Monetary policy and the central bank’s autonomy
by Dr Hamza Ali Malik

Over the 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, productivity etc.

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 (MPS).

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 is misleading.

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

Source : Institute of Bankers Pakistan Website

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