Is Policy Rate an Appropriate Monetary Tool? A Time-Frequency Causal Investigation

Abstract

This study is the earliest endeavor to comprehend the time-frequency causal relationship between inflation and interest rate about two beneficiaries of the International Monetary Fund (IMF); Pakistan and Egypt. Traditional investigations observationally explored the association between these significant macroeconomic variables just for the short run and long run. It is important to study the relationship in different time & frequency scales to have a refined image of a time when these variables correlate. This study employs Wavelet transforms to establish a reliable relationship between the policy rate and inflation that would be valuable for the Central Bank (CB) to design effective monetary policy. For this research, monthly data on inflation and CB policy rate from July 1992 to December 2021 has been used for the selected countries. Initially, we decomposed the time series of inflation and policy rate into time and frequency scales. Then, multi-scale Granger causality analysis is used to examine the co-movements, nature, and direction of causality between inflation and policy rate for Pakistan and Egypt. On balance, in both developing countries, results show the validity of the causal relationship between the policy rate and inflation but with a positive significant correlation. Thus, the policy rate is an ineffective tool to tame inflation. i