The State Bank of Pakistan (SBP) needs to keep the interest rate sustained at 15% for the short term to reduce the risk of more inflation, says a financial expert.

The current monetary policy rate is sustained at 15% by the monetary policy committee of the central bank. It is to prevent overheating of the economy, reduce aggregate demand, and then reduce inflation.

According to Shamraiz Bhatti, a monetary policy expert at the Institute of Business Administration (IBA) Karachi, the International Monetary Fund (IMF) policy stance is in line with the macroeconomic theory of inflation and interest rate.

“It is the basic function of a central bank to control inflation and ensure macroeconomic stability. The European central bank has one of the top three objectives to keep inflation rate below 2%,” he mentioned.

“In the same way, the SBP also does the job of inflation-targeting primarily. Right now, our economy is facing another exogenous shock in the form of floods. These floods are going to make the prices go through the roof,” he added.

Shamraiz said the job of the State Bank will become tougher since it will have to increase the interest rate further to control inflation.

“But our inflation rate is already very high. Increasing the interest rate further runs the risk of stopping production activity,” he explained.

He said that if the interest rate is increased more than the current 15% level, “our economy will slowly move towards stagflation where we see high prices and decreasing productive activity at the same time.”  

He however concurred with the IMF report that interest rates need to be sustained at the current level of 15% to control inflation or even to reduce it.

Inflation has continued to increase in Pakistan since the economy started to open up after the Covid-19 shock. The monetary policy committee has consistently increased the benchmark policy rate so as to contain the runaway prices.

In the same vein, the IMF the report titled “Seventh and Eighth Reviews Under the Extended Arrangement Under the Extended Fund Facility” has outlined various recommendations to reduce inflation and re-anchor expectations.

By keeping the interest rates high, the report says that an inflation target of 5-7% can be achieved over the medium term.

In essence, Pakistan’s monetary policy authorities will have to follow the same strict regimen that was followed by Paul Volcker during the 80s in the United States. For a better part of the whole decade, Paul Volcker as federal reserve chairman continued to keep a tight monetary hold on the economy.

To contain the high inflation of the late 70s and early 80s, Paul Volcker raised the federal funds rate to a maximum of 20%. This helped him to reduce the inflation rate from a high of almost 15% to below 3% in three years.

Tight monetary policy is the only practical tool available to the authorities to curb inflation. Available tools to reduce inflation should be employed to their full effect.

Credit : Independent News Pakistan-WealthPk