IF there were a central bankers’ roll of honour, it would prominently feature Paul Volcker’s name, perhaps even at the very top. Volcker, who died in 2019 at the age of 92, single-handedly tamed inflation in the US, which had touched 15 per cent in 1980, by rising above political affiliations to do the right thing.

Resisting tremendous political pressure, Volcker raised interest rates, taking them as high as 21.5pc in 1981, killing inflation, but also bringing about the electoral defeat of his benefactor, president Jimmy Carter.

Despite Volcker’s epic battle against inflation, his legacy remains somewhat mixed, mainly because of the steep economic costs attached to the ‘Volcker shock’ that came in the shape of the 1981-82 recession, unsustainable fiscal deficits and rampant unemployment above 10pc.

Over the last two years, just like the US in 1980, Pakistan, too, has suffered from skyrocketing in­­flation, though of even larger magnitude. It started with the Russia-Ukraine conflict that raised international oil prices, taking inflation to 38pc in May 2023 before coming down to 17.3pc in April.

Pakistan’s central bank had good reason to keep interest rates unchanged.

Where inflation created challenges for everyone, it impacted the most vulnerable or poor segments of society the most, given they spend a disproportionately large fraction of their incomes on food — last year, food inflation had reached an unbelievable 48pc.

No one has specifically connected the present political instability with this inflation, as the recent political upheaval is seemingly driven by structural factors of the political system itself. Still, the political crisis’ persistence and unending social unrest make a convincing case for attributing some causal power to two-plus years of very high inflation.

In a sense, this backbreaking inflation is reminiscent of Weimar Germany of the 1920s, when facing the mother of all inflations, Germany veered to the extreme right, opening up space for Adolf Hitler and the Nazi Party, enabling them to seize power democratically, but then turning Germany into a fascist-totalitarian state.

There is no ambiguity about whether very high inflation devastates society. But economists are not entirely sure how much influence high interest rates hold in controlling inflation. Whereas some economists argue that, instead of raising interest rates, central bankers should target money supply, others say that inflation is also a supply-side phenomenon, meaning that supply shortages feed into price spikes, leaving inflation somewhat immune to interest rates.

Not only do these perspectives raise questions about the impact of monetary policy, they also highlight concerns about the huge economic cost that comes from very high interest rates in the shape of anaemic economic growth and almost no job creation.

This was one reason why the recent State Bank decision to keep the interest rate unchanged at 22pc was scrutinised, with some analysts clamouring for a decision review. These analysts argue that since inflation has now come down significantly, Pakistan’s central bankers should have lowered interest rates by at least 100-200 basis points to spur economic growth that has all but stopped, given the high cost of borrowing.

However, these analysts may have missed out on some very important developments that, when taken into context, demonstrate that the decision to keep rates unchanged is not without merit.

First, data reveals that inflation has not really come down as expected in big advanced economies such as the US and UK. Higher-than-anticipated inflation numbers have stopped American and British central bankers from slashing interest rates. Though the impact is not significant, inflation in advanced economies does push inflation higher in emerging economies by raising international commodity prices, in particular. Moreover, there are additional challenges emanating from fraught geopolitics as international oil prices could suddenly spiral upwards on top of this higher-than-anticipated inflation in advanced economies.

Second, the world is probably witnessing the possible end of globalisation and free trade. In this new era of geo-economic fragmentation and ‘slowbalisation’, nations like the US that previously championed free trade, are increasingly becoming inward-looking and protectionist as demonstrated by the US slapping a 100pc tariff on Chinese electric vehicles. The IMF calculated the long-term impact of these trends to cost 7pc of global GDP or $7.4 trillion. For this reason, analysts believe that these structural transformations, whereby nations are busy rewiring their supply chains, are going to be inherently inflationary for a few years.

Third, lower interest rates could bring about a sharp depreciation in the exchange rate as capital will head to destinations where it can obtain a higher return. This is sometimes referred to as the ‘carry trade’. Recently, the Japanese yen fell to a 34-year low against the US dollar primarily because of the interest rate differential between Japan and the US. Sitting atop more than $1tr of forex reserves, Japan made quick interventions to the tune of $60 billion to prop up its currency. Needless to say, Pakistan does not have the forex reserves to play this game.

Last, despite whatever has been said about inflation coming down, it still clocked in at 17.3pc compared to 12 months ago — not a small number. But, this purported ‘drop’ in inflation is driven, in large part, by what is called the ‘base effect’, meaning that prices were towering so high a year ago that even a significant absolute increase would look like a modest percentage change. Falling inflation does not mean falling prices; they are still increasing, but at a slower rate. It should then not come as a surprise that people are up in arms against rising prices in various parts of the country.

What this analysis points out is that despite intense scrutiny, Pakistan’s central bankers had good reason to keep interest rates unchanged. If tailwinds and trends continue, there would be a strong case for lowering interest rates next month. But, perhaps the most important message of this analysis is that central bankers must never give in to political — or social — pressure to always do the right thing, just like Paul Volcker.

The writer completed his doctorate in economics on a Fulbright scholarship.

aqdas.afzal@gmail.com

X: @AqdasAfzal

Published in Dawn, June 1st, 2024