In August 2009, the State Bank of Pakistan (SBP) officially changed its monetary policy framework from monetary aggregate targeting to interest rate-based monetary policy framework called the inflation targeting-lite regime by introducing the interest rate corridor (IRC).

Within international systems, the adoption of IRC would be a transitional move for implementing a flexible or full-fledged inflation targeting monetary policy framework, where the policy rate is used as a primary tool for anchoring inflation expectations (Stone, 2003). Indeed, most of the inflation targeting central banks place corridor systems not only to stabilise overnight rates but to anchor these rates around a policy rate to strengthen monetary policy transmission and policy signalling. This has been quite contrary to the case of Pakistan, where a significant domestic literature and official SBP communication, such as working papers, research bulletin, and policy notes emphasise that the IRC was introduced as a means of reducing volatility in the weighted average overnight repo rate (repo), which has weakened policy signalling and disrupted money markets (Mahmood, 2016).

Moreover, the SBP’s working papers and policy notes also document how liquidity shocks, often driven by government cash flows and FX operations, caused overnight rates to deviate from the policymakers’ desired levels prior to 2009. The objective of reducing volatility in the repo, being operationally valid, goes against the global justification of inflation targeting-lite regime, that is, reduction in volatility is not an objective but a by-product of a smooth and coherent monetary system. Thus, the IRC was implemented into an economy where the macroeconomic conditions for interest rate-led inflation control were partially established.

It would not be the design of corridor which is challenging but the surroundings where it functions. The inflationary trends in Pakistan are heavily influenced by administered prices, especially energy, college tuition, and regulated food items, which can get adjusted through fiscal adjustments but not market forces. These non-continuous changes, which are frequently large and discrete, can undermine the relationship between policy rate and headline inflation. Consequently, the tight monetary policy coincides with increasing inflation due to supply shocks, which undermine interest rate signalling.

Pakistan is simultaneously experiencing the limitations of the monetary policy trilemma. External imbalances and exchange rate pressures are persistent, which often leads to the balance of payments conditioning of monetary policy decisions. Practically, this leads to the phases where interest rate is as influenced by external stability as it is influenced by domestic inflation and output growth. As a result, liquidity shocks are generated by FX interventions that the IRC must absorb to stabilise the money markets. This strengthens the IRC’s role as the stabiliser of money markets and not as an anchor of expectations.

Such limitations highlight why the inflation targeting regime, be it strict or flexible, has eluded it even though this has been expressed in terms of policy aspiration in the SBP’s Vision 2016-2020. Demand-driven inflation, flexible exchange rate, and limited fiscal dominance are the key elements required to stipulate inflation targeting. However, these conditions are fulfilled partially in Pakistan, which results in a system where the objective of inflation targeting exists but with a weak functional core.

Notably, this does not mean that Pakistan should drop the interest rate corridor or adopt monetary aggregates targeting. Neither does it imply that the targeting of inflation should be mechanically adopted and that structural reality be violated. The important step is to implement a transparent and flexible structure, which highlights and acknowledges Pakistan’s constraints and not obscure them.

This type of structural framework whose primary medium-term objective should be price stability, and policy is carried out with clear secondary constraints, the most important of which is external stability and administered price shocks. Rather than a point target, a medium-term inflation rate is announced by the central bank with special concentration on forecasts made publicly available. This will ensure transparency of the framework and add to the credibility stock of the central bank. Deviations that are temporary are acceptable, if they are well explained. This framework would ensure that instead of hidden goals, exchange rate pressures, reserve adequacy, and risk premium are treated as the conditioning variables. The decisions on policy rates have been explained as weighing between inflation stabilisation and external sustainability as a reminder of discretion with accountability. Credibility is anchored on transparency.

In this context, the policy rate role is re-defined. It is no longer supposed to tighten or loosen demand or to counteract the inflation produced by supply mechanisms. Rather, it pegs expectations over the medium term, constrains second-round effects and conveys commitment when the economy is under strain. The interest rate corridor appropriately works as a liquidity management tool, which ensures that there is smooth market functioning with operational control, without the strains associated with the responsibility of macroeconomic credibility, on its own.

In the long run, this structure enables sequencing as opposed to being subject to shock therapy. Reforms in administered pricing, improvement in exchange rate flexibility and reduction in fiscal dominance may relax the constraints on monetary policy over time. Flexible inflation targeting then develops naturally, as a matter of adaptation and not imitation. The introduction of the IRC to Pakistan provides more of a general lesson, that is, the sophistication of operations cannot replace the clarity of strategy.

By taking its monetary framework and its structural realities to be in accord with each other, and by ensuring the trade-offs are clear, the SBP can get closer to inflation targeting, not as an imported model, but rather as a nationally consistent policy regime.

Dr Ateeb Syed is a visiting professor of economics at Grand Valley State University, Allendale, Michigan and Tayyaba Kamran is a research assistant at the Economic Growth and Forecasting Lab, IBA