Rise in interest rates and its implications | By Dr Atiq-ur-Rehman


Rise in interest rates and its implications

On November 25, the State Bank’s Monetary Policy Committee further increased the policy rate by one percentage point and said in a statement that the hike was aimed at controlling rising inflation.

The logic behind the efforts to reduce inflation by increasing the interest rate is that increase in interest rate will reduce overall demand and due to this reduction in demand, inflation will decrease.

On the other hand, the State Bank in its monetary policy statement is admitting that the recent wave of inflation is largely driven by commodity prices.

Prices of imported goods cannot be influenced by the domestic market of Pakistan. Rather, it is not easy for any country to influence the global market individually.

Suppose a large country and large economy like India decides to increase interest rates to reduce inflation, driven mainly by the price of petrol.

Suppose historical data indicates that a one percent decrease in the demand for gasoline in the world market can lead to a two percent decrease in the price of gasoline.

To achieve this two percent reduction in the price of petrol, India has to reduce the overall demand in the global market by one percent.

Despite being a large economy, India’s share in the global market is only 7%, so if India reduces the demand for petrol in its domestic market by 14%, the demand for petrol in the global market will decrease by 1%, which will reduce the price of petrol to the desired level.

For developing economies, a difference of one or two percent in inflation is meaningless. The difference in inflation will be significant when there is a reduction of around 5% and for this the demand for petrol in the domestic market will have to be reduced by 75%.

Is it possible for a developing country to reduce its demand for petrol by 75%? Pakistan’s share in the world market is very less than that of India.Pakistan’s share in the total economic activity of the world is only 0.3%.

Even if Pakistan shuts down its economy completely, it will make a difference of only 0.3% in the world market.

In such a case, how is it possible to reduce import-based inflation by means of interest rates?

Based on these same arguments, Nobel Prize-winning economist Joseph Stiglitz wrote an article in 2008, arguing against raising interest rates to control inflation.

According to Stiglitz, controlling inflation through monetary policy is effective only for those economies that have a significant share of the overall world market.

Small economies will always fail in trying to reduce inflation through monetary policy. This is the reason why after June 2021, more than a hundred nations of the world tried to reduce inflation by increasing interest rates.

So far, no single nation has been successful in bringing down inflation significantly among these countries.

Controlling inflation by reducing demand has proven to be futile, on the contrary, there are many other factors that are relatively more effective channels to prove that a rise in interest rates leads to a rise in inflation.

At current interest rates, it has become almost impossible for a new entrepreneur to get a loan, and the supply of credit to existing businesses has decreased.

A decrease in the supply of business credit leads to increased inflation. For example, the recent floods caused enormous damage to agriculture.

The easiest way to revive agriculture was to give farmers enough cheap loans to resume production.

But at the current rate of interest, no farmer would want to take a loan. Therefore, there will be a decrease in agricultural production in the coming season and this decrease will cause an increase in inflation.

In the current financial year, an amount of more than 4000 billion has been set aside for the payment of interest on the government debt, which is about 42 percent of the total budget.

An increase in interest rates will cause the amount of interest owed on government debt to increase further and the government will need to levy more taxes to cover this additional interest, which will further increase inflation.

As stated above, the current government allocated more than 4000 billion for interest payments in the budget.

When the budget was prepared, the interest rate was 13.75 percent, which has now been increased by another 2.25 percent.

Due to this increase, the amount required to pay the interest will also increase, and about 4500 billion will be spent in this regard this year.

As mentioned in yesterday’s monetary policy statement and other monetary policy statements before, the main purpose of such high interest rate is to control inflation.

But the most surprising fact is that the State Bank whose policy causes all these are expenses, and the State Bank does not have any analytical report of these expenses so that the benefit of these expenses could be estimated.

Project Inflation Control costing more than double the defence budget, Pakistan’s most expensive and failed project, has never been audited.

— The writer is Director Kashmir Institute of Economics, Azad Kashmir University