The design and conduct of monetary policy: lessons for Pakistan.
Khan, Mohsin S.
Movements in global capital during the late 1990s and the greater
emphasis on price stability led many countries to abandon fixed exchange
rate regimes and to design institutions and monetary policies to achieve
credibility in the goal of lowering inflation. Such recent developments
have brought to the forefront the idea that freely mobile capital,
independent monetary policy, and fixed exchange rates form an
"impossible trinity". Inflation-targeting regimes being
adopted by many countries provide a way of resolving this dilemma, and
it is suggested that such a regime be implemented in Pakistan as well.
JEL classification: E42, E52
Keywords: Monetary Policy, Rules versus Discretion, Inflation
Targeting
I. INTRODUCTION
The design and conduct of monetary policy has undergone two
significant changes since the 1990s. First, a number of countries have
moved from fixed exchange rate regimes to more fexible rates, thereby
allowing for greater monetary independence. Second, inflation targeting
regimes have been adopted as a framework for conducting monetary policy
in several industrial economies, as well as in a number of emerging
markets and developing countries. These changes have triggered
considerable debate about monetary policy in the literature, a debate
that has important implications and lessons for how monetary policy
should also be designed and implemented in developing countries. (1)
This paper starts by discussing the key issue of "dynamic
inconsistency", which has led to the major shift in the thinking
about monetary policy. Dynamic inconsistency and inflationary bias in
monetary policy arise because policy-makers have an incentive to
"fool" the public by generating an inflation
"surprise" to achieve a short-term gain in output. Setting up
rules, or targets, for money and credit growth, interest rates, the
exchange rate, and inflation are all mechanisms designed to overcome the
dynamic inconsistency problem. In this connection, the paper will
outline the principal arguments in the rules versus discretion debate to
determine if there are significant advantages to be had from adopting a
rules-based monetary policy like inflation targeting in the case of
Pakistan.
The paper is organised as follows. Section II provides a general
discussion of dynamic inconsistency and inflationary bias. The issue of
rules versus discretion in the operation of monetary policy is covered
in Section III. Section IV outlines the evolution of different monetary
frameworks that fulfil the need for a nominal anchor, and Section V
discusses inflation targeting, focusing on the preconditions for
implementing such a regime. Section VI considers the feasibility of
inflation targeting in Pakistan, and Section VII contains some
concluding remarks.
II. DYNAMIC INCONSISTENCY AND INFLATIONARY BIAS
While both theoretical and empirical studies have demonstrated that
there is no long-run relationship between inflation and unemployment,
under certain circumstances a short-run trade-off between these
variables may be found. The existence of this short-run Phillips curve
is widely believed to be associated with the presence of sticky wages
and prices. The possibility that an expansionary monetary policy could
increase output and employment in the short-run leads to what has been
termed the "problem of dynamic inconsistency," developed
principally by Kydland and Prescott (1977) and Calvo (1978). (2)
Dynamic inconsistency refers to the difference between the optimal
policies that a central bank announces it would carry out, and the
policies that the central bank would carry out after the public had made
decisions on the basis of its expectations. If the central bank
announces that it will target a particular rate of inflation, and the
public engages in contracts based on that announcement, the central bank
has an incentive to renege on its promise and try to achieve higher
output by producing surprise inflation. But the public will then know
this, and will adjust its inflationary expectations upward, thereby
limiting the desired output gain. Another way of putting this idea is to
say that policy-makers unconstrained by rules have an incentive to
"cheat" the private sector in order to spur an output gain.
However, since rational agents recognise the incentive of policy-makers
to produce surprise inflation, they will change their behaviour
accordingly, creating an economy with an inflationary bias.
One could therefore ask the following question: Are countries
condemned to an equilibrium with high inflation rates, where the public
distrusts the government because of its incentive to inflate? Of course,
there are institutional reforms that countries can adopt to lower
inflationary expectations and still keep some flexibility to counteract
shocks in the economy. Chari and Kehoe (2006) propose two possible ways
of alleviating the dynamic inconsistency problem and the consequent
inflationary bias. One option is to pass legislation that would require
the monetary and/or fiscal authority to abide by a clear set of rules.
The second option is to tie the hands of the government by delegating
policy to an independent authority. This brings the issue of rules
versus discretion in the operation of monetary policy into the picture.
III. RULES VERSUS DISCRETION
Most economists and central bankers now agree that central banks
cannot act in a completely discretionary manner. Some kind of guideline
or rule is essential for good policy, and acting without a rule may have
adverse consequences. This consensus emerges from a long debate among
economists regarding the relative merits of rules versus discretion in
the conduct of monetary policy. (3)
Traditionally, economists have focused on two main kinds of
instrument rules:
* Money growth rules [advocated by McCallum (2000 and 2004)] are
extensions of Friedman's (1960) proposal for constant money growth
but have been extended to include feedback elements as a way to correct
past mistakes of to gradually adjust to permanent shifts in velocity.
* Interest rate rules [advocated by Taylor (1993)] also include
feedback elements: the central bank raises interest rates when expected
inflation rises but also reduces interest rates when unemployment rises
above an undesirable level.
Which of these target rules should be more successful in
restraining inflation, preventing unnecessary business cycle
fluctuations, or encouraging growth over the long term remains an
unsettled question. More recently, economists have come to agree that
rules may apply to targets as well as instruments. Examples of target
rules include both exchange rate management regimes and inflation
targeting regimes. Finally, most economists now agree that any
rules-based regimes still permit a margin for discretion, and have come
to reject the idea that rules and discretion are diametrically opposed.
The more well-defined the rule, the more effectively can discretionary
policy be applied.
IV. THE NEED FOR A NOMINAL ANCHOR: EVOLUTION OF MONETARY FRAMEWORKS
As policy-makers in many countries throughout the world have
gravitated toward an approach based more on rules than on full
discretion, the issue of choosing an appropriate target for policy has
become key. In a rules-based policy, the target serves as a
communication tool with the public, as it reveals policy-makers'
intentions and priorities, and indicates whether a policy action--for
example, a change in the short-term interest rate, or intervention in
the foreign exchange market--will be required. In turn, to the extent
that the public observes and understands this target, it establishes a
"nominal anchor" for agents' expectations, thus helping
to achieve and maintain price stability.
Nominal anchors can either be price or quantity based. The list of
possible price anchors is relatively extensive, encompassing for
example, the exchange rate, the price of gold, and the inflation rate.
On the other hand, discussion of quantity anchors tends to focus on two
major candidates: monetary (and credit) aggregates and to a lesser
extent, nominal income.
In practice, countries adopting rules-based frameworks in recent
years have chosen either monetary or exchange rate targets as their
nominal anchors. Although it is possible to operate within a relatively
wide range of intermediate arrangements, it is apparent that more
reliance on explicit monetary of inflation targets requires allowing a
greater degree of flexibility in the exchange rate and, likewise,
adherence to an exchange rate target or peg leads to greater volatility
in monetary aggregates and inflation.
A number of factors weigh in favour of adopting monetary over
exchange rate targets. Having a flexible exchange rate allows a country
the option of pursuing an independent monetary policy, which may then be
used countercyclically to minimise fluctuations in real activity. A
flexible exchange rate could act as an automatic stabiliser in the event
of adverse trade shocks, for example, by providing stimulus to demand
for non-tradable when the market for a country's exports has been
bit with a negative shock. Finally, the experience in recent years has
shown that fixed exchange rates tend to be particularly vulnerable to
speculative attacks, and thus currency crises are more likely when a
government commits to a pre-announced level for the exchange rate.
For those countries that opt for greater exchange rate flexibility,
the choice then shifts to what monetary target is more appropriate:
monetary aggregates of the inflation rate itself. Targeting monetary
aggregates has one appealing advantage: policy-makers exert much greater
control over monetary aggregates such as M1 and M2 than they obviously
do over the inflation rate. However, there are two major drawbacks to
targeting monetary aggregates. First, monetary aggregates are less
easily understood by the public, and thus their informational content is
considerably lower than that of the inflation rate. Second, in order to
be effective, monetary targets require that a stable, or at least
predictable, relationship exist between the aggregate and the rate of
inflation. If this is not the case, then policymakers run the risk of
consistently meeting the target for monetary aggregates yet missing the
(implicit) inflation target. Thus, policymakers will ultimately fail in
their goal of lowering and stabilising the inflation rate, thereby
rendering the exercise futile. Numerous studies have shown that
instability of money demand is particularly common to developing
countries undergoing processes of financial liberalisation, and even
industrialised countries are not immune. Thus, most countries choosing
monetary over exchange rate targets in recent years have favoured an
inflation targeting framework over one that targets a monetary
aggregate.
V. INFLATION TARGETING (4)
Over the past two decades, a number of countries have moved to an
explicit and formal inflation targeting framework. Table 1 lists the 29
countries by the date at which the new regime was adopted. Starting in
the late 1990s many developing and emerging market countries also
adopted inflation targeting, and by 2007 some 19 of these countries were
classified as formal "inflation targeters."
The successful implementation of an inflation targeting regime
requires the presence of certain macroeconomic, institutional, and
operational conditions. (5) First, the authorities should be fully
committed to price stability as the primary goal of monetary policy.
This rules out the possibility of targeting at the same time any other
variable, including nominal exchange rate of unemployment (output). In
this context, exchange rate arrangements with limited
flexibility--crawling pegs of target zones--could coexist with inflation
targeting as long as the latter has priority. Also, in a flexible
exchange rate regime, central bank intervention in support of the
exchange rate should be limited to smoothing out the effects of
temporary shocks on inflation. This is particularly important in the
case of small open economies in which the pass-through from the exchange
rate to inflation may be high.
Unemployment (real output) stabilisation may also be given some
consideration within an inflation targeting regime, but only as a
secondary goal of monetary policy. In a "strict inflation
targeting" regime the monetary policy instrument may respond to the
output gap, but only to the extent that it affects the inflation
forecast, and not because it enters in the central bank's loss
function.
A second major consideration for an inflation targeting regime is
central bank independence in the conduct of monetary policy, or what is
known as "instrument independence" as opposed to "goal
independence". Once the goal of monetary policy (the inflation rate
to be achieved) is established either by the central bank, the
government, or jointly, the central bank has to be able to choose and
manage its instruments to achieve that goal. Instrument independence
requires the absence of what is called "fiscal dominance".
Fiscal dominance, a situation in which monetary policy is governed by
the financial needs of the government, undermines the ability of the
central bank to achieve the inflation target. This is particularly the
case in which the public sector relies systematically and significantly
on revenues from money creation, of on continuous placements of
government bonds in thin domestic financial markets. Under these
conditions the central bank may resist an increase in market interest
rates to correct deviations of the forecasted inflation from the target
because of the potential impact on the fiscal position.
A third major condition for the implementation of the inflation
targeting is accountability of the central bank for achieving the goal,
and transparency in communicating to the public the main aspects of
policy design and implementation. This is essential to increase
discipline and to enhance credibility in a framework in which monitoring
performance against targets is difficult because of lags in the
transmission of policy actions. It also contributes to reducing
political pressures to deviate from the announced policy. Transparency
implies the following: first, the explicit announcement of inflation
targets; second, availability of clear and sufficient information to the
public to assess the stance of monetary policy; third, the announcement
of any changes in monetary policy, a clear explanation of the reasons
behind the changes, and the expected impact on the inflation outlook;
fourth, an ex-ante indication of a possible target breach, its causes,
and the policy actions that will be taken to bring inflation back on
track; and finally, an ex-post comprehensive analysis of the performance
of monetary policy. The central bank may use different mechanisms to
communicate these issues to the public, including through the periodic
release of Inflation Reports, regular press releases and press
conferences, and publication of the minutes of monetary policy meetings
in the central bank.
Inflation targeting requires an operational framework to guide the
authorities in conducting monetary policy. This framework relies on:
first, reasonably well-understood channels between policy instruments
and inflation, the relative effectiveness of different monetary
instruments, and the lags involved; second, a methodology to produce
inflation forecasts using different approaches and considering all
information available; and third, a forward-looking operating procedure
that derives an optimal policy rule--the central bank's reaction
function--by which changes in the instrument depend on deviations of the
inflation forecast from the inflation target.
One main issue present in several emerging market economies tends
to complicate the task of the central bank in monetary management.
Countries that have large capital movements may require some degree of
central bank intervention in the foreign exchange market in the case of
temporary shocks. The key issue here is for the central bank to be able
to assess the true nature of the shocks, and determine if there is clear
case of exchange rate appreciation or depreciation, which is by no means
an easy task.
Although there is some disagreement on the criteria used to
classify a country as a full-fledged inflation targeter, it is clear
that there is an increasing trend in targeting inflation as the main
goal of monetary policy. Even some emerging market economies that do not
have in place all requirements for the adoption of a full-fledged
inflation targeting framework have initiated a transition process
leading toward a future implementation of this framework.
In emerging markets the legal framework deserves greater attention
prior to the adoption of a full-fledged inflation targeting. In this
context, several emerging market countries have revised the central bank
charter to allow for more institutional independence, including
prohibiting central bank financing of the government. However, there is
a clear and unique mandate to the central bank for achieving price
stability only in a few countries. In most emerging market countries
monetary policy objectives aim at achieving both internal and external
stability. Finally, in most full-fledged inflation targeting countries,
the government is involved in the setting of the inflation targets. This
provides an additional support in those cases in which price stability
is not a clear and legal mandate of the central bank.
There are some common features and several differences in
operational issues between advanced countries and emerging markets. All
inflation-targeting countries employ market-based instruments of
monetary policy to achieve the desired level of the operating
target--usually, the short run interest rate. With regard to
differences, emerging market economies tend to rely less on econometric
models in the conduct of monetary policy, and more on the use of
judgment, due to the higher degree of uncertainty with respect to
transmission channels and the effectiveness of monetary policy
instruments because of ongoing structural changes. This also explains
why in emerging markets central banks use shorter horizons as well as
bands instead of point targets for inflation targets. Also, there are
more frequent interventions of the central bank in the foreign exchange
market, partly explained by the existence of a higher pass-through from
the exchange rate to inflation, and its role in forming inflationary
expectations.
On balance, the inflation targeting approach appears to be very
promising for developing countries. It offers a number of operational
advantages, and it compels policymakers to deepen reforms, enhance
transparency, improve the fiscal stance, and eventually converge to the
international level of inflation. It is important to keep in mind that
the inflation-targeting strategy is not a panacea.
It is a useful framework for conducting monetary policy under
constrained discretion. It relies on rules, as the adoption of explicit
targets requires commitment by the central bank toward policy
consistency. At the same time, it leaves at the central bank's
discretion the decision on how to deploy its instruments, which allows
for some flexibility in responding to unforeseen domestic and external
shocks. In the end, maintaining sound macroeconomic fundamentals still
remains the necessary condition for price stability under any monetary
framework.
VI. INFLATION TARGETING IN PAKISTAN?
The principle objectives of monetary policy in Pakistan are to
promote growth and maintain price stability. (6) The objective of
achieving higher growth by monetary policy measures can, however,
conflict with the goal of keeping inflation low. This section argues
first why controlling inflation should be the primary objective of the
State Bank of Pakistan (SBP), and then discusses what type of monetary
regime is best suited to attaining this objective.
1. Inflation and Growth
Ask a macroeconomist what is meant by "macroeconomic
stability" and the usual answer would be "low inflation".
Why? Because high inflation has well known negative effects--it imposes
welfare costs on society, impedes efficient resource allocation by
obscuring the signalling role of relative price changes, inhibits
financial development by making financial intermediation more costly,
hits the poor disproportionately because they do not hold financial
assets that provide a hedge against inflation, and perhaps most
importantly, reduces long-term economic growth. As discussed in earlier
sections of the paper, while it is possible to generate a spurt in the
growth rate, or more precisely in the level of output, through
expansionary monetary policies, this effect cannot be sustained and
fairly soon growth will falter. (7) In the long run, the relationship
between inflation and growth is negative.
So if inflation is inimical to long-term growth, it obviously
follows that central banks should aim for a low rate of inflation. But
how low should inflation be? There are several empirical studies now
that provide fairly convincing evidence that the relationship between
inflation and growth is nonlinear in nature. (8) More specifically, at
low levels of inflation, the relationship can be positive or
nonexistent, while at higher rates it becomes negative. In principle, it
is possible to estimate the threshold level of inflation at which the
sign of the inflation-growth relationship would switch from positive (or
zero) to negative.
There are now several empirical studies that estimate this
threshold level of inflation. Using panel data covering 1960-1996, Sarel
(1996) estimates the threshold level of inflation to be in the 8-10
percent range. Below the threshold inflation rate of 8 percent,
inflation has no significant effect on growth, but when it gets above
8-10 percent the effect is negative and statistically significant. Ghosh
and Phillips (1998), using a larger sample than Sarel (1996), find a
substantially lower threshold level of inflation of around an annual
rate of 2 1/2 percent. Khan and Senhadji (2001) show that the inflation
thresholds tend to be higher in developing countries, with threshold
estimates falling in the 7-11 percent range versus 1-3 percent for
industrial countries. They also find the negative relationship between
inflation and growth beyond the threshold level of inflation is quite
robust to sample size, model specification, and the estimation method.
Two studies on Pakistan also find evidence of a threshold between
inflation and growth: Mubarik (2005), using time series data over
1973-2005, finds that an inflation higher than 9 percent harms growth in
Pakistan, and Hussain (2005), on the other hand, estimates the threshold
to be between 4-6 percent.
Growth and inflation are not, however, the only objectives that the
SBP considers. Other objectives include the improving the external
current account balance, increasing the stock of international reserves,
and stabilising the real exchange rate. (9) But in contrast to the
growth-inflation relationship, monetary policy geared to lowering
inflation would reduce aggregate demand, and thereby improve the
external imbalances and increase international reserves. Therefore,
there is no trade-off between objectives. Similarly, achieving a rate of
inflation equal to inflation rates in partner countries will stabilise a
real exchange rate. Again, there is no trade-off here either.
2. Inflation Targeting by the SBP
The SBP has historically followed a regime of targeting monetary
aggregates (basically M2 and bank credit) and continues to do so at
present. As mentioned earlier, this type of regime assumes that the
demand for money is a stable function of a well-defined set of
variables, and that there is a close link between money and credit
growth and the ultimate objectives of growth, inflation, and
international reserves.
One reason for choosing a monetary targeting regime is that by
controlling monetary aggregates the SBP can affect the outcome variables
with some degree of reliability and predictability. But it should be
noted that another important reason is that Pakistan has had a series of
IMF programmes, and that the IMF "financial programming"
approach gives credit a preeminent role. (10) This approach is based on
the proposition that in a regime of fixed (or semi-fixed) exchange
rates, the aggregate money supply is beyond the direct control of the
central bank and is in fact endogenous. The central bank can only
control the volume of credit, one of the sources of monetary expansion.
Within this framework, the distinction between the monetary base (or
money supply) and its domestic credit component becomes critical. For a
given expansion of the demand for money, ah equivalent increase in the
money supply can be realised through a suitable increase in domestic
credit. However, when the rate of domestic credit creation diverges from
the changes in money demand, the difference is made up by equivalent
changes in net foreign assets arising from a balance of payments surplus
or deficit.
Using this financial programming framework, it is relatively
straightforward to design the basics of an IMF financial programme. In
the simplest case, only three steps are required. First, one has to set
a target for changes in net foreign assets over some period of time,
usually one year. Second, an estimate is made of the demand for money
over the same period. This involves projecting the main determinants of
money demand, such as real income and prices. This is the critical
behavioural relationship in the analysis. The demand for money must be
stable in order for there to be a predictable relationship between the
balance of payments and domestic credit. Finally, given the forecast of
the demand for money during the period in question and the overall
target for the balance of payments (i.e., for the change in net foreign
assets), the corresponding change in domestic credit is derived from the
balance sheet identity of the assets and liabilities of either the
central bank of the banking system. In IMF programmes these values for
the change in domestic credit become "credit ceilings" that
are used to monitor performance under the programme. That is why in all
programmes, including the current one with Pakistan, performance
criteria always include a ceiling on domestic credit expansion.
The instruments that the SBP uses to affect monetary and credit
aggregates are the standard ones of monetary policy: changes in the
rediscount rate; open market operations; and reserve requirement
changes. It should be noted that interest rates have at times themselves
become a target if the SBP believes that the market is pushing rates up
to much. In this case the SBP loses an important instrument of monetary
control, and has to rely on direct controls, such as individual bank
credit ceilings, or moral suasion to persuade banks not to extend credit
beyond what is considered desirable by the SBP.
Several studies have questioned monetary targeting, principally by
casting doubt on one of the key assumptions of this type are regime,
namely the stability of the demand for money. (11) Although money and
credit variables have been found to have a reasonably strong link with
the ultimate objectives, the predictability of these effects is
uncertain. (12) After 2001, M2 has consistently exceeded its target
growth, and since 2004 inflation has been above the target number.
Clearly, the targeting of monetary aggregates has not been particularly
successful in recent years. It has been argued by some that this is a
consequence of financial developments and financial innovations that
have led to a breakdown of the money demand function, thus calling into
question the monetary aggregates targeting regime. This is not a
phenomenon unique to Pakistan, as many emerging market and developing
economies have experienced similar problems and been forced to think of
alternative monetary regimes.
In circumstances where the link between monetary aggregates and
inflation is weakened of breaks down, it makes sense to move directly to
targeting inflation. Essentially, this is what led 19 emerging market in
developing countries (listed in Table 1) to adopt formal inflation
targeting as the monetary policy regime. (13) Should the SBP then move
to formal inflation targeting? This is a question that has been debated
in the SBP, although the decision is apparently to stay for the present
with the monetary targeting framework. (14) So if the SBP were to move
to inflation targeting, are the preconditions outlined in Section VI
met?
(a) Commitment to Price Stability
This has to become the highest priority for the SBP, even though it
is not necessary to completely forgo other objectives like output and
the balance of payments. However, if there is a conflict among
objectives, inflation stabilisation must dominate the others. In recent
years, the SBP appears to have made inflation its highest priority, and
inflation targeting would simply formalise an existing practice.
(b) Flexible Exchange Rate
While not freely floating, the exchange rate has considerable
flexibility. In fact, full flexibility may not be desirable in countries
like Pakistan that are prone to external shocks and where the
pass-through from exchange rate changes into consumer prices may be
quite rapid. Most emerging market and developing countries intervene in
the forex market to counter excessive movements in the exchange rate.
(c) Independent Central Bank
The SBP became more independent from the government since 1994, but
its operations are still significantly influenced by the Ministry of
Finance. However, an amendment to the SBP law to enhance the central
bank's operational independence was submitted to Parliament in
December 2009, and is expected to be passed in 2010. In the meantime,
the SBP announced the formation and composition of the nine-member
Monetary Policy Committee (MPC) of the SBP Board, and this committee
started its work in November 2009. At this point, the MPC reports to the
SBP Board and includes two members of the Board, which is unusual since
the MPC should ideally be independent of the Board as well, but possibly
the reporting requirement and the composition of the MPC will change as
the amendments going through Parliament become law.
(d) Absence of Fiscal Dominance
In order for the SBP to implement formal inflation targeting, it
must have instrument independence. That is, it must be able to focus
exclusively on inflation and be able to use the instruments at its
disposal, particularly interest rates, to achieve the target. Fiscal
dominance can interfere with this objective in two related ways. First,
the government can oblige the central bank to finance its fiscal
deficit, thereby creating excess liquidity in the economy. Second, the
government can pressure the central bank to keep interest rates low so
as to lower the government's borrowing costs as well as the
interest payments on its outstanding debt. In such a case, the central
bank will likely be unable to achieve its goal of low inflation, since
its ability to manage monetary conditions and liquidity in the economy
will be circumscribed.
The SBP has operated under the constraint of fiscal dominance
throughout its history. While it has gained a measure of independence
since 1994, (15) nevertheless the government has continued to have a
major influence on its operations. The most obvious example is the
period leading up to the recent crisis that ended up with Pakistan
approaching the IMF for a programme. Starting in early 2007, as
international oil prices continued to rise steadily, basically for
political reasons the Musharraf government decided to abandon the
domestic oil pricing formula, and the increases in international oil
prices were not passed on to the public. (16) As a result, the
government's subsidy bill ballooned, and the fiscal deficit jumped
from 4 percent of GDP in 2007 to 7.3 percent in 2008. This fiscal
deficit was financed mostly by the SBP, to the tune of Rs 650 billion
(nearly $10 billion). Effectively this amounted to printing money to
finance the fiscal deficit, and the two well-known consequences of such
a policy are inflation and a loss of international reserves. That is
exactly what happened. Inflation, which was already rising because of
the increase in food prices, jumped to over 20 percent in 2008, almost
triple the 2007 rate, and the country lost nearly $6 billion in
international reserves between June 2007 and June 2008.
Very reluctantly the government then approached the IMF at the end
of 2008 for a programme. Recognising the reasons why Pakistan had got
into the crisis, the IMF introduced an important condition into the
programme--SBP financing on the government had to be eliminated. (17) It
is worthwhile noting that the condition has been met during the course
of the programme, even though the ceiling on the fiscal deficit has
not.j8 Therefore, it is certainly possible to argue that the government
can adhere to the condition of no borrowing from the SBP if it so
chooses, and fiscal dominance can be eliminated as a constraint on SBP
operations.
In a sense, the adoption of inflation targeting by the SBP would in
fact lead to a fundamental institutional change, unrelated to an IMF
programme, that would restrict the Ministry of Finance from borrowing
from the SBP and trying to keep interest rates below market-determined
levels. From that standpoint alone, the adoption of inflation targeting
would serve as an important disciplining device on the government in
exercising undue influence over the SBP in the conduct of monetary
policy.
(e) Transparency and Operational Capability
The SBP already has initiated a policy of making public its
inflation reports and the MPC monetary policy decisions. A substantial
degree of transparency has already been achieved, and presumably more
transparency and accountability will follow, hopefully with the
publication of the minutes of the MPC discussions. The SBP has the basic
operational capacity to make inflation forecasts, and further work on
both econometric models and short-term forecasting models should enable
it to make their projections. The tools and the capacity are there, and
it is only a question of how they are refined and utilised in the design
of monetary policy. Furthermore, as argued previously in the paper,
because of ongoing structural and institutional changes, inflation
forecasts in emerging market and developing countries have to rely on
judgment as well as models.
Overall, a move to inflation targeting by the SBP is both desirable
and feasible. All the preconditions that are considered necessary for
implementing inflation targeting are satisfied, save one. And that is
the absence of fiscal dominance. However, by adopting an inflation
targeting regime the independent SBP would be in a position to turn down
any Ministry of Finance request for deficit financing if it ran counter
to its policy of keeping a low rate of inflation. It would also be a
clear and transparent rules-based policy and easily understood by the
public, leading to greater accountability for the SBP. Right now the SBP
is held responsible for inflationary developments even though it may
only be supporting the policies of the fiscal authorities. With
inflation targeting, the responsibility will rest squarely with the SBP
and it would be accountable to the public, the government, and
Parliament for the outcomes.
The new monetary regime could be implemented in the fairly near
future as the amendments to the SBP Act become law. However one issue to
take into account is the current IMF programme, which is based, as
argued before, on the monetary aggregates targeting framework. The
standard IMF programme would therefore be inconsistent with inflation
targeting, although it can be adjusted to fit the different framework.
(19) However, as the IMF programme ends later this year, it may be
advisable to wait until then to establish the new framework so as not to
go through a protracted renegotiation of the current programme.
Inflation targeting could therefore be implemented in January 2011,
leaving enough time to make the necessary operational and institutional
preparations for the new monetary regime.
VII. CONCLUSIONS
In developing countries, monetary policy has become increasingly
important in recent years, even though capital accounts have been
progressively liberalised. The reason is that the large movements in
global capital during the late 1990s forced many of these countries to
abandon fixed or closely managed exchange rate regimes and implement
monetary policies to control inflation. Such recent developments have
brought to the forefront the now well-known fact in international
monetary economics: namely that freely mobile capital, independent
monetary policy, and fixed exchange rates form an "impossible
trinity," or "Trilemma," as it has come to be called.
Specifically, it is possible to have any two of these policies, but not
all three.
In a globalised capital markets environment, there is less room for
divergence of views among market participants about the appropriate
stance of exchange rate and monetary policy, less time to adjust to
shocks, and greater pressure to achieve closer convergence of economic
performance among trading partners. As a result, a number of developing
countries have adopted exchange rate regimes with more flexibility--and
therefore provided greater scope for monetary policy.
Traditionally, monetary rules have been based on the behaviour of
monetary instruments. However, in an environment of large international
capital flows with continuing financial innovations and ever more
sophisticated asset markets, rules based on monetary aggregates have
become more difficult to implement. Accordingly, central banks have
increasingly embraced the inflation-targeting approach. In some cases,
the approach has helped monetary policy become more coherent,
transparent, and credible. And, if supported by proper fiscal measures,
the inflation-targeting approach has helped policymakers guide inflation
rates lower, while permitting them some discretion to stabilise output.
This regime has become increasingly popular even in developing
countries, and so far the results have been promising. It is a monetary
regime that the SBP should adopt if it is to fulfil its role as guardian
of monetary and financial stability in Pakistan.
Comments
At the outset I would commend Mohsin Khan's efforts in
preparing a very good paper on a subject that is quite important for
understanding the efficacy of economic management in Pakistan. I feel
the paper would serve as good reading material both in macroeconomics as
well as in monetary theory.
Although he discusses a variety of objectives and instruments of
monetary policy, the main thrust of the paper is to highlight the
critical role of central bank in ensuring price stability through a rule
based policy, particularly in developing countries where inflation
remains an important fact of life. It is underlined that in the backdrop
of weak institutional arrangements and low credibility of central
bankers in such countries incentives are created that promote dynamic
inconsistency and inflationary bias in the conduct of monetary policy.
The paper comprehensively surveys the instruments available to central
banks in achieving the objective of policy stability and narrates in
some details how the use of such instruments has evolved over the last
several decades.
I would take the liberty of moving straight to the key
recommendation of the paper, which is for the SBP to more toward
inflation targeting. It has already been noted that in the framework of
an IMF programme monetary aggregates still remain the dominant modes of
conducting monetary policy. It has also be recognised and despite this
being the case inflation remains an important consideration in judging
the success of stabilisation programme. And even though inflation may
not be a performance indicator like the buildup of reserves or credit
expansion yet it remains a guiding principle, for instance in interest
rate setting. Without having a formal linkage, since interest rate
remains an important part of the programme, an implicit mechanism of
worrying about inflation is already available in the present programme.
This is not to suggest that we already have an inflation targeting
monetary policy in place. Clearly, there is work to be done before we
can claim to be amongst the countries following rule based monetary
policy.
At the outset, let me state that the pursuit of price stability
should not be a basis to create wedge within the apparatus of economic
management. I see many implications of this recommendation that may be
unintended but in the context of past experience in Pakistan, they are
quite pregnant with suggestions that will promote precisely such
consequences.
To begin with, and without de-emphasising what has been proposed,
it needs to be recognised that inflation has not been a problem in
Pakistan the way it has affected many other emerging markets. The
unusual inflation we experienced last year is an outlier in the data on
inflation, which may have occurred once or twice more in the last six
decades of our existence. As one of the papers read out in the
conference has demonstrated, the average inflation in the past 60 years
has been in the range of 5-6 percent. And that is because this is a
country, with low income and high population, where peoples'
capacity to absorb large doses of inflation is quite low. The country
produces a great deal of its own food and many people are engaged in
subsistence agriculture and are occasionally paid in-kind, which is an
effective way of insulating them from price-hikes. This may be a reason
behind the relative price stability observed over a very long period of
time. Again, speaking in relative terms, inflation has not been a
problem which could warrant a one-dimensional conduct of monetary
policy.
In the case of Pakistan, I would suggest that rather than inflation
it is growth that has been a more worrying concern for the
policy-makers. It is growth, of lack of it, that pushes people into
poverty. Obviously, you will argue that growth itself is affected
because of inflation. Without denying the growth retarding character of
inflation, it should be noted that there have been episodes of major
decline in growth which had nothing to do with inflation nor, as I have
already suggested, has inflation been so menacing as to retard growth.
For instance, the unusual draught in the first few years of the present
decade clearly had nothing to do with price stability of loss of it.
That draught had pushed people significantly below the poverty line.
Similarly, we have had long spells of growth without high inflation.
Let us recognise that we should be interested in price stability
per se. For there are mechanisms, indeed very brutal ones for that, for
instance through ceding the country's sovereign right to create
money tremendous price stability can be achieved. If a country does not
print money beyond that which is absolutely necessary to meet the
growing needs of the economy, barring the questions of stability of
demand for money function, then clearly there will be no inflation. But
it will be difficult to make out a case for a country like Pakistan that
it should move in that direction, for we have never had inflation so
problematic as to warrant such an extreme step. Accordingly, by price
stability it should not be meant that the country should lose its
sovereign right to enjoy the seigniorage which is a legitimate income of
any government. Needless to say that this has to be within reasonable
limits.
When we move toward price stability through the mechanism of
inflation targeting this issue has to be solved as to who will have the
right to decide as to what level of inflation should be targeted. Will
it be an empirical thing of judgment? And if it's a judgment, whose
judgment it will be? The paper has spelled out the conditions needed for
efficient conduct of inflation targeting. It has been particularly noted
that SBP's freedom of independence is an important requirement for
the success of this exercise. The author and I have had the privilege of
witnessing together how this issue of central bank's autonomy has
evolved in Pakistan over the years. Clearly, prior to 1990-91, when
public auction of debt started there was not much by way of monetary
management. The entire capital market was in the public sector. There
was not much public debt traded by banks of general public, it was held
exclusively by the nationalised commercial banks. It all started with
the public auctioning system. The first step toward giving autonomy to
State Bank was taken in 1993. When a new initiative was proposed by the
IMF in the current programme, I had really wondered what is wrong with
the current quantum of autonomy that would call for yet another round of
amendments in the law.
It has been stated that the SBP was treated like an attached
department of the ministry of finance and that the secretary finance of
additional secretary were running the SBP. Frankly, I have not had this
privilege to treat SBP in this fashion, not that I wanted to, of to
influence in any way, the manner in which the SBP was run. To the
contrary, I saw on many an occasions that the powers that vest in the
Board of Directors of SBP were freely exercised by the Governor, and
occasionally, not entirely in accordance with the law. The first three
Governors the country has seen since the central bank was made
autonomous would conduct monetary policy as a one person show. They will
take decisions and will come to the meeting of the Board simply
announcing their decisions. Clearly, this is not the kind of freedom of
autonomy that is envisaged in the SBP Act.
The package of autonomy, when approved in 1993, had envisaged a
Monetary and Fiscal Coordination Board which were to set the basic
policy parameters, including a determination of the inflation target for
the year. The Board has not met as frequently as it should have. But
that does not take away the significance of its existence. If State Bank
has to work as an insulated institution divorced from what is happening
in economic management in the rest of the economy, clearly there will be
huge coordination problems. The paper apparently does not address this
issue. I would also like to bring before this august forum the Indian
Reserves Bank Act, which was precisely the same as SBP Act before it was
amended in 1993. There has been not been a single notable amendment in
the Indian law since its promulgation the way that we amended our law or
are going to do yet again. Now I wonder if India is wanted in any way in
the conduct of its monetary policy or its economic management of the
type we have just been discussing.
It is important to note that it is the federal government that
interacts both with the IMF and the World Bank. It is the government
that negotiates the programmes with these bodies. I have had occasions
to share candidly this with these institutions that the way they are
promoting the notion of autonomy and independence of several economic
institutions, it is only encouraging--I hate to say
disintegration--divisions within the government and thereby affecting
the coherence in economic management and perhaps, on occasions, we may
working at cross purposes. Accordingly, the quality of economic
management expected of the government is missing precisely. New agendas
are added to an already complex policy-making regime with little
significance and relevance, which adversely affect the ability of the
ministry of finance to deliver on the discipline that is imposed through
a Fund programme.
Although not part of the paper, the author in his discourse has
expressed a view regarding the causes behind the recent inflationary
episode which eventually led the country into an IMF programme. He has
said the Musharraf Government had not passed-on the oil price increase
to consumers for political expedience and the resulting deficit was
financed through central bank borrowing. He suggested that had the
central bank been independent it would have refused to finance this huge
deficit and the consequent derailment of economic stability would have
been avoided. I would beg to differ with this description as the facts
are quite different than what is being suggested.
There is clear evidence that during those important days the
auctions of public debt held had witnessed considerable demand from
commercial banks for government securities. It was SBP's decision,
who curiously was conducting such auctions and deciding on how much to
take and what prices. It was SBP who decided not take those offers even
when these were within the reasonable limit of interest rates and the
Ministry of Finance would not have any objection in accepting those
offers. I have difficulty in understanding on what basis the SBP then
decided to reject those offers and instead buy those securities and
create reserve money in the process.
At a broader level, let me also suggest that price stability cannot
be the only objective of economic management to be handled at a
different place and the rest of economic management somewhere else.
There has to be coordination. There has to be some understanding amongst
all those responsible for economic management. After all we should look
at how the US Federal Reserve has handled the recent financial turmoil.
Here again we will the contrast between what is an international best
practice and what is being done here in Pakistan. In the aftermath of
the financial melt-down, Federal Reserve Bank had gone in the market and
purchased any kind of securities issued by any authority, including
private securities to an extent that it has doubled its balance sheet.
It was discounting these securities because it wanted to provide the
liquidity that was the single most important reason why the entire
financial system had paralysed and frozen. Well, compared to what was
happened in USA, there was not much that happened in Pakistan. In our
case some small banks and mutual funds were faced liquidity problems.
They had some illiquid assets, in the form of rated-TFCs (term financing
certificates) of corporate sector entities, some of those carrying AAA
rating. The then governor was not interested in discounting those
securities. This position was not modified even when the Government was
willing to provide a guarantee for this purpose. Curiously, the Governor
was occasionally insisting federal government to provide it guarantee in
the same form as it provides to commercial banks. This was not entirely
in accordance with the provisions of law, as the federal government has
the authority to give directions to central bank on such matters, and of
course the responsibility and obligations incurred on this account are
those of the federal government.
It may also be noted that whenever federal government borrows from
the central bank it is priced at the same rate as is observed in the
last auction of 6-month T-Bills and as such there is no pre-determined
rate at which government borrows and this rate keep changing, because
much of government borrowing is short term.
Finally, I would like to say that this issue of independence has to
be settled with respect to its fullest meaning. One of the Governors,
who was attending the meeting of the Senate's Standing Committee on
Finance, asked the Chairman: Sir, you are part of the government, please
help us in controlling the government from borrowing excessively from
the State Bank. Obviously, the Chairman was shocked that the governor
thought the Senate was part of the government.
Here lies the dilemma. What is it that the Central Bank would like
to be? Is it part of the executive, of judiciary of legislature? Where
would it like to fit in'? I think there is no other model in the
world but to acknowledge that central banks, despite any amount of
autonomy, remains a part of the executive. Undoubtedly, they are
carrying a fiduciary responsibility that calls providing it special
existence, duly sanctioned under the law and with protection of tenure
and insulation from normal bureaucratic intervention in its working. But
such considerations cannot be carried too far to develop an antagonism
with the executive branch and arrogate more responsibility for economic
management then an elected government has under the Constitution of
Pakistan.
I have no difficulty in supporting a programme whereby the central
bank will move toward inflation targeting. But at the same we must
recognise that the objectives of economic management are much broader,
and in particular growth is no less important an objective. Accordingly,
there has to be close coordination amongst the institutions charged with
the formulation and implementation of economic policies.
Waqar Masood Khan
Ministry of Textile Industry, Islamabad.
Comments
Dr Khan has presented a comprehensive paper on various aspects of
monetary policy emphasising in particular the issues of dynamic
inconsistency, the nexus between inflation and economic growth, and
rules-based vs. discretionary monetary policy frameworks. The paper
methodically builds on several strands of literature in the broad areas
of macroeconomics and monetary economics to make a convincing case for
the adoption of inflation targeting regime in Pakistan.
The idea of inflation targeting has been extensively debated in the
literature and has now gained broad acceptance among academic and policy
circles. The empirical evidence shows that the performance of Inflation
Targeting regimes around the world has been largely positive. Average
inflation in both emerging markets and developed economies is found to
be substantially lower after the adoption of the Inflation Targeting
regime than immediately before its adoption.
In view of the compelling theoretical arguments in favour of
Inflation Targeting and broad empirical support, there can be little
question on the desirability of adopting Inflation Targeting regime as
long as the pre-conditions for its successful implementation are met.
The question then is of feasibility. In this context, the paper
spells out various conditions that are necessary for inflation
targeting; and examines in detail whether these conditions are satisfied
in Pakistan. It is argued that all the conditions are met except the
condition of fiscal dominance.
To be sure, the adoption of the Inflation Targeting regime would
mark a fundamental shift in macroeconomic management in Pakistan. At the
same time it would pose some difficult challenges too.
First and foremost is the issue of fiscal dominance. The paper
argues that the adoption of Inflation Targeting would act as a
disciplining device helping to restrain government borrowing from the
central bank. However, this is going to be difficult in a country where:
(1) Tax to GDP ratio has been chronically low;
(2) Efforts to raise tax revenues have not been very successful in
the past with future prospects remaining uncertain; and
(3) Financial markets lack the necessary depth making it difficult
for the government to use market-based debt instruments to finance the
fiscal deficit.
All these issues would have to be resolved to effectively limit the
scope of fiscal dominance.
Second, in view of diverse development challenges typically faced
by the developing economies, it may be difficult to accept the primacy
of price stabilisation over all other macroeconomic objectives. For
example, poverty remains a pressing issue in Pakistan and consequently,
one of the major goals of economic policies is poverty alleviation. As
economic growth is a necessary condition for poverty reduction, there
will always be a strong temptation to achieve higher economic growth in
the short term through the use of accommodative monetary policy.
Third, Pakistan would have to brace for a greater degree of
exchange rate flexibility typically associated with an Inflation
Targeting regime. As rightly pointed out in the paper, more flexible
exchange rate could serve as an automatic stabiliser in the face of
adverse external shocks. However, it the exchange rate becomes
excessively volatile, this would enhance exchange rate risk which is
detrimental to international trade and investment and hence economic
growth. As a matter of fact, there is some empirical evidence that
volatility of exchange rate in emerging countries adopting Inflation
Targeting has been higher than in developed market economies.
Fourth, there may be some practical issues in the implementation of
Inflation Targeting regime. For example, there is evidence in the case
of Pakistan that interest rate channel of monetary policy is rather weak
and that there are long lags in the pass through of short term interest
rate to the lending rate. This implies that the short term interest
rate--which is the principal policy tool in inflation targeting
regimes--does not have significant effects on the rate of inflation.
Surely there will be ways to deal with this problem but exactly how the
central bank would tackle this issue needs to be looked into.
It should be emphasise here that none of these problems is
insurmountable. What is required is a strong political will and a focus
on long term goals rather than short term expediencies. The adoption of
Inflation Targeting regime would help solve the fundamental problem of
dynamic inconsistency associated with a discretionary monetary policy
regime. As the paper rightly emphasises, this problem is especially
important in low income countries with weak institutions and low
credibility of the central bank.
Research undertaken at the PIDE corroborates this view in the
context of Pakistan. The PIDE regularly conducts inflation expectations
survey and these surveys have found a persistence of inflationary
expectations which is taken to be a sign of low policy credibility.
Incidentally, the fact that inflationary expectations are fairly
entrenched partly explains the persistence of inflationary pressures in
the economy despite tight monetary policy in the recent period.
Let me say in the end that the paper is a valuable contribution on
modern views of monetary policy and lessons for Pakistan. The issues
raised in the paper are of profound significance and deserve serious
consideration and debate.
Musleh ud Din
Pakistan Institute of Development Economics, Islamabad.
Author's Note: The author is grateful to Laurence Harris,
Waqar Masood Khan, Syed Salim Raza, and participants in the conference
for helpful comments and suggestions. Christine Ryan provided excellent
research assistance in the preparation of the paper. Paper prepared for
the Pakistan Society of Development Economists Silver Jubilee
Conference, Islamabad, Pakistan.
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Transmission Mechanism of Monetary Policy in Pakistan. Karachi: State
Bank of Pakistan. (SBP Working Paper No. 9).
Bokil, M. and Axel Schimmelpfennig (2005) Three Attempts at
Inflation Forecasting in Pakistan. Washington, DC: International
Monetary Fund. (IMF Working Paper 05/105).
Calvo, Guillermo A. (1978) On the Time Consistency of Optimal
Policy in a Monetary Economy. Econometrica 46: (November), 1411-28.
Carare, Alina, Andrea Schaechter, Mark Stone, and Mark Zelmer
(2002) Establishing Initial Conditions in Support of Inflation
Targeting. Washington, DC: International Monetary Fund. (IMF Working
Paper 02/102.)
Chari, V. V. and Patrick J. Kehoe (2006) Modern Macroeconomics in
Practice: How Theory is Shaping Policy. Journal of Economic Perspectives
20: (Fall), 3-28.
Felipe, Jesus (2009) Does Pakistan Need to Adopt Inflation
Targeting? Some Questions. SBP Research Bulletin 5: (May).
Fischer, Stanley (1993) The Role of Macroeconomic Factors in
Growth. Journal of Monetary Economics 32: (December), 485-512.
Freedman, Charles, and Douglas Laxton (2009) Why Inflation
Targeting? Washington, DC: International Monetary Fund. (IMF Working
09/86).
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York: Fordham University Press.
Hussain, M. (2005) Inflation and Growth: Estimation of Threshold
Point for Pakistan. Pakistan Business Review (October).
Ghosh, Atish and Steven Phillips (1998) Warning: Inflation May Be
Harmful to Your Growth. IMF Staff Papers 48: (March), 1-21.
Khan, Mohsin, S. and Abdelhak S. Senhadji (2001) Threshold Effects
in the Relationship Between Inflation and Growth. International Monetary
Fund. Staff Papers 48:1, 1-21.
Khan, Mohsin, S. and Axel Schimmelpfennig (2006) Inflation in
Pakistan: Money or Wheat? SBP Research Bulletin 2.
Kydland, Finn E. and Edward C. Prescott (1977) Rules Rather Than
Discretion: The Inconsistency of Optimal Plans. Journal of Political
Economy 85: (June).
Malik, Wasim, S. (2007) Monetary Policy Objectives in Pakistan: An
Empirical Investigation. Pakistan Institute of Development Economics,
Islamabad. (PIDE Working Papers 2007:35).
McCallum, Bennett T. (2000) The Present and Future of Monetary
Policy Rules. International Finance 3: (Summer), 273-86.
McCallum, Bennett T. (2004) Misconceptions Regarding Rules vs.
Discretion for Monetary Policy. Cato Journal 23:Winter, 365-71.
Moinuddin, (2009) Choice of Monetary Policy Regime: Should the SBP
Adopt Inflation Targeting? SBP Research Bulletin 5.
Mubarik, Yasir A. (2005) Inflation and Growth: An Estimate of the
Threshold Level of Inflation in Pakistan. SBP Research Bulletin 1.
Omer, Muhammad and Omar F. Saqib (2009) Monetary Targeting in
Pakistan: A Skeptical Note. SBP Research Bulletin 5.
Qayyum, Abdul (2008) Does Monetary Policy Play Effective Role in
Controlling Inflation in Pakistan. University of Munich, Munich. (MPRA
Paper No. 13080).
Roger, Scott (2009) Inflation Targeting at 20: Achievements and
Challenges. International Monetary Fund, Washington, D.C. (IMF Working
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Sarel, Michael (1996) Nonlinear Effects of Inflation on Economic
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Taylor, John B. (1993) Discretion versus Policy Rules in Practice.
Amsterdam: North-Holland. Carnegie-Rochester Conference Series on Public
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Woodford, Michael (2003) Interest and Prices: Foundations of a
Theoly of Monetary Policy Princeton, NJ: Princeton University Press.
(1) The standard reference to modern monetary analysis is Woodford
(2003). A recent survey by Chari and Kehoe (2006) also provides a useful
description of where things stand with respect to the new developments
in the design of monetary policy.
(2) For a good summary of the time inconsistency problem, see Chari
and Kehoe (2006).
(3) See, for example, Woodford (2003), Chapter 1, for a
comprehensive discussion of this debate.
(4) For a recent survey of inflation targeting, see Freedman and
Laxton (2009).
(5) A detailed exposition of inflation pre-conditions can be found
in Carare, et al. (2002) and Freedman and Laxton (2009).
(6) These dual objectives are enshrined in the State Bank of
Pakistan Act of 1956.
(7) This was very evident over the past decade in Pakistan. During
2001-2005 easy monetary policy supported a higher growth rate while the
inflation rate was fairly modest. But in 2006 inflation started to pick
up and growth began to slow down steadily. By 2008 inflation had gone
over 20 percent, and growth had fallen to only 2 percent.
(8) Fischer (1993) was the first to describe the possibility of
this nonlinear relationship between inflation and growth.
(9) Malik (2007) specifies and estimates a policy reaction function
for the SBP relating the policy interest rate to the output gap,
inflation, exchange rate, interest rate smoothing, and the trade
deficit. He finds the most of the coefficients of these variables are
statistically significant.
(10) During the past decade, for example, Pakistan has had
programmes with the IMF in 6 out of 10 years: a Stand-by arrangement
(November 29, 2000-September 30, 2001); a PRGF arrangement (December 6,
2001-December 5, 2004); and most recently another Stand-by arrangement
(November 24, 2008-October 23, 2010). As a matter of fact, in the 1990s
Pakistan had an IMF programme every year.
(11) In an IMF paper, Bokil and Schimmelpfennig (2005) show that
the money demand equation for Pakistan has non-constant coefficients
when estimated with either annual of monthly data. Similar instability
has been found by SBP researchers; see Moinuddin (2009) and Omer and
Saqib (2009).
(12) For example, by Ahmed, et al. (2005) and Khan and
Schimmelpfennig (2006). Qayyum (2008) questions this supposed link,
particularly since 2000 on.
(13) In fact many other countries have adopted the same practice,
albeit less formally.
(14) For a discussion of the pros and cons of inflation targeting
in Pakistan, see Felipe (2009) who does not favour it, and Moinuddin
(2009), who argues that the SBP should move in this direction.
(15) Prior to 1994, the SBP functioned like an agency of the
Ministry of Finance, and all major monetary policy decisions had to have
the implicit, if not the explicit, approval of the Secretary of Finance
(who also still sits on the SBP Board).
(16) This policy was continued by the successor caretaker
government in early 2008.
(17) More specifically, net borrowing by the government from the
SBP was to be zero on a quarterly basis.
(18) It has been argued that meeting the zero net borrowing target
has been achieved through an element of "window dressing".
That is, net borrowing takes place during the quarter, creating excess
liquidity in the system, and is brought down to zero in the last days of
the quarter. So while the ceiling is formally met, the damage has been
done.
(19) This was in fact done in the case of the last IMF Brazilian
programme in 2002-2003.
Mohsin S. Khan <mkhan@piie.com> is Senior Fellow, Peterson
Institute for International Economics, Washington, DC, USA.
Table 1
Inflation Targeting Regimes
Country Effective IT Adoption Date
New Zealand (1) January-1990
Canada (1) February-1991
United Kingdom (1) October-1992
Sweden (1) January-1993
Finland (1) February-1993
Australia (1) April-1993
Spain (1) January-1995
Czech Republic (1) December-1997
Israel (1) June-1997
Poland (2) October-1998
Brazil (2) June-1999
Chile (2) September-1999
Colombia (2) September-1999
South Africa (2) February-2000
Thailand (2) May-2000
Korea (1) January-2001
Mexico (2) January-2001
Iceland (1) March-2001
Norway (1) March-2001
Hungary (1) June-2001
Peru (2) January-2002
Philippines (2) January-2002
Guatemala (2) January-2005
Slovakia (1) January-2005
Indonesia (2) July-2005
Romanian (2) August-2005
Turkey (2) January-2006
Serbia (2) September-2006
Ghana (2) April-2007
Source: Roger (2009).
(1) High income countries; (2) Low income countries
(based on World Bank Development Indicators classification).
