Pakistan’s food inflation even today is clocking around 30% and naturally there is a lot of pressure on the central bank to further raise the interest rates. So far, the governor has done well to resist this temptation, as by now trust everyone knows that the monetary tool of interest rate beyond a certain level may do little to tame inflation, but instead cause a lot of damage to employment generation. Developing countries such as Pakistan with a very high population, which is mostly young and fast attaining employable age, invariably face the dilemma between the need to balance growth cum employment generation with monetary tightening. The important question today is how high can interest rates go without tipping Pakistan’s economy into a recession; that is if it is not already in one. This has been the debate roiling the economists deciding monetary policy in the State Bank of Pakistan (SBP). So far, the SBP has been committed to stemming inflation, but has shied away from raising the current bar that already reflects a comparative imbalance with regional competitors!
Interest rate changes alone do not create more factories or build more houses but raising rates can slow down economic activity enough to ease inflationary pressure squeezing Pakistani pocketbooks, witnessing perhaps the worst inflation trap since 1947. The decision, however, facing the SBP is how hard to tap the brakes. In its latest meeting, the opinions have been oscillating from lowering it to 12% to raising it to 18%, so one can see how difficult the balancing act is becoming amidst a very charged and polarised political backdrop. The reality is that exactly any percentage hikes will affect inflation and economic growth is still unclear. The reason is that higher interest rates won’t address the underlying drivers behind today’s inflation: mainly currency devaluation, shortages of raw materials, and supply chain failures. In the 1970s, inflation was driven up by wages and prices chasing each other—an additional issue that could also very well happen today with rising wages (especially comparative minimum wages within the South Asian region), but so far thankfully it hasn’t visibly been an issue yet. The positive argument in all this is that our central bank so far has not only raised interest rates in small increments but has also kept them stable to give a clear signal that it is serious about bringing inflation down without hampering the recovery of the labor market. Smaller hikes limited to 50 basis points or under in general don’t risk much beyond the short-term.
How do interest rate hikes affect the economy? In a nutshell, higher interest rates reduce borrowing and spending by households and businesses. When the central bank raises the interest rate on money it gives banks, the banks raise their rate for loans on everything from car loans to mortgages. As a result, businesses invest in fewer projects, hire fewer people, and contain wages. Consumers then spend less and pay down debts. For investors, higher government securities rate reduces the overall market value of corporate stocks, meaning that investors that hold large or significant stock exchange portfolios—typically a measure of market strength as well - will have to sell off some parts of their portfolio to rebalance their losses.
Also, at the same time this phenomenon makes them less likely to invest in new, riskier businesses, thereby consistently driving the stock levels/index down – something, which if not checked can result in a free fall of the stock market. Why does the central bank still mull over hiking interest rates? Now for almost the past 3 years, the prices in Pakistan have been rising dramatically with the WPI (Wholesale Price Index) - that now economists consider a more accurate yardstick for measuring the intensity of inflation than the Consumer Price Index (CPI) – almost touching 43% just a few months back. Now the central bank is concerned inflation may spread to stubborn levels simply untenable for the poor, in turn stocking further poverty and hunger. Further, until recently, leisure & hospitality, real estate/construction, and textiles, the most labor-intensive parts of the economy, had a negligible effect on their momentum, whereas, today these sectors are faltering as well. The danger of course in this trapeze dance is always being for the central bank that if inflation transitions into stagflation, it means that it has left it for too late and the fallout could instead be long-term!