July 13, 2022 (MLN): It was certain that the Monetary Policy Committee (MPC) of the State Bank of Pakistan would raise the policy rate but by how much magnitude was the real question. The MPC on Friday, pitched for a high number of 125 basis points (bps) to 15%, last seen post the 2008 global financial crisis, due to multi-year high inflation readings, which are expected to remain elevated for the fiscal year 2023.
Under the rapid changeable conditions in global markets, MPC seemed to be more cautious to make definite commitments about future interest rates based on the evolution of inflation expectations and global commodity prices, as well as fiscal and external fronts. Looking at the risks that exist on these fronts, SBP said that going forward, MPC will remain data-dependent.
However, the central bank did not rule out timely and credible policy measures in the future to moderate domestic demand, preventing the compounding of inflationary pressures and reducing risks to external stability.
To combat multi-decade high inflation in most countries amid a surge in demand and supply bottleneck issues, worsened by Russia’s invasion of Ukraine, central banks have been responding aggressively by increasing interest rates.
This hike in policy rate could reduce the purchasing power of businesses and consumers as borrowing money from commercial banks for a house or a car becomes expensive which they pass on a portion of higher rates to their customers. Thus, it lowers the demand for goods and causes prices to fall.
On the other side, emerging market currencies have been facing depreciation pressure due to monetary tightening in advanced economies. The volatility in EM’s exchange rates leads to further inflation with higher repayment burdens for US dollar-denominated debt.
Like most of the world, the inflation perspectives look quite menacing in the case of Pakistan as well. The country has been facing a large negative income shock from high inflation as energy subsidies were reversed taking headline inflation to rise to a 14-year high in June 2022.
“Without decisive macroeconomic adjustments, there is a significant risk of substantially worse outcomes that would compromise price stability, financial stability, and growth,” MPC said.
Although global commodity prices have begun to ease, it is too early to say whether the fall will help control Pakistan's rising import bill which needs continuous monitoring. The central bank expects CPI to be at higher price levels between 18-20% on average in FY23 before falling sharply to the 5-7% target range by the end of FY24, driven by tight policies, the normalization of global commodity prices, and beneficial base effects.
This outlook is subject to significant uncertainty, and risks associated with the path of global commodity prices, fiscal stance and exchange rate.
“Despite the massive 800bp adjustment in rates since September 2021, the uncertainty however continues to be driven by pressure on the rupee and need to accumulate reserves, leaving opinions divided on the path of interest rates amongst market participants,” said Amreen Soorani, Head of Research at JS Global.
Looking ahead, economic growth is expected to moderate to 3-4% in FY23, on the back of monetary tightening and fiscal consolidation, helping to close the positive output gap and diminish demand-side pressures on inflation. This will pave the way for higher growth on a more sustainable basis.
With such measures, the current account deficit is projected to narrow to around 3% of GDP as imports moderate with cooling growth, while exports and remittances remain relatively resilient.
The expected completion of the ongoing IMF review remains critical for an alarmingly low level of SBP’s foreign exchange reserves. This bailout loan program will also catalyze important additional funding from external sources that will ensure that tail risks associated with meeting Pakistan’s external financing needs are averted, releasing pressure on the rupee.
Apart from the monetary action taken by the SBP to stabilize the rupee against the greenback, the MPC is of the view that fiscal surplus on the back of improved tax collection, reduced energy imports as domestic demand tapers off and support from both exports & remittances flow to strengthen the domestic currency going forward, Abdul Rehman Siddiqui, Deputy Head of Research at BMA Capital noted.
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