ECB response to inflation
Historically, there have been multiple objectives of the central banking including price stability, GDP growth and full employment.
The objective of price stability and full employment often have a trade-off; i.e., if you try to achieve one objective, the progress toward the other objective will become difficult and vice versa.
Therefore, the mandate of Federal Reserve, the central bank of United States is often termed as dual mandate.
Unlike Federal Reserve, the European Central Bank (ECB) is having unique primary objective of price stability.
Every other objective is taken as secondary or tertiary objective of the central banking. Inflation in Europe today is at highest level of past three decades.
Increasing interest rate is considered as standard remedy for reducing inflation. Christina Lagarde who is now heading ECB has been working as the Managing Director of IMF few years ago and was a part of negotiation of the IMF package for Pakistan.
One of the first demands of IMF for providing a package to any country is to increase interest rate, and so was the case in Pakistan.
Therefore, within few months after arrival of PTI government, the interest rate in Pakistan went up to 13.25%.
Due to Covid-19, the policy rate was reduced in 2020 to 7% and it was increased again to 12.25% recently.
A question arises; given the unique mandate of the ECB to control inflation, what the ECB is doing to control it?
In particular what are they doing with the interest rate, the standard remedy often prescribed for developing nations to come out of inflation?
The history is evident that the interest rate in European Union was zero before the start of pandemic and it remain zero after the current wave of inflation.
How can a central bank headed by the top advocate of high interest rate policy and having unique objective of price stability ignore the response to this rise in inflation?
This paradoxical behavior of the ECB and its president indicate one of the two things; first, in the eyes of ECB and its chief, the rise in interest rate is not capable to reduce inflation or second, the ECB is focusing on other objectives of central banking disregarding the constitutionally mandated primary objective of price stability.
In fact, there is substantial element of truth in both of these possible reasons. In the history of monetary economics, particularly in post-pandemic economic history, there is substantial evidence to deduct that high interest rate policy is not successful in achieving lower inflation.
There are about 25 countries of the world who increased their interest rates on or before September 2021, with the explicit aim of reducing inflation.
These countries include Angola, Tajikistan, Kyrgyzstan, Russia, Brazil, Moldova, Belarus, Georgia, Ukraine, Armenia, Uruguay, Nicaragua, Hungary, Bosnia and Herzegovina, Kazakhstan, Mexico, Iceland, Chile, Czech Republic, Peru, Venezuela, El Salvador, Bolivia, Cambodia.
One can verify their data from the online sources, and the data indicates that until today, after spending more than 6 months in pursuit of high interest rate policy, no single country out of this list has been successful in reducing inflation.
In last six months, many other countries joined the club of choosers of high interest rate policy and these includes South Korea, United Kingdom and United States.
These countries also increased their interest rates in a hope to control inflation and so far, the success is not achieved by any single country.
There is a reason behind this evidence; the high interest rate policy can control demand sided inflation.
The current wave of inflation is clearly supply sided and no economic theory predicts a fall in supply sided inflation due to increase in interest rate.
The second possible reason to explain the response of ECB could be that the bank is focusing on other objectives of central banking instead of the price stability.
This is also very true, the ECB and its constituent central banks provided huge expansionary packages in form of lending to their respective governments during the pandemic.
Obviously, this action cannot be explained keeping in view the core objective of price stability.
ECB and its constituent central banks responded to the sharp reduction in GDP and the falling unemployment due to pandemic and provided huge packages to come out of the crisis.
Making the prices top priority and undermining other objectives makes little sense. It is in fact very welcome step that central banks responded to crucial needs of their respective countries and saved their nations from a probable catastrophe.
However, the question arises why these countries and institutions are reluctant to change their advices for the developing economies like Pakistan?
Why IMF is still insisting on high interest rate policy for Pakistan and why IMF supported the recent legislation in Pakistan which prohibits government to borrow from central bank?
There must be someone to ask this to IMF in forthcoming negotiation. There is a difference between textbook economics and the practices of successful economies and to be a successful economy, we have to learn economic practices of other nations not from the textbooks.
The high interest rate policy has serious and undesirable implications for an economy.
In Pakistan, a one percent increase in policy rate puts an additional burden of Rupees 300 billion on markup payments.
If the policy rate is brought back to the level of January 2018, this can save more than half of the amount currently being paid in markup.
At a policy rate of 3%, the business loans can be made possible at 5-6%, which will make a best employment support scheme without any subsidy from the government.
Therefore, it is the need of time to revise the recent legislations on SBP autonomy and to reduce the interest rate, in line with global best practices and practices of the peer economies.
—The writer is Director, Kashmir Institute of Economics, Azad Jammu and Kashmir University.
