An Analysis of Inflation Targeting in Pakistan

Abstract

This research is aimed at analyzing inflation targeting with regard to inflation expectations for the case of Pakistan. The first part of the study is centered upon empirical estimation of the monetary policy reaction function of the State Bank of Pakistan over a period ranging from 2012M01 to 2020M05. For this purpose, inflation expectations of economic agents were incorporated into the Taylor-type rule to develop a forward-looking model. The model was estimated using the Generalized Method of Moments (GMM). The results obtained suggest that the SBP significantly responded to changes in household inflation expectations over the period considered. The estimated coefficient of inflation expectations is relatively large as compared to the coefficient of output gap suggesting more than proportional reaction of monetary policy to inflation. The second part of this research is aimed at understanding the role of inflation expectations in shaping domestic inflation. In order to do this, we studied how inflation expectations of economic agents respond to fluctuations in prices of certain variables. The variables considered in this study are international and domestic oil prices, international and domestic food prices, house rent and exchange rate. The inflation resulting from a price shock is divided into two components namely first round and second round effects. A rise in actual inflation following a price shock is known as the first-round effect whereas the second-round effect refers to inflation arising from a rise in inflation expectations in response to a price shock (Barsky et al. (2001)) A Structural Vector Autoregressive (SVAR) model was employed to estimate the relationship between variable prices, actual inflation and inflation expectations. The estimated Impulse Response Functions generated via SVAR were used to study the first-round effects. The findings suggested that there were significant first round effects following a price shock in case of each variable being studied. Another important finding was that inflation expectations were sensitive to price shocks in all the considered variables. To establish the presence of second-round effects, a counterfactual analysis was conducted. This was done to understand whether a rise in inflation expectations in response to a price shock translated into higher actual inflation or not. The results revealed that second-round effects were modest in case of international and domestic oil price and food price shocks and were weak/negligible in case of the rest of the variables. The overall results suggest that while the inflation expectations are sensitive to price shocks, they only play a minimal role in propagation of the real price shocks into inflation.