In times of rising inflation, the central banks around the world use a common tool to curb inflation by increasing the interest rates. The logic behind increasing the interest rates is simple: to make borrowing more expensive and reduce the demand, since reducing demand leads to a reduction in prices, thus lowering inflation. The primary mechanism of increasing the interest rates is usually to control the demand in the economy.

In the case of Pakistan, the government has formally assured the IMF that it will uphold a tight monetary policy stance by increasing the interest rates (if necessary) to address rising inflation pressure due to the current war in the Middle East.

The issue at hand

Given the above situation, applying this approach to Pakistan of “increasing interest rates to control inflation” without considering the underlying drivers of inflation, risks not only ineffectiveness but also potential harm to Pakistan’s economy, which merely fixes a specific economic indicator rather than looking at the on-ground situation.

The fundamental issue is that Pakistan’s inflation is largely cost-push rather than demand-pull. This means that inflation is not because of excessive demand, but inflation is because of limited supply, increasing the prices. Pakistan’s significant import dependence for its energy needs contributes to a constrained supply environment. In this context, increasing the interest rate will address the wrong side of the equation, because this policy is suppressing an already suppressed demand instead of maintaining the shortage of supply.

Raising interest rates discourages borrowing, reduces consumer spending, and slows investment. This policy might be effective in economies facing issues of excessive demand, but it offers limited relief for supply shortages. Instead, higher interest rates can elevate the problem. Businesses facing increasing borrowing costs often reduce production. Small and medium enterprises may reduce output or exit the market altogether, which, as a result, can further reduce the supply, intensifying the very pressures causing inflation in the first place. Since higher interest rates make savings attractive, people will tend to hold and keep their money in banks, reducing the circulation of money in the economy.

The Second-Round Effect

The justification policymakers give is that even though increasing the interest rates won’t have an impact on supply shortages, it will instead have an impact on the aftershocks. This means that the policy of increasing interest rates might not curb inflation at the moment, but will curb inflation in the near future. The State Bank of Pakistan (SBP) calls this the “Second-Round Effect.”

This indicates that with the given increase in general prices, the people will demand an increase in their wages, and an increase in wages will lead to an increase in purchasing power, and an increase in purchasing power will lead to an increase in demand, which ultimately increases the prices, thus creating a second round of demand-driven inflation along with supply shortage inflation.

To avoid this second round of demand-driven inflation, interest rates are increased to keep this demand in control, giving space to fix the supply shortage.

But contrary to this strategy, the real wages of workers in Pakistan have decreased by almost 20% over the last three years, along with high unemployment, due to rising supply-side inflation along with increasing interest rates. Demand is already constrained in Pakistan due to low income, rising unemployment, high living costs, and limited wage bargaining power since the wages are not quickly adjusted to the rapid rising inflation, all this weakens the second-round effect strategy itself.

The International Institutions

Another dimension to examine is the global dimension of these policy prescriptions. International institutions like the IMF advocate for specific economic indicators in the name of stabilization programs. However, these frameworks are mostly designed for a “one size fits all” mindset, regardless of the actual economic reality, which varies from country to country. It can be possible that the IMF already considers its prescriptions won’t necessarily work, but still applies them since their decisions often reflects the interests and priorities of major shareholder countries like the U.S., being a political tool for them.

With Pakistan acting as a mediator for a truce between the U.S. and Iran, it can possibly be observed and have questions raised whether the IMF’s tightening economic policy prescriptions for Pakistan, such as reducing subsidies, devaluing currency, and increasing interest rates, might indirectly strengthen the U.S. leverage over Pakistan’s foreign policy approach to Iran. This tightening of economic conditions by the IMF can also possibly translate to Pakistan being forced to pressure Iran for opening the Strait of Hormuz impacting the fuel prices, so that Pakistan can ease its own economic condition of inflation and supply shortage, indirectly aligned with the U.S.’s interest.

The Way Forward

The way forward, therefore, cannot lie in recycling the same externally prescribed policies that have repeatedly failed to address Pakistan’s issues or, at large, the issues of the Muslim world. What Pakistan faces today is not merely an inflation problem but a question of total revival for political, social, and economic sovereignty altogether. Breaking free from this cycle requires a fundamental transformation of the state’s current economic philosophy to its initial philosophy on which the idea of Pakistan was built.

It must be willing to adopt bold and unconventional measures to break out of this cycle, such as rethinking ownership of essential resources, which are a common need of the public. This includes resources such as oil, gas, electricity, water, gold mines, and other essential resources that the public depends on. They are required to be treated as public ownership rather than being left at the mercy of private corporations and state ownership, safeguarded from unchecked practices that may exploit these resources.

These essential resources are to be under the ownership of the public, while the state supervises these resources as the representative of the people, making sure these essentials have a transparent and accountable public framework. This can shield citizens from artificial price hikes, reduce vulnerability, and dismantle profiting from scarcity, making them available at much cheaper prices.

While this is done, the dominance of the dollar-based financial system needs to be challenged, as it is currently being questioned. Since Richard Nixon ended the dollar’s convertibility to gold in 1971, the world, particularly resource-dependent regions, are now forced to operate within a fiat system, which makes it harder to survive. It can be questioned that why should Pakistan, or the broader Muslim world, be forced to purchase its own essential energy resources with a currency it does not control?

A return toward a gold-backed system, rooted in real value to which everyone mutually agrees, offers not just monetary stability but a pathway to reclaim economic sovereignty from a current fundamentally imbalanced system. It keeps prices stable by constraining the money supply with its backing of physical assets, thereby anchoring inflation despite global shocks. These are just some of the many genuine changes, which have now become a strategic necessity rather than an option.