In all well-managed economies, monetary policy plays a key role in ensuring relative price stability, balance of payments viability, economic growth and employment generation. In fact, in the recent past, central banks have become more assertive in the context of the failure of some governments to ensure fiscal discipline.
The US is a prime example of this, where the Congress and the president continue to quarrel about the path and speed, if not the direction, of fiscal adjustments. In the meantime, the Federal Reserve Board – the central bank of the country – while warning about the harmful consequences of continued fiscal mismanagement, has been fine-tuning its monetary policy to sustain the economic recovery without fuelling inflation. It may also be mentioned that the chairman of the Federal Reserve Board is nominated for appointment on merit by the president and confirmed by the Senate. Once appointed, neither the president nor the senate can in any way influence him or the conduct of monetary policy.
Unfortunately, in Pakistan both the governor of the State Bank of Pakistan and the monetary policy are de facto subordinates of the fiscal authorities. This is notwithstanding the fact that both were given statutory autonomy in 1997 through legislative reforms. In a law-abiding country, such deviations from the law could easily be challenged and corrected – but not so in Pakistan.
Monetary expansion has recently been determined by fiscal operations rather that SBP actions based on monetary policy considerations. In fact, instead of functioning as a central bank in charge of monetary policy, the SBP stands by helplessly as monetary developments unfold under the dictates of the fiscal authorities. Its activities have mainly been confined to the printing of notes as dictated by the government and ensuring liquidity in the commercial banking system to meet the credit demand of the public sector.
Additionally, the SBP is required by law to collect, report and interpret monetary statistics. But the monetary policy statement released on June 21, 2013 has avoided the mention of the rate of monetary expansion and its relationship with prices. This reflects that institutional decay is not confined only to public sector enterprises but encompasses the SBP as well. No wonder then that the country is trapped in a situation of low growth, high inflation and balance of payments crisis.
The pretension of the SBP, as reflected in its statement, that it is in charge of the monetary policy in its conventional sense is very unfortunate. More regrettable is its selective use of irrelevant data to justify a reduction in the policy rate by 50 basis points to nine percent. Equally importantly, the SBP continues to confuse the ends with the means and the instruments of monetary policy with its objectives. If nothing else, it should clarify that its policy rate is an instrument and not an objective of the monetary policy.
The objective of the monetary policy is to regulate money supply in line with the requirements of the economy so as to keep inflation under control. In the last five years the growth in the supply of goods and services in the economy has been around three percent per annum. If inflation was to be contained within a low single digit, and inflationary expectations were to be managed prudently, the SBP should have aimed to keep the annual growth in demand – as represented by increase in money supply – to 78 percent.
The actual annual increase in money supply has been 14.15 percent. The double digit ‘inflationary gap’ in the last five years is not captured by the distorted official price indices but is experienced by the people in their daily lives in the form of rising cost of living and by the balance of payments through depreciating exchange rate.
This year – up to June 7, 2013 – money supply expanded by 12 percent compared with 11 percent in the same period last year. If the ratio of the end-year level of money supply last year with that at the end of June 8, 2012 is applied to extrapolate money supply for FY13 as a whole, it will exceed 15 percent. The SBP owes it to the people to explain the justification for growth in money supply of 15 percent in the context of growth in the supply of goods and services of 34 percent.
There is no doubt that the SBP has completely failed to control money supply in line with the prudent limit dictated by the growth in supply of goods and services. Instead of highlighting the excess liquidity in the economy as the main cause of inflation, the monetary policy statement says that SBP surveys show improvement in consumer confidence, expected economic conditions and inflation expectations.
This is not borne out by the public clamour about their deteriorating economic conditions and rising cost of living, and near-default situation of the balance of payments. The assertion in the policy statement that the SBP has been giving a relatively high priority to inflation control in its monetary policy is also blatantly false.
While making a case for lowering of the policy rate to support private investment activity, the SBP seems to have forgotten that the country needs to accelerate the rate of domestic saving as a prerequisite for accelerating investment if it was to get rid of dependence on foreign borrowing and lower the high rate of inflation on a sustainable basis. The real rate of return is an important determinant of the rate of saving in the country but it has mostly been kept negative by inappropriate interest rate policy. The fact that there is no lobby for savers in contrast to an effective lobby of borrowers should not blindfold the SBP to make lopsided statements in its monetary policy.
The policy rate is not an end in itself but a means to regulate the volume and cost of reserve money base to achieve the targeted rate of monetary expansion and inflation. The information compendium accompanying the monetary policy statement shows that the reserve money is overwhelmingly created by fiscal operations of the government and not by monetary policy instruments.
In this context, the SBP should openly concede that the asset side of the balance sheets of the SBP itself and those of commercial banks are predominantly determined by fiscal operations rather than by monetary policy instruments, and that in such a situation the SBP is unable to discharge its statutory responsibilities. Alternatively it should exercise the powers vested in it by law to regulate the reserve money base, including the volume of government borrowing from the SBP.
The SBP needs to understand that it is a professional – not political – institution and that its governor has a statutory national responsibility without having a blind commitment to a particular government. At the same time, the political leadership of the country needs to understand that economic recovery and price stability will come with strengthening, not weakening, vital economic institutions like the SBP.
What is needed is a competent macroeconomist with appropriate experience in policymaking to be appointed as the governor SBP, allowed to function professionally and then held accountable for the formulation and conduct of monetary policy to control inflation and promote private sector investment and economic growth in coordination with fiscal and exchange rate policies. A subservient governor and an ineffective SBP do not serve the national interests.
The writer is a former governor of the State Bank of Pakistan.

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