Is Inflation in Pakistan Linked to Exchange Rate Depreciation? SBP Explains

The State Bank of Pakistan in its State of Pakistan’s Economy Report for H1-FY24 admitted that it doesn’t understand why the depreciation of the Pakistani Rupee (PKR) impacts inflation in the country.

‘The real effective exchange rate in Pakistan (R…

The State Bank of Pakistan in its State of Pakistan's Economy Report for H1-FY24 admitted that it doesn't understand why the depreciation of the Pakistani Rupee (PKR) impacts inflation in the country. 'The real effective exchange rate in Pakistan (REER) depreciates in response to increases in global oil prices, even when they are in the process of recovering from an immense fall in the preceding period. However, the impact of exchange rate depreciation itself on headline inflation is not particularly clear,' it said in the report. SBP mentioned a survey that suggests that exchange rate depreciation influences the price-setting behavior of firms, more than even the strength of domestic demand, rising financing costs, and weakening of labor productivity. The exchange rate played a significant role in explaining inflation, especially during the short to medium-term. However, most other prior studies show that the pass-through of exchange rate depreciation is either low or unconvincingly established, the regul ator explained. It said past surveys do not find any significant relationship between changes in the exchange rate and domestic prices. Another study finds no long-run relationship between the exchange rate and inflation during the period 1980-2009. SBP mentioned periods where the exchange rate pass-through was low on consumer price inflation even when it had a stronger impact on the wholesale price index (WPI), particularly its fuel and lighting and manufacturers' baskets. There was another period many years ago when SBP detected pass-through of exchange rate depreciation on domestic prices but the effect was not precisely determined and termed 'statistically insignificant' by the bank. SBP noted that the Consumer Price Index's response to exchange rate shocks was close to zero for up to 10 quarters during the period 1982-2001. These findings seem contrary to popular opinion as exchange rate depreciation influences prices through both direct and indirect channels, such as the price of both imported finis hed goods and raw materials for domestic production. The central bank said there were two plausible reasons why most earlier research on the impact of exchange rate depreciation on inflation found little to no impact: earlier studies have not conducted episode-wise analyses, which means the impact, if any, of one-time adjustment may have been diluted over long sample periods; and the data analyzed in these surveys are mostly before Pakistan transitioned to a flexible exchange rate in July 2000, and a market-based exchange rate in May 2019. SBP added that inflation in Pakistan has significantly been a monetary phenomenon, but failed to ascertain whether currency trends directly impact it or not. Source: Pro Pakistani