Monetary policy: two sides of the same coin | The Express Tribune


The State Bank of Pakistan (SBP) is due to announce its interest rate stance on August 22, 2022.

Recent surveys indicate that most market participants expect a status quo decision to keep the policy rate at 15%. This is accompanied by a view that interest rates have peaked and will eventually start to decline towards the end of the current fiscal year.

The SBP’s decision will depend on which data points it chooses to focus on. In the last Monetary Policy Statement (MPS), the SBP stated it would monitor the fiscal/ external deficits, monthly changes in inflation and global commodities as these would drive expectations of future prices. It had noted that the real sector was exhibiting resilience (sales for cement, autos and petroleum were up), and LSM growth was strong.

The external sector remained challenging with a higher current account deficit, led by energy imports, though the completion of the IMF review would lead to a build-up of FX reserves and currency stability.

Meanwhile, the fiscal policy had become unexpectedly expansionary (subsidies on petrol/ electricity) with the primary deficit up 2x over last year. Private sector credit continued to grow with demand for fixed investment and consumer loans up.

Inflationary pressures had become broad-based and were likely to remain elevated at an average of 18-20% due to supply shocks. As a result, the MPC decided to increase the policy rate by another 1.25%.

The case for stability

If the SBP wishes to put forth a narrative that further monetary tightening is not required, then it is likely to highlight the following developments:

Sharp decline in high frequency economic indicators. Sales for cement, cars and petroleum products have dropped by 45%, 52% and 26% respectively over last year. Similarly, the monthly import bill saw a 13% decline to $4.9 billion in July.

This indicates that demand destruction has occurred at a rapid pace which would translate into slower growth and eventually a decline in inflation.

While the Wholesale Price Index (WPI) rose substantially year-on-year, on a month-on-month basis it was flat which indicates that supply-side pressures may be easing. Similarly, real interest rates on a core inflation basis still remain positive.

The government has eliminated subsidies on electricity and petrol which would lead to lower consumption and consolidate the precarious fiscal position. New taxes have been imposed in the budget which target a primary surplus.

With a more restrictive/ supportive fiscal policy, there is little need to tighten financial conditions further.

Crude oil prices are down 5% since the last rate hike and with fears of a global recession taking hold, the outlook for commodities is more favourable for a net importer such as Pakistan. This should ease pressure on the trade deficit.

The IMF review is near completion with board approval expected on August 29. This should unlock other multilateral/ bilateral flows, arrest the decline in FX reserves and stabilise the currency.

In fact since the peak of 240, the PKR has recovered 10%+ against the USD as fears of a default recede. Eurobond yields and the credit default spread for Pakistan are reflecting this improved sentiment as they have declined sharply in the last few weeks.

And finally market yields for treasury bills are more in sync with the policy rate than they have been for the past year. Longer term bonds are in fact trading significantly lower than 15%, indicating expectations of a slowdown in growth and inflation ahead. So the SBP can rest easy knowing the market has not run ahead of them.

Why tighten further?

On the flip side, if the SBP wants to justify an increase in interest rates, it can focus on:

Inflation in July came in higher than expected at 24.9% (4.4% month-on-month), core inflation continues to rise while the WPI has witnessed a surge of 38.5% over last year. SPI is up 7.7% since the last MPS and 42.3% year-on-year. With CPI yet to peak and upside risks to inflation intact, real interest rates of -10% are unsustainable.

Decline in sales for various sectors and imports is exaggerated due to one-offs including heavy rains, Eid holidays and temporary administrative measures. Given the presence of a large cash economy, the demand for hard commodities will sustain and needs to be curtailed.

Fiscal consolidation will require further increases in electricity and gas tariffs while the government has committed to Rs50/litre PDL on petrol and diesel. These supply shocks run the risk of further entrenching inflationary expectations which can only be moderated through higher rates.

With a record Rs5.5 trillion fiscal deficit in FY22 and the short-term nature of public borrowing, the SBP will have to remain hawkish.

Broader commodities have rebounded on average by 10% since early July (as indicated by the Bloomberg Commodity Index) and geopolitical uncertainties have intensified, which increase the risk of tail-end events that could derail the nascent recovery in macroeconomic stability.

FX reserves have dropped by 19.6% in the current fiscal year and provide barely one month of import cover. The government is required to build reserves up to 2.2 months of import cover, finance a current account deficit equal to 3% of GDP and ensure debt repayments/ rollover of $21 billion.

With the US Federal Reserve expected to increase interest rates and the dollar appreciating (DXY index is up 15% over the last 12 months), the SBP needs to slow down domestic dollarisation by offering savers more attractive deposit rates.

Policy credibility

The same economic data is subject to vastly different interpretations depending on who is looking at it. However, it is clear that the two logical policy choices are either no change or a hike of 1%+.

The monetary policy committee has sufficient ammunition to justify either decision. A small increase does not make sense given that interest rates are already at very high levels and the gap with inflation is significant.

Which way the SBP tilts will depend on the political ramifications, recent bias and feedback from international creditors.

The writer is an economist and portfolio manager working in Pakistan’s capital markets for the past decade


Published in The Express Tribune, August 22nd, 2022.

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