A double dose of monetary tightening
A double dose of monetary tightening

Ignoring calls from the private sector business lobbies for keeping the interest rate intact, the State Bank of Pakistan (SBP) has raised its key policy rate by 100 basis points to 9.75per cent.

The Federation of Pakistan Chambers of Commerce & Industry (FPCCI) had asked the central bank before its Dec 14 monetary policy committee meeting to hold the interest rate. The apex representative body of Pakistan’s private sector feared that any further monetary tightening after the 150bps rate hike announced on Nov 19 would cause “stagflation”. The FPCCI chief, through a press statement, had also questioned the efficacy of monetary policy in controlling inflation arguing that only 7pc of commercial entities in Pakistan actually borrow from banks.

The SBP says that “together with the natural moderating influence of the flexible and market-oriented exchange rate” the interest rate tightening would help achieve the goal of a sustainable current account deficit this fiscal year.” This statement explains one part of the rationale for a double-dose of monetary tightening. What explains the other part is that the central bank expects inflation to average 9-11pc this fiscal year.

A higher interest rate plays a role in containing imports by making bank finance for importers costlier — but it also makes banking funds pricier for all businesses and exporters

The recent 100bps increase in policy rate immediately after the 150bps rate hike announced on Nov 19 is obviously meant to keep inflationary pressure bursting through this range. A massive rise in year-on-year consumer inflation to 11.5pc in November from 9.2pc in October had left no room for the central bank to avoid a double dose of monetary tightening.

But this surge in inflation did not come as a surprise. Inflationary pressures had been building up for months due to rising electricity, gas and fuel prices as well as due to local and imported food inflation.

The SBP’s September 20 decision to increase its policy rate by just 25 basis points to 7.5pc was a weaker signal to markets about the central bank’s intention of fighting inflation with full force.

A larger increase in policy rate back in September could have sent a stronger signal to markets keeping those inflationary expectations under check which later on peaked and produced additional inflationary pressures.

The 150bps rate-hike announced on November 19 had, thus, become quite necessary because by that time the central bank’s core inflation data sets had also established the tenacity of the inflationary pressures. And now another dose of 100bps policy rate rise also seems appropriate because monetary tightening of a lesser degree could not have sent the right signal to the markets about the seriousness of the SBP to fight inflation.

The SBP strategy is a natural response to higher than expected inflation (11.5pc in Nov and 9.3pc in five months of this fiscal year against the SBP’s initial estimate of a maximum of 9pc). But as it decelerates the pickup in domestic demand the economy has seen so far, the SBP’s statement that it “would also help achieve the goal of a sustainable current account deficit this fiscal year,” warrants some explanation.

The current account deficit in July-Nov FY22 soared past $5 billion equaling 4.7pc of GDP against a surplus of $1.3bn equaling 1.4pc of GDP in FY21. The assumption that a dramatic rise in interest rate would bring the deficit to a sustainable level is based on the premise that a higher interest rate would depress the buildup in domestic demand thereby reducing imports that witnessed a meteoric rise in July-Nov FY22. Imports bill of merchandise goods, according to SBP’s balance of payments statement, skyrocketed past $23.48bn in July-Nov FY22 from about $14.12bn.

This pace of increase in imports would surely decelerate in coming months for a host of reasons including a fall in import prices of fuel oils, anticipated slower increase in prices of edible oils that have already peaked and the massive rupee depreciation so far this fiscal year that has sent prices of imported stuff beyond the reach of many consumers. The government’s move to contain imports via tariff and non-tariff barriers being erected around non-essential items may also help.

A higher interest rate, too, would play a role in containing imports by making bank finance for importers costlier — but it would also make banking funds pricier for all businesses and exporters. This means the momentum in merchandise exports, thanks partly to the post-Covid concessional bank financing and specific fiscal incentives would also be hit. Essentially, then, a 250bps monetary tightening in less than a month (between Nov 19 and Dec 14) would have a somewhat neutral effect on the trade deficit.

And that, by extension, means it would be of little help in addressing the issue of the current deficit within this fiscal year. In the next fiscal year, too, if the current deficit falls to an extent that our policymakers may view as ‘sustainable’ that would be due to the decline in aggregate demand and slower GDP growth thanks partly to the double dose of monetary tightening.

That is why the PTI government — confronting make-or-break challenges for longevity in power, has accepted the current monetary tightening but does not own it wholeheartedly. And, that is why the private sector businesses continue to decry the move.

But then, economics is all about making trade-offs. Ultra-loose monetary policy that remained in vogue till Sept 20 this year had rendered real interest rates negative. Ultra tight monetary policy should make real interest rates positive, promote savings and may lead to a much-needed buildup in domestic investment in the medium to long term.

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