Once again, the State Bank of Pakistan (SBP) has kept its policy rate intact at seven per cent for the next two months. It has warned that consumer inflation during this fiscal year can remain “close to the upper end of the previously announced range of 7-9pc”. This means somewhere between 8.5pc and 9pc.

The central bank’s decision of keeping the interest rate unchanged at 7pc was well expected. Because even a modest increase at this stage could have upset pro-growth sentiments. The government had initially set the GDP growth target at 2.1pc for this fiscal year. The SBP had said in its last monetary policy statement on Nov 23, 2020 that growth could be “slightly above 2pc”. But in its March 19 policy statement, it said growth could be higher — around 3pc. So the continuation of the accommodative monetary policy could be seen as a reflection of the SBP’s desire to support the ongoing economic recovery. Last fiscal year, Pakistan’s economy shrank 0.4pc.

The latest monetary policy statement is significant in the sense that the central bank has put a numerical value to the inflation outlook in the medium term. “Looking ahead, as the temporary increase in inflation from administered prices wanes, inflation should fall to (the) 5-7pc range in the medium term,” says the statement.

Future monetary policies will exclusively aim at achieving yearly inflation targets in a manner that does not deviate from the predetermined medium-term inflation range

Does the statement indicate that once the SBP gets the required autonomy to begin inflation targeting (which it expects to get in the near future), the first medium-term target will be 5-7pc? Or is it for the consumption of the financial markets’ growing restlessness to see the birth of a positive real interest rate?

The real interest rate has remained negative for the past one year — and looks set to remain negative in the near future. Headline inflation has stayed well above the policy rate and is also likely to remain higher than that — at least till June. In February, inflation was 8.7pc.

On March 9, the federal cabinet cleared a proposed law that seeks to make the SBP more autonomous. If the SBP Amendment Bill 2021 is approved by parliament then the primary responsibility of the central bank will be to ensure “price stability” and supporting economic growth will become a tertiary objective for it, Finance Minister Dr Abdul Hafeez Shaikh said at a media briefing on March 10. The central bank is being made more autonomous as part of broader fiscal and monetary reforms agreed upon with the IMF.

The government plans a fast-track legislation for this purpose. Without it, the stalled $6bn IMF lending programme cannot be revived. How on earth this will be done is a million-dollar question though. Nine out of 10 parties in the grand opposition alliance, including the PML-N, are apparently not willing to participate in parliamentary politics and are, instead, demanding the federal government’s resignation. But the government, backed by the powerful “establishment”, is confident that the SBP Amendment Bill and other related proposed laws designed to meet the IMF conditions will soon be tabled in and approved by the two houses of parliament.

Since the approval of the SBP Amendment Bill by the federal cabinet, the move is being debated in the national media. The federal government is trying to explain that even when the SBP switches over to inflation targeting, supporting economic growth will remain its tertiary responsibility. Inflation targeting will only mean that the SBP will direct all its efforts to ensure that inflation remains within a certain band set by the National Economic Council.

Keeping inflation in that certain band in the medium term — for three to five years — should, theoretically, help the government hit or get closer to yearly economic growth targets.

Under this system of “inflation targeting”, maintaining inflation within a certain band can lead to temporary volatility in exchange rates. The central bank will avoid and manage such volatility making the exchange rates increasingly market-oriented rather than intervening in the foreign exchange market. Initially, or even during the first few years of inflation targeting, economic managers may also find it extremely difficult to hit economic and employment growth targets. But such risks can be managed by introducing greater fiscal discipline right before the central bank begins inflation targeting or immediately afterwards.

For more than a year, the SBP has made no net intervention in the foreign exchange market. Nor has the government made net fresh borrowing from the central bank. These two key developments indicate that enough groundwork has been made for enabling the SBP to begin inflation targeting. It is not a question of whether it will do so. It’s a question of when.

Once the proposed piece of legislation to make the SBP truly autonomous is approved, the central bank will set a medium-term inflation target range in consultation with the National Economic Council. A yearly inflation target will be set within that range. Then future monetary policies will exclusively aim at hitting yearly inflation targets in a manner that does not deviate from the pre-set medium-term inflation range.

Back in February 2020, two officials of the Monetary Policy Department of the SBP had found in their joint study after applying “a variety of technical methods” that in Pakistan’s context, inflation above 8-9pc is harmful for society. They had also found that on the lower side, “inflation below 4pc is also undesirable”.

“Keeping in mind these findings, the inflation target range in the similar emerging economies, history of inflation volatility in Pakistan and the importance of exchange rate,” they recommended the inflation target to be set at 5.5pc with a band of plus or minus 1.5pc.

This recommended inflation target of 7pc on the higher side and 5pc on the lower side matches exactly the medium-term range of inflation mentioned in the SBP’s latest monetary policy statement of March 19. The stage is set for inflation targeting!

Published in Dawn, The Business and Finance Weekly, January 22nd, 2021