Yaseen Anwar: Monetary policy framework in the SAARC region
Address by Mr Yaseen Anwar, Governor of the State Bank of Pakistan, at the
SAARCFINANCE seminar on "Monetary policy framework in the SAARC (South Asian
Association for Regional Cooperation) region", Islamabad, 14-16 June 2012.
* * *
Distinguished speakers, honored guests and fellow colleagues, allow me to welcome you, on
behalf of the State Bank of Pakistan, to Islamabad for the seminar on "Monetary Policy
Frameworks in the SAARC region".
The seminar, as you all know, has been organized under the auspices of the
SAARCFINANCE banner. The SAARCFINANCE initiative, now more than 14 years old, has
been instrumental in providing a platform that enables knowledge-sharing across the SAARC
region and allows for discussion and debate amongst the region's premier economic decision
makers.
Let's move on to the subject of the seminar now.
Central banks are often synonymous with monetary policy. And why shouldn't they be? After
all, monetary policy is any central bank's premier policy tool to achieve its objectives. Strictly
academically, the monetary policy framework consists of an institutional arrangement, which
provides an anchor to identify monetary policy objectives and describes how the policy is
implemented through a set of instruments and their intermediate and operating targets. Wow,
that was quite a mouthful! Let's make it simple. In essence, monetary policy has its means
(i.e. the framework) and its ends (i.e. macroeconomic objectives). When those two are
congruent, the monetary policy framework is considered well-defined.
Let's go backwards here and have a look at the ends first. The universal aim of monetary
policy is achieving price stability; a secondary aim of monetary policy may be growth. For
instance, the preamble to The State Bank Act states that the bank is supposed to "regulate
the monetary and credit system of Pakistan... with a view to securing monetary stability and
fuller utilization of the country's productive resources". Therefore, SBP is concerned with not
just inflation and price stability, but also with economic growth.
That was the easy part. The tough part is actually finding and calibrating the tools that are
required to achieve these ends.
Broadly speaking, central banks tend to target one or more of monetary aggregates, inflation
or exchange rates. All three of these have an impact on the real economy and have
implications for price stability. In the recent past, countries have moved towards inflation
targeting regimes. However, such a regime requires that the central bank's policies remain
independent of the fiscal authority, have market credibility and are time-consistent. Given
that conditions in developing countries may not allow for such freedoms, inflation targeting
may prove to be ineffective in such economies. Indeed, these are interesting times to be an
economist; and in such times, we must occasionally toss conventional prescriptions aside
and seek customized solutions. But for that it is necessary to fully understand our individual
economies.
The Greeks may not be going through the best of times right now, but it was a Greek
philosopher who first advised "know thyself". And, analogous to this, any competent
policymaker must know his or her own economy inside out. He must know what makes the
economy tick; how the linkages in the economy interact with each other; how signals and
information gets transmitted through these linkages; and what each of the knobs and dials on
his dashboard does to calibrate the economy. The process of self-discovery is as relevant for
the individual as it is for the economy. The process of improving the economy starts after the
process of understanding.
For instance, monetary policy may be transmitted through a variety of different channels.
Most commonly, the real interest channel is used to influence aggregate demand and
fine-tune the economy. But we must take a step back and ask ourselves: do the linkages
hold as strongly in the actual economy as they do in theory, especially given the high level of
inflation and the high frequency of price changes that most developing economies face?
Monetary policy may also be transmitted through the balance sheets of banks and firms.
Once again, we must know how bank lending and pricing behavior changes in response to
changes in the policy rate. Then, there's also the exchange rate channel and finally, the
expectations channel, which I shall discuss in a bit more detail later. But they key idea here is
that a thorough understanding of all these transmission channels is needed in order to
calibrate an effective monetary policy framework. Know thy economy!
Allow me to share my understanding regarding the workings of these channels in Pakistan.
As I pointed our earlier, the real interest channel is extremely weak in times of frequent
prices changes and high inflation. A recent survey carried out by the Research Department
revealed that prices are revised roughly every quarter in the economy. Coupled with the fact
that we have had, more or less, double-digit inflation for the past 4 years now, prices are very
quick to adjust. Therefore, the impact on aggregate demand through the real interest channel
is muted.
On the contrary, we have observed that the lending channel via the banks is quite robust. In
fact, the transmission of monetary shocks through the lending channel is asymmetrically
distributed; smaller banks, which have a higher cost of funds, tend to amplify monetary
shocks for smaller borrowers. In fact, the bank lending channel is the primary channel
through which monetary policy is transmitted to the real economy in Pakistan. On a related
side-note, it's important to mention that Pakistan has moved away from credit allocation
policies and now let's the market decide both the quantity and the price of credit to various
sectors.
The country has also liberalized its foreign exchange markets and lets the forces of demand
and supply dictate the rupee exchange rate. While this is an important step towards greater
global integration, it has meant that the exchange rate channel is particularly relevant now -
especially due to the implications that it has for inflation. Given the influence that full
exchange rate pass-through has, SBP monitors the foreign exchange market very closely.
Finally, monetary policy may also influence inflation through the expectations channel. I can
think of no better example to illustrate the mechanism of the expectations channel than Paul
Volcker's time at the helm of the Fed. Having credibly committed to tackling inflation, Volcker
raised rates drastically and managed to weed out the inflationary expectations that had taken
root in the American economy after the oil shocks of the 70s. In my opinion, the two decades
of low inflation that the American economy enjoyed following Volcker can at least be partially
attributed to the suppression of inflation expectations. In fact, I also believe that a large part
of the persistence of inflation in Pakistan's economy is due to the sustained period of high
inflation, which has allowed inflationary expectations to incubate.
The transition from understanding these channels to developing the proper mechanisms to
impact our objectives may not be smooth. After all, we should concede that there are some
things that we have absolutely no control over in the short-run. Similarly, a certain policy
measure may also produce conflicting outcomes, such as a reduction in inflation but a rise in
current and fiscal accounts; how should we proceed then? We need to stay abreast of a very
steep learning curve and constantly keep checking if the relationships that we have
assumed, while developing our models, still hold. The economy is a living, evolving
organism. Relationships between variables break down ever so often. This only adds to the
excitement of being a policymaker, ladies and gentlemen!
The complexity and the uniqueness of our economy only emphasize the need to develop a
thorough grass-roots understanding of the economy, and a customized toolbox to deal with
the multiples challenges along the way. Far too often have we relied on conventional
prescriptions without fully understanding the symptoms. I challenge you all to question the
assumptions that you have based your frameworks on; let's take nothing as a given and let's
make our policy directives as unique as the economies they target.
I'm in a room full of central bankers here and it is probably unnecessary to say this, but, at
the end of the day and despite our best efforts, even seemingly seamless plans may fail and
our policy instruments may let us down. Yes, it is tough to map out the behavior of an
informal sector that is probably the size of the formal economy; yes, it is difficult to impose
fiscal discipline; yes, it is almost impossible to control the international prices of fuels and
grains; and yes, our textbooks seem to be clueless when it comes to tackling today's
economic problems. But this only underscores the need - no, the necessity - to fully
understand the nature of our economies. Know thy economy, ladies and gentlemen!
And now I invite you all to share your ideas and experiences with the rest of us. Tell us about
the nature of your economies; tell us about your toolkits; and tell us how they have fared with
time. I can tell you that we, at the State Bank, have come a long way from the days of
rationalized credit and strict controls on exchange rate. We have moved towards a better
understanding of our economy and we've made some significant progress towards
discovering the impact that our monetary policy has on the real economy. I hope that you will
get a chance to share your thoughts with us and lead our minds to previously unexplored
territories.
The SAARCFINANCE seminar series was meant to facilitate the transfer of ideas and
experiences. Today, I am excited about what we may learn from each other over the next
few days.
On that note, ladies and gentlemen, let us share our insights regarding monetary policy
frameworks; and let's get to know our economies.
Thank you for your time and I wish you all an amazing stay in Islamabad!