The State Bank of Pakistan (SBP) raised the policy rate by another 100 basis points (bps) to 17 per cent in a meeting of its Monetary Policy Committee on Jan 23 — the highest since October 1997.

Experts are divided on whether the hike is sufficient to anchor inflation expectations. Missing from the debate, however, is a focus on monetary policy communication. This is important as the SBP seems to — at least as it claims in the latest monetary policy statement (MPS) — be targeting and anchoring inflation expectations right.

Good communication enhances policy effectiveness by influencing expectations and reducing uncertainty in the market. Communication problems do the opposite. Any inconsistencies or lack of follow-up information can compromise the credibility of any central bank and its effectiveness at influencing the market, the economy and the people.

A Financial Times article stated that central banks need to say what they do, and do what they say. A monetary policy statement is the most important instrument of central banks’ communication with markets, experts and the general audience. Good communication demands clarity and consistency. It is even more important for central banks as they run on credibility, unlike the government which has instruments to forcefully implement its decisions.

Monetary policy, MPS and communication problems

A closer look into monetary policy communication, including the Jan 23 statement, highlights some problems.

One big problem is the lack of clarity on whether the SBP has officially adopted inflation targeting — setting an inflation target and then adjusting the monetary policy to achieve that. What framework does it have for this?

Presumably, the SBP is following inflation targeting. But it seems it is doing so in a loose sense as there has been no official communication in this regard, particularly on what model of inflation targeting the central bank is following.

This part of the monetary policy statement, “The MPC stressed that it is critical to anchor inflation expectations and achieve the objective of price stability to support sustainable growth in the future,” to some extent suggests that the SBP was mindful of slowing down the economy while taking a decision on the size of the rate hike.

This may be a potential reason for the rate hike being less than what experts were expecting as the SBP is following integrated inflation targeting (hereafter IIT), which outgoing deputy governor Dr Murtaza Syed termed as “flexible inflation targeting” in one of the SDPI’s webinars, hosted by the writer. In other words, the SBP is not following inflation targeting (hereafter IT) in the strictest sense.

While the SBP seems to have made the right choice by following IIT, it has never communicated it clearly to the market. Or, at least the communication has not reached the market properly. Even the experts in the field of central banking and monetary policy continue to assume that the SBP is following IT.

Integrated inflation targeting vs inflation targeting

In IIT, decisions are made while giving considerable weight to secondary and tertiary targets of the SBP, which include financial stability and supporting growth and development. On the contrary, when strictly following IT, price stability gets all the weight. In the IT regime, the rate hike would be higher than 100bps as the country’s inflation levels are at decades-high and inflation expectations seem to not have anchored around the SBP’s medium-term target of 5-7pc.

Clear communication about which inflation targeting regime the SBP is actually following is critical as the market was expecting a higher rate hike on the assumption the central bank was following inflation targeting. This inconsistency and mismatch of information and expectations may compromise the SBP’s objective of correcting inflation expectations and not letting them “feed into higher inflation expectations over a longer-than-anticipated period”.

Furthermore, the effectiveness of communication depends on providing follow-up information. This, too, seems to be missing both in the monetary policy statement as well as the central bank governor’s press conference.

Take, for example, the latest monetary policy statement in which two important items are missing. It does not clearly communicate what the “anticipated period” of higher inflation expectations is and on what basis the SBP is hopeful of lower inflation expectations afterwards.

Exchange rate

The post-MPS presentation of the SBP deputy governor stated, “USD has weakened in recent weeks, providing some respite for emerging market currencies — PKR depreciated by only 2.5pc since the last MPC meeting.” This was clearly not the case as the USD-PKR exchange rate was not market-based.

This claim of the exchange rate’s stability came days before the PKR depreciated by a record Rs24.54 in the interbank market. The rupee, which closed at Rs230.89 per dollar on Jan 25, plummeted to Rs255.43 per dollar by the close of the next day.

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On Jan 30, a week after the SBP governor’s press conference, the rupee closed at 269.63 a dollar. The rapid decline in value came after the government removed an unofficial cap on the exchange rate.

This poses a real challenge to the SBP’s claim that the PKR depreciated by 2.5pc and can hurt the credibility of numbers coming from the bank. Moreover, since the last MPC, businessmen had been protesting that the SBP and commercial banks were not opening letters of credit (LCs) in an attempt to suppress demand for the greenback.

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Despite these demand controls, the interbank market was out of dollars when this statement was made, the black market was growing and, most importantly, the 2.5pc depreciation figure did not represent the true decline in the rupee’s value as a price cap was in effect in the open market to support interbank ad hoc overvaluation. The central bank was aware of this.

A mismatch between words and actions — as was visible on the exchange rate policy — can hurt the SBP’s credibility which in turn will affect its influence on inflation expectations. Therefore, the SBP must avoid these kinds of statements, which are better left to the treasury. The market’s trust in the SBP’s words is essential to its influence on the market and economy.

On the exchange rate policy, the SBP must ensure it clearly communicates that it does not and will not accumulate depreciation through ad hoc measures. While it should work with the government to arrest speculative pressures, it must make sure that the exchange rate is reflective of changing economic fundamentals.

Remittances

Most recently, a rebuttal from the SBP that was circulating on social media caught much attention. According to it, the SBP believes that the drop in remittances was linked to a slowdown in global activity. While it may be a factor, there can be no denying that an equally important factor was a difference of Rs25-30 per dollar in the interbank and black markets. This led to more remittances through hundi and hawala.

What the SBP should do

The SBP must take a cautious approach to avoid too many rebuttals, particularly those not supported by evidence for the claims. It is not the central bank’s job to defend every discussion in the market and particularly discussions on unwarranted policies of any government. It must take an independent position on issues falling under its domain, including the exchange rate.

The SBP must clearly and consistently communicate to the market and the public at large that it has adopted IIT, what it calls flexible inflation targeting regime. It must take the market into confidence about why this choice is more sensible for Pakistan than the standard IT. This will help narrow the gap between the market’s expectations and the SBP’s stance.

The SBP will be walking a tightrope in FY23 with the rupee under pressure, the economy slowing down, growth rate dropping below 2pc and historic inflation. As the SBP touches the upper limit of the policy rate, effective communication will be the main instrument in its armoury. Transparent and consistent communication will be the decisive factor in maintaining the market’s trust in the central bank’s policies.