(Thread: 1/n) Here is a somewhat technical thread on inflation, exchange rate and @StateBank_Pak 's decision to cut the interest rate by another 150bps
(2/n) In the long-run, the change in exchange rate depends on inflation differential between relevant countries. If inflation increases at home, exchange rate 'will' have to depreciate by as much to restore competitiveness.
(3/n) This means that the only sustainable way to keep exchange rate stable is to keep inflation stable. This now takes us to monetary policy. By committing to bring inflation down, a central bank is also indicating that exchange rate will not need to depreciate by as much.
(4/n) If the commitment is credible, investors r less likely to run away frm local currency assets thus keeping exchange rate stable. This is also one of reasons y investors r happy to invest in adv. economies which offer much lower interest rates but also hav much lower infl.
(5/n) Now Pakistan... Until now, SBP had maintained a policy outlook which was consistent with inflation outlook. SBP had also assured that they will cut the interest rate only when inflation outlook will improve.
(6/n) Two weeks before, the market expected inflation to start decreasing in coming months. In line with inflation outlook, the SBP decreased the interest rate by 75bps. Not surprisingly, exchange rate remained stable after the policy announcement on the 17th March.
(7/n) Why? Because inflation outlook had improved and, therefore, rupee was expected to depreciate by less going in the future. In other words, with improvement in inflation outlook, rupee remained attractive enough even after the drop in interest rate of 75bps.
(8/n) Then came the surprise decision where the SBP cut the interest rate by another 150bps - much more than suggested by inflation outlook. We can now see the implication. As soon as SBP became less concerned about inflation outlook, exchange rate started depreciating.
(9/n) Some think that the SBP was setting interest rate to keep exchange rate stable. I dont think so. In my view, SBP was setting interest rate to improve inflation outlook which, as a result, was also keeping exchange rate stable.
(10/n) You can still argue that perhaps SBP has done the right thing by cutting the rates by so much. This will lower refinancing costs and will improve liquidity conditions of businesses connected to the banking sector. But one must also appreciate the cost of doing so:
(11/n) 1. Now, with interest rate no longer consistent with inflation outlook, economy has once again been exposed to external vulnerabilities. As investors (both local & foreigner) sell local currency assets for foreign currency assets, pressures on exchange rate will intensity.
(12/n) 2. Govt will also have to seek other sources of funding both to finance their budgetary expenditures but also to build foreign currency reserves and finance current account deficits going in the future.
(13/n) 3. Together with the massive fiscal package govt has announced, a less cautious monetary policy will see a resurgence in infl pressures ... which will go on to adversely affect a much bigger section of society than those who r able to benefit from rate cuts.
(14/n) Finally, I do want to note that the SBP has tried to justify the rate cut based on improvement in inflation outlook. SBP has stated in the policy statement that they expect inflation to fall a lot more than what they expected before.
(15/n) I think SBP is being too optimistic here. Currency markets also seem to disagree with SBP's assessment. Yes, we all expected inflation to fall. But a lockdown can also intensify inflationary pressures by restricting supplies & encouraging hoarding.
voxeu.org/article/supply…
voxeu.org/article/supply…
(16/n) In my view, SBP should have waited for latest data on inflation before making such a decision. In the meantime, they should have created a funding facility aimed at providing liquidity to formal/informal businesses which are facing cash flow squeeze during these times.
(n/n) A fiscal stimulus, together with cautionary monetary policy focused more on emergency liquidity provision, would have been a more effective policy response to the economic crisis as a result of the lockdown.
p.s. and this 👇
