MPS Review: Monetary tightening is not too far?

May 31, 2021 (MLN): Unsurprisingly, the Monetary Policy Committee (MPC) of the SBP held its benchmark policy rate at 7% on Friday, to facilitate economic growth and recovery. The decision was in line with the global trends as Central Banks across the globe have also retained a similar stance.

Broadly, the reasons for keeping the policy rate unchanged were the same as in the previous MPS – growth, though impressive, remains uncertain; outlook for fiscal consolidation ahead; and core inflation remains stable amid few visible demand pressures.

However, the latest statement shows flexibility to potentially change the Policy Rate in the next meeting as the SBP has changed the wordings of its forward guidance which it has been providing for the past three policy statements.

In the previous statement, SBP clearly stated that it expects monetary policy setting “to remain broadly unchanged in the near term,” however, in the latest policy statement, SBP said that in the absence of unforeseen developments, the monetary policy is expected “to remain accommodative in the near term” and any adjustments in the policy rate to be measured and gradual to achieve mildly positive real interest rates over time. This change in the wordings indicates that monetary tightening is not too far away.

“We believe there is more flexibility in the latest statement by SBP to potentially change the Policy Rate in the next meeting as the Central Bank can remain accommodative even with a gradual and measured increase,” Syed Atif Zafar, Director Research and Chief Economist at Topline Securities said.

MPC remained cautious if the economy reaches its potential driven by certain demand-side pressures which can possibly emerge. Due to this it would be better to gradually reduce accommodation in the monetary policy, which will protect against any upside risk from inflationary pressure.

Highlighting key concerns on inflation, MPC noted that inflation for Apr’21 picked up due to an increase in electricity tariff and higher food prices (partially driven by the usual seasonality in the month of Ramzan).

It was also noted that the demand-side pressures on inflation remain well contained for now with some spare capacity still available. As per SBP, the headline inflation is likely to remain elevated in the coming months and monetary policy can’t do much to control this inflation as it will be mostly linked to a food supply shock, electricity tariff hike, and rise in global commodity prices. However, as supply shocks dissipate thereafter, inflation is expected to gradually fall toward the 5-7% target range over the medium term.

Nevertheless, SBP abstained from giving an estimate of inflation for FY22, as it waits on the federal budget announcement, Jun-end wage appraisal cycle, and also monitors the movements in commodity prices.

The latest National Income Accounts data confirmed that the economy has rebounded strongly from last year’s severe Covid-shock, led by services and industry. The manufacturing sector continues to expand strongly as recent readings of LSM have been very encouraging. However, the growth outlook still remains uncertain, because of the third wave of COVID-19, in addition, the slack in the output gap and the labor market has not been overcome. SBP estimated the output gap at -0.08% in FY21 and -0.06% in FY22. The negative output gap in FY22, despite growth, is largely due to an increase in the overall capacity because of higher investments.

On the external front, with a lower trade gap and improved dynamics around remittances (greater than $24.0bn over the last 10months), the current account balance remains well within the desired range as for the first time in 17 years it stood at a surplus of $0.8bn during 10MFY21. SBP expects to close the year with a current account surplus. Recently, the trade gap has started widening on the back of the import of capital goods, industrial materials, and more recently due to the import of food/commodities to counter domestic shortages. Exports have recovered to pre-pandemic levels while export of High-Value Added (HVA) textiles stand higher than its the pre-COVID-19 era. SBP has highlighted that the recent surge in imports of plant and machinery is a healthy indicator as this would lead to higher output in coming years.

On the fiscal side, the SBP pointed out that Pakistan’s fiscal balance has improved since the onset of Covid-19 – with a primary balance of 1% of GDP in FY21 so far – and the increase in debt to GDP since Covid-19 has been relatively modest compared with other regional countries. But the central bank expects a fiscal contraction in the upcoming Budget, calling for the monetary policy to remain accommodative.

In the light of the aforementioned facts, the market is not expecting any change in July’s MPC meeting as SBP considers the present accommodative monetary policy to be appropriate and it will aim for positive real rates only gradually. However, details of the upcoming Budget, the future path of Covid-19 in Pakistan, and global commodity price trends are key variables that could influence the next monetary policy decision in July 2021.

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