November 30, 2018 (MLN):  Most of the economic analysts expect the State Bank of Pakistan (SBP) to raise the benchmark policy rate by 100 basis points to 9.5% in the upcoming Monetary Policy Statement for subsequent two months.

These expectations are primarily driven by numerous factors on macroeconomic front, which include persistent rise in headline and core inflation, widening twin deficit, depleting foreign reserves and rupee depreciation against dollar. These macroeconomic imbalances necessitate further policy adjustments.

Monetary policy over the long run determines the behavior of the price level. While inflation is precipitated by supply shocks, hoarding, official restrictions, import prices, and so on, these influence price level in a given year. However, it is the monetary policies that can prevent an effect on the rate of inflation over a more extended period.

Trends in key macroeconomic variables indicate that SBP monetary policy stance has proven to be successful in striking the required balance between curbing the demand side inflationary pressures and supporting the growth momentum. Unexpectedly low (high) core inflation usually indicates the need for easing (tightening) in the policy stance.

Source: MG Link

Past trend of Macroeconomic Indicators and Policy Stance

A closer look at the figures above depict that, during the period May 2015 to May 2016, SBP decided to keep policy rate low as declining trend of inflation, stability in exchange rate, significant rise in foreign exchange reserves, created room for SBP to decrease the policy rate to a historically low level of 5.75 percent.

During the period January 2018 to October 2018, SBP decided to tighten monetary policy by keeping interest rate high on account of increasing trend of core inflation, depleting foreign reserves and other macroeconomic imbalances.

Inflation to rise further along with other Macroeconomic Imbalances

CPI in the month of Oct 2018 rose by 6.78% YoY and is expected to rise further in the month of Nov 2018. Despite the fact that oil prices are declining, most of the commodities like food, housing & utilities and transport group in the CPI basket reflect an increase.

Moreover, widening current account deficit will continue to put pressure on foreign exchange reserves in the coming months.

Furthermore, delay in IMF talks and pressure on economy due to current account deficit and the lowest level of foreign exchange reserves will result in further devaluation of rupee against dollar.

Policy rate hike to exceed market expectation

Given that the rupee has suffered a sharp decline at interbank market today, one can’t help but associate the reason for depreciation, with the IMF conditions that have been doing the rounds, lately.

Further devaluation of Rupee was one of the three main conditions that the Fund presented to Pakistan, in order to qualify for a bailout. It can be the case that the government plans to weaken the currency in several segments over time.  

Provided that this is true, the rise in policy rate might exceed the market’s expectation of 100 basis points, thereby drawing close to another condition put forth by IMF, that is, to increase the interest rates to two-digits.

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