Monetary policy in 2021 | Political economics



After a period of monetary easing in 2020, the central bank, particularly monetary policy, was in rough waters in 2021. It faced serious choices to balance the short-term needs of combating the pandemic and the long-term constraints and challenges. As 2021 draws to a close, central banks face a hangover from the pandemic, an uncertain economic outlook, unanticipated distributive effects of policies and rising inflation.

Pakistan’s monetary policy has faced even more serious choices this year. The second half of 2021, from June to December, was particularly difficult for the State Bank of Pakistan (SBP), mainly due to three related challenges. First, inflation, unstoppable throughout the year, accelerated sharply. It rose to 11.5% in November, from 9.2% in October. It was the highest monthly jump in a decade and put the SBP under pressure.

Second, the current account deficit started to swell, setting new records every month. As stated in the December 2021 Monetary Policy Statement (MPS), the SBP forecast a deficit “at around 4% of GDP – a little higher than previously expected”.

However, independent experts expect the deficit to exceed 5% of GDP. Monetary policy had to step on the key rate pedal to control the deficit. But this intervention comes at a high cost; the downturn in the economy can further distort the picture of poverty and unemployment. Third, the rupee continued to decline throughout the year. Historically high trade deficits each month have kept the rupee under pressure, making friendly deposits less useful.

Towards the second half of 2021, the SBP therefore had to make difficult decisions. While businesses needed an accommodative monetary policy, a lower policy rate, a growing deficit, a depreciating rupee and rising inflation demanded the opposite. The SBP has decided to align with the latter. After rising 25 basis points in September, the SBP decided to surprise everyone. It raised the rate by 150 basis points in November, followed by another 100 basis point hike in December. The key rate now stands at 9.75%, one of the highest in the region. Despite the rise, inflation continues to rise. An economic slowdown is to be expected, however.

While the SBP has been very proactive in putting in place policies to mitigate the impact of Covid-19, major monetary policy challenges have persisted in 2021. It has encountered serious problems controlling inflation. In fact, for over three years inflation has been above the medium-term target of 5-7%. Price stability is the first assessment of any central bank’s monetary policy. Control seems loose. The SBP raised the inflation outlook to an average of 9-11% for this fiscal year, compared to initial expectations of 7-9%.

More importantly, monetary policy tries to do what it cannot. The December 2021 MPS specifies that “[t]the purpose of this decision [rate hike] is to counter inflationary pressures and ensure that growth remains sustainable ”. Obviously, monetary policy mixes stability and sustainability.

Controlling deficits by managing aggregate demand is stabilization of growth, not sustainability. Growth stabilization here refers to a level of growth that is accompanied by manageable trade and current account deficits. Historically, this combination has been available at low growth levels, particularly around 3% of GDP growth.

Rate hikes can do it. At a high cost however; unemployment and poverty. We saw it in 2018 and 2019 when GDP growth went from 5.48% to 1.9% in 2019 while the policy rate went from 6.25% in 2017 to 13.25% in 2019. We can start over. This, however, is ad hoc stabilization. This goes as we return to higher growth. This stabilization forced by the economic slowdown seems to have come at a bad time.

Even though some notable communication errors of 2021 are ignored, effective communication of monetary policy and other SBP decisions has emerged or resurfaced as a major challenge. While it is agreed that there must be an increase in frequency and communication tools, this comes with noise that disrupts political signals. Despite the problems with the nature and drivers of inflation in Pakistan, there is a growing consensus that the SBP has not been able to communicate clearly to anchor the inflation expectations of the population and the business confidence.

Central banks have increasingly relied on various communication strategies in the conduct of their monetary policy. As Pakistan’s monetary policy is expected to evolve towards an inflation targeting regime, effective communication will be the most important tool. For clear signals on the way to the policy rate, the noise must go. MPS and other forms of communication need to be focused and specific. Technical jargon, open statements laden with adjectives should be avoided.

To reduce uncertainty in the market, the SBP gave forward guidance for the first time in 2021. But two important points need to be taken into account for the future. Forward guidance may not work when inflation expectations are not anchored or are weakly anchored. This is what happened here. Unanchored inflation expectations prompted the SBP to tighten its belt and slow the economy to control inflation.

It is important to note that Pakistan’s monetary policy had its limits and challenges in 2021 which are different from those of comparable economies. Pakistan was under IMF program when Covid-19 hit it.

Monetary policy had to respect certain priorities, in particular a rate hike. The country was going through a serious balance of payments crisis when Covid-19 arrived. The economy was slowing down; GDP growth had already fallen to 1.9% in 2018-19. Pakistan is once again facing a severe balance of payments crisis as the world plans for a sustainable recovery and tough fiscal and monetary policies return.

The year 2021 also brought a fundamental change in the central bank. The SBP gave forward guidance, increased the number of Monetary Policy Committee (MPC) meetings to eight from six per year. The most notable change in the country’s monetary policy, however, has been the introduction of the SBP Amendment Act 2021 to modernize the central bank in Pakistan.

Primarily, the law proposes structural revisions in three key areas: i) redefining and clearly articulating monetary policy objectives, ii) appointment procedures and terms of office, and iii) indemnifying the liability of all government agencies. the country’s public sector for actions undertaken in good faith.

Overall, the objective of the law appears to shift towards an inflation targeting regime and focus on price stability. The law, however, has met strong resistance. Although there is a debate on the appropriateness and feasibility of the inflation targeting regime for Pakistan, much of the debate has revolved around the perception of “absolute government autonomy” of the SBP with little. of responsibility.

The reasons for the emergence of a heated debate, mostly against the proposals, are multiple. There was resistance in the way the law was presented. The law was rushed through cabinet without any large-scale discussion. A debate around the proposed amendments in a more open manner could have helped to avoid most of the negative reactions.

In addition, the perception of “forced autonomy” pushed by the IMF as a condition of the Extended Financing Facility (EFF) caused some ripples. The IMF and the SBP must understand that the approval of the SBP 2021 law under pressure will create credibility problems and harm the country’s monetary policy. The SBP (Amendment) 2021 law must be made available to the public and openly debated within and outside parliament before it is approved.

The SBP must be made independent from political influence, but with strong mechanisms of transparency, accountability and foresight in place. The ultimate right to accountability and foresight lies with government and parliament.

Overall, 2021 has been a challenging year for monetary policy across the world. At the same time, it opened a window to new opportunities. It has put monetary policy in the spotlight more than ever. So people are talking about monetary policy more than ever. This has enabled the SBP to broaden and deepen the scope of its monetary policy.

To take advantage of the opportunity, however, the SBP must be more robust in its assessments; more open to debate and discussion; and clearly focused on price stability. While there is much to do, two things require serious and immediate attention: a renewed commitment to ensuring price stability at a lower level of inflation and clearer communication to send a clear message to businesses and consumers. individuals to anchor inflation expectations. Otherwise, 2022 will further intensify these challenges.

The author directs the Policy Solutions Lab. He tweets @sajidaminjaved

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