ECB response to inflation
Historically, the objectives of the central bank have been multiple, including price stability, GDP growth and full employment.
The objective of price stability and full employment often has a compromise; that is, if you try to complete one goal, progress to the other goal will become difficult and vice versa.
Therefore, the mandate of the Federal Reserve, the central bank of the United States, is often referred to as a dual mandate.
Unlike the Federal Reserve, the European Central Bank (ECB) has price stability as its sole primary objective.
Any other objective is considered secondary or tertiary objective of the central bank. Inflation in Europe is now at the highest level in three decades.
Raising interest rates is considered the standard remedy for reducing inflation. Christina Lagarde, who now heads the ECB, worked as the managing director of the IMF a few years ago and helped negotiate the IMF package for Pakistan.
One of the first demands of the IMF to provide a package to any country is to raise interest rates, and this was the case in Pakistan.
Therefore, a few months after the arrival of the PTI government, the interest rate in Pakistan rose 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 is the ECB doing to control it?
In particular, what are they doing with the interest rate, the standard remedy often prescribed to developing countries to get out of inflation?
The story is obvious that the interest rate in the European Union was zero before the start of the pandemic and remains zero after the current wave of inflation.
How can a central bank headed by the main proponent of high interest rate policy and whose sole objective is price stability, ignore the response to this rise in inflation?
This paradoxical behavior of the ECB and its president indicates one of two things; firstly, in the eyes of the ECB and its leader, raising interest rates is not capable of reducing inflation or secondly, the ECB is focusing on other central bank objectives without taking into account the constitutionally mandated primary objective of price stability.
In fact, there is a substantial element of truth in both of these possible reasons. In the history of monetary economics, especially in post-pandemic economic history, there is substantial evidence to infer that high interest rate policy fails to bring down inflation.
There are about 25 countries around the world that raised their interest rates in September 2021 or earlier, 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 check their data from the online sources, and the data indicates that till today, after spending more than 6 months pursuing a policy of high interest rates, no country in this list has succeeded in reducing inflation.
Over the past six months, many other countries have joined the club of high interest rate policymakers, including South Korea, the United Kingdom and the United States.
These countries have also raised their interest rates in hopes of controlling inflation and so far the success is not achieved by just one country.
There is a reason behind this evidence; the policy of high interest rates can control inflation from the demand side.
The current wave of inflation is clearly supply-side and no economic theory predicts a drop in supply-side inflation due to rising interest rates.
The second possible reason for the ECB’s response could be that the bank is focusing on other central bank objectives instead of price stability.
This is also very true, the ECB and its constituent central banks have provided huge expansionary packages in the form of loans to their respective governments during the pandemic.
Obviously, this action cannot be explained keeping in mind the central objective of price stability.
The ECB and its constituent central banks reacted to the sharp reduction in GDP and the drop in unemployment due to the pandemic and provided huge packages to get out of the crisis.
Prioritizing price and undermining other goals makes little sense. It is in fact a very welcome step that central banks have met the critical needs of their respective countries and saved their nations from probable catastrophe.
However, the question arises why these countries and institutions are reluctant to change their advice for developing economies like Pakistan?
Why does the IMF still insist on a high interest rate policy for Pakistan and why has the IMF supported recent Pakistani legislation that prohibits the government from borrowing from the central bank?
There must be someone to ask the IMF for this in the next negotiations. There is a difference between textbook economics and the practices of prosperous economies and to be a prosperous economy we must learn the economic practices of other nations and not from textbooks.
The policy of high interest rates has serious and undesirable implications for an economy.
In Pakistan, a 1% increase in the policy rate imposes an additional burden of Rs 300 billion on mark-up payments.
If the policy rate is brought back to the level of January 2018, it can save more than half of the amount currently paid in markup.
At a policy rate of 3%, business loans can be made possible at 5-6%, which will be a better employment support program without any government subsidy.
Therefore, it takes time to revise the recent legislations on the autonomy of SBPs and to reduce the rate of interest, in line with global best practices and practices of peer economies.
—The author is director, Kashmir Institute of Economics, Azad Jammu and Kashmir University.