rate of only 50 basis points. In this case, the real rate has gone up by 50 basis points. In other words, when contractionary forces are operating on the economy, monetary policy is additionally contractionary. When times are bad, monetary policy acts to make them worse.

These two examples show that when there is a 100 bps rise in expected inflation, and the central bank is not hawkish, and rates are raised by less than 100 bps, then monetary policy is destabilising; monetary policy exacerbates the volatility of GDP.

The “Taylor Principle” asserts that the only stabilising monetary policy is one which responds to a shock in expected inflation by greater than one-for-one. If SBP wants to help stabilise GDP growth rate, which is the ultimate goal of monetary policy, then it has to be hawkish in responding to expected inflation. Interest rates must go up by more than one-on-one when expected inflation goes up. Conversely, interest rates must go down by more than one-on-one when expected inflation goes down.

The empirical evidence in support of the “Taylor Principle” may be found in the literature for numerous countries. One such study was carried out by Andrew Aug and Sen Dong on US economy. They have concluded that one-to-one increase in expected inflation and interest rate reduces GDP volatility.

In another study, the author finds that in 1960s and 1970s, the US Fed had an inflation coefficient of 0.8. That is, on average, when expected inflation went up by 100 bps, rates were only raised by 80 bps. This violated the “Taylor Principle”, and US GDP volatility was high.

From 1979 onwards, the monetary policy of Paul Volcker and Alan Greenspan was compatible with the “Taylor Principle”. The inflation coefficient went up to 2.1. There has been a remarkable drop in US GDP volatility in the post-1979 period. While other factors, such as financial globalisation and improved information technology, have surely played a role in calming GDP volatility, there is a strong consensus that adhering to the “Taylor Principle” has also played an important part in reducing US GDP volatility. Similar characteristics have been found in numerous major economies, particularly those that have adopted inflation targeting as the legal foundation of their central bank.

If one goes by the results of these empirical research, it may be concluded that Pakistan has violated the Taylor Principle. Its monetary policy has not responded properly to changes in expected inflation. The policy has been destabilising; interest rates have been raised to choke the economy at the wrong time, and they have been dropped at a time when they exacerbated inflation.

Like other less developed countries, Pakistan is saddled with a very defective measurement system of both inflation and expected inflation. The expected inflation cannot be measured easily in the absence of a well-traded yield curve or inflation-linked bonds in the market.

As per Taylor Principle “jacking up the policy rate” signalled market for urgent rise in interest rates to avoid destabilising impact of presumed inflationary expectations. SBP’s hawkish stance may lead to GDP growth stability in the medium-term. If the situation demands, the State Bank may not be shy in future to have such a hawkish outlook.

The writer is joint director, monetary policy department of the State Bank of Pakistan. .