Monetary policy and the central bank’s autonomy
by Dr Hamza Ali Malik
last few years, a lot has been said about the
monetary policy, some writers have criticised it
while others recognised its prudence. Overall, the
discussions have been very healthy and bode well for
a better understanding of the role of the monetary
policy in the economy.
The discourse also reflects the efforts of the State
Bank of Pakistan to be more transparent and
accountable. This article explains the monetary
policy framework to remove ambiguities and
misconceptions in recent comments
First and foremost it must be understand that
central banks world-wide are essentially creatures
of central governments and Pakistan is no exception.
A central bank can only be autonomous within a
government and that monetary and fiscal issues
cannot be entirely divorced from each other.
Effective coordination between the central bank (SBP)
and fiscal authority (ministry of finance (MoF)) is
the key in understanding a central bank’s
performance and its role in the economy. In this
context, the SBP is an autonomous organisation and
monetary policy is formulated independently under
the umbrella of the State Bank of Pakistan Act.
The ultimate target of monetary policy is to achieve
price stability without prejudice to economic
growth. The targets of average CPI inflation and
real GDP growth are set by the government and
announced prior to the beginning of a fiscal year.
These targets provide a basis for setting an
indicative target for broad money (M2) expansion,
which serves as an intermediate target.
Broad money is chosen as an intermediate target
because the availability of money in the system
helps to determine aggregate demand in the economy.
Whether broad money should be an intermediate target
or not is a useful debate. However, it is beyond the
scope of this article. A practical reason for its
use as an intermediate target is that this
information is compiled by the SBP on a weekly
basis, whereas the information on other
macroeconomic variables and sectors becomes
available with a considerable lag.
Available information on the components of broad
money – the net foreign assets (NFA) and the net
domestic assets (NDA) of the banking system – and
their projections for the next fiscal year are used
in understanding and analysing interactions of the
monetary sector with the real, fiscal and external
sectors of the economy. This helps in assessing the
demand pressures in the economy relative to its
productive capacity, which mainly depends on
structural factors such as availability of energy,
NFA is essentially determined by developments in the
balance of payments and reserve
accumulation/depletion and NDA is composed of the
credit extended by the banking system to the
government (for budgetary support as well as
commodity operations) and the non-government sector
(private sector and public sector enterprises) and
the (net) other items.
Looking at their trends along with their
projections, updated regularly, gives SBP a fairly
good idea as to how the external, fiscal and real
sector developments will influence the broad money
expansion and thus the inflation and growth targets
of the government. Thus, the projections of
equilibrium money growth have to be consistent with
not only the projections of the external account and
announced federal budget, but also the projected
inflation path and the likely real GDP outcome.
Herein lie the importance of coordination between
SBP and the MoF.
Some observers see government borrowing from SBP as
a sign of SBP’s weakness and compromise of its
autonomy. Government borrows from the SBP for cash
flow purposes; the timing of government expenditure
and revenues or financing from other sources is
generally not in sync with each other. There is
nothing wrong with this practice. The problem arises
when the government continues to borrow unabatedly,
as it did in fiscal year 2008 and first quarter of
fiscal year 2009.
Asserting its independence and using its legal
powers, SBP has raised this issue of excessive
borrowing in writing to the MoF, in meetings at the
highest level, and in its Monetary Policy Statements
Excessive government borrowing creates numerous
problems for the effectiveness of monetary policy.
Apart from causing inflation, it complicates
liquidity management, dilutes the monetary policy
stance, puts pressure on foreign exchange reserves,
and hurts the private sector credit growth.
It also creates a sense of complacency on the part
of the fiscal authority that rather than adopting
prudent fiscal measures, it tends to rely on the
easily available funds.
The natural question that arises here is why then
SBP does not enforce its recommendations by
‘bouncing government’s cheques’. The reason is that
it is not a practical solution and would only result
in creating systemic risk for the financial sector
and loss of public confidence over its institutions.
Thus the conclusion that government is allowed to
borrow at will and that the SBP is not independent
The solution lies in reforming the fiscal policy and
its debt operations and enhancing cooperation and
interaction with the SBP to ensure consistency
between monetary and fiscal policies. Failure to do
so will only result in less than optimal policy
outcomes. On its part, SBP will continue to do its
assessment of developments in the economy, in
relation to its targets, communicate the necessary
actions required from other policy institutions, and
take its monetary policy decisions independently.
Nonetheless, the SBP and MoF officials do interact
with each other to resolve issues of mutual
interest. The result of these efforts is that a
comprehensive macroeconomic stabilisation programme
was formulated last year, which is being implemented
with the IMF support.
Almost all the targets of the programme have been
successfully met so far, despite fast changing
domestic and global conditions. The government
borrowing from the SBP is within the quarterly
limits, foreign exchange reserve position has
improved, and inflation has fallen considerably.
Moreover, numerous structural measures have either
already been taken or are in the pipeline. All of
this would not have been possible without the
coordinated efforts of MoF and SBP.
Coming back to the description of the monetary
policy framework, change in the monetary policy
stance is signaled through adjustments in the policy
discount rate after assessing the actual trends of
NFA and NDA, their underlying interactions with the
rest of the economy, and their projections and
likely impact on ultimate targets. Not only the
current behaviour of economic variables is affected
by monetary policy actions (current as well as
expected) but also the expected path is influenced
via many channels; monetary policy formulation is
essentially a forward looking phenomenon. Thus,
forecasting the behaviour of key macroeconomic
variables, in particular inflation, is an integral
part of SBP’s monetary policy framework.
The change in the policy discount rate is
complemented by appropriate liquidity management
mainly through Open Market Operations (OMOs) and if
required changes in the Cash Reserve Requirement (CRR)
and Statutory Liquid Reserve requirement (SLR) are
also made. The effects of these measures are
transmitted to the economy mainly through changes in
the numerous market interest rates, starting with
the overnight money market repo rate, which serves
as the operational target of monetary policy.
Effective control of this rate through calibrated
liquidity management ensures smooth functioning of
the money market, helps in influencing other market
interest rates in a desired manner, and thus
increases the effectiveness of monetary policy in
fostering price stability. The policy discount rate
(SBP’s overnight reverse repo rate) serves as the
effective ceiling, while the repo rate on the new
overnight facility (SBP’s repo rate) provides a
binding floor to its downward movement.
Prior to the adoption of this new explicit
operational target, SBP had already transferred the
decision of setting the T-bill cut-off rate to the
MoF to separate liquidity management from debt
management. The former is the responsibility of the
SBP while the latter pertains to fiscal operations
and is the responsibility of the MoF. Despite SBP’s
clear communication of the rationale of this
decision, some commentators have asserted that SBP
compromised its authority over monetary policy by
handing over this power.
In fact, SBP deliberately transferred this
responsibility to clearly communicate to the market
that cut-off decisions in T-bill auctions should and
are taken purely on debt management considerations
and do not reflect monetary policy stance. This
difference can only be made clear by separating debt
and monetary management and was not possible with
SBP deciding both the policy discount rate and
auction cutoff rates.
The writer is director, monetary policy department,
State Bank of Pakistan
Institute of Bankers Pakistan Website