In the last four years, money supply (M2) rose at an annual average rate of 13.3 percent and the supply of goods and services at the rate of 2.9 percent leaving an annual 'inflationary gap' of 10.4 percent which contributed to an annual increase of 14.6 percent in the officially recorded consumer price index. The wholesale price index went up by 17.6 percent per annum during the same period.
In the first five months of the current fiscal year, money growth has accelerated as compared to the same period last year, while the official consumer price index, that has been prepared on a revised basis, has begun to show a steady decline in the rate of inflation. During the first five months of the FY13, money supply increased at a rate about 2.8 times larger than that in the same period of last year. But the annual inflation is shown to have declined from 11 percent in FY12 to 6.9 percent up to November 12, 2012.
If this is a correct price trend, it disproves the monetary theory being taught in the economics classrooms because it shows that inflation declines with a rise in money supply. If proven right, authors of this reverse relationship between monetary expansion and inflation should be legitimate candidates for a Nobel Prize in Economics for the discovery of a new theory of money.
However, if research points to distortions in the construction of the latest price index to build a downward bias in the measurement of inflation to fool the people on the eve of elections, the authors of the price indices should leave the economic profession and join politics.
It is quite obvious that the people stand successfully fooled about the current falling rate of recorded inflation notwithstanding the increasing trend in money creation. The stagnating exports, depreciation of the exchange and steady depletion of the foreign exchange reserves also reflect a buildup, and not easing of, inflationary pressures in the economy.
The whole argument of the SBP for lowering the policy rate hinges on the declining rate of inflation in spite of a rising rate of growth of money supply. There is a boastful claim made in the last several monetary policy statements that inflation having been tamed, the SBP has begun to cut the policy rate arguing that it will promote private sector borrowing, investment and growth. Probably, they will come up with a similar alibi in announcing the level of policy rate in December.
Lowering of policy rates is hailed by the government and large borrowers because in the case of the government it reduces its debt servicing and in the case of large borrowers it inflates their profits. What happens to the economy, the rate of saving and allocation of resources in the country is another matter for which the SBP has not shown much concern.
There are three additional points with regard to the conduct of the SBP in announcing the so-called monetary policy decisions. First, the SBP's main task is to control inflation by controlling money growth. The causation runs from monetary stability to control on inflation to higher investment rather than it being a trade-off between inflation control and increase in investment.
In order to be able to ensure monetary stability, the SBP has to have a complete control on its own balance sheet and on the sources of reserve money creation that provide the foundations for monetary expansion. Right now the reserve money is mainly being created by government borrowing from the SBP/discount window of the SBP and simultaneously it is being used by banks to finance lending to the government. The SBP, instead of acting as the central bank of the country, has become a facilitator of the process losing control on its own balance sheet and on the reserve money creation.
In this situation, the monetary policy and SBP's bimonthly monetary policy decision are no more than a farce. The monetary policy has been confined to announcement of the policy rate dictated by the government on fiscal policy and political considerations without much focus on the expansion in money supply. In the process, the ends and means of monetary policy get mixed up and an instrument of monetary policy is mistaken as the monetary policy itself. As a result, the SBP is rapidly losing its international reputation as a central bank that was painstakingly built in the past.
Second, as stated before, the main task of a central bank is to promote monetary stability and contain inflation and thereby help create a favourable environment for investment and growth. Any help to investment is as a by-product of this main task. The SBP policy statement should stop propagating that reduced policy rates will promote investment. Investment depends on a whole host of structural and fundamental factors and the lowering of the policy rate will not neutralise their impact on investment if it is negative. Moreover, there is no proof that the recent reductions in policy rate have in fact increased credit to the private sector, accelerated investment or pushed up economic growth.
Third, the SBP is not a political entity. Its main job is professional to strike a delicate balance between the supply of goods and services and demand for them by controlling money supply, and also to protect the internal and external value of the rupee. That task is not being performed effectively and in line with the laws of the land. If Pakistan was a law abiding society, the SBP could be dragged to the court of law for not adhering to the provisions of the SBP Act in the formulation and implementation of the monetary policy.
The Supreme Court has made it clear in its recent decisions that the public institutions are expected not to obey unlawful orders of even a law full authority. The governor of the SBP has a statutory protection to his tenure and should lead the rest of the civil service in demonstrating his steadfastness in adhering to the rule of law without taking into account its personal implications.
(The writer is a former governor of the State Bank of Pakistan)