Shifting sands of monetary decisions

Quite unsurprisingly, SBP kept the discount rate unchanged at 9.5 percent, in the monetary policy announced on Friday. Although, the CPI for the nine months of the ongoing fiscal year is quite mild that could comfortably yield a positive real return even after a rate cut. But the SBP wisely didn’t count on the inflation numbers alone, amid hideous Balance of payment position.
The current Monetary Policy Statement (MPS) gives an obvious feeler that those sitting in the board of the apex regulator are mindful of the fact that inflation numbers can swindle them any-time; and that, other economic variables such as exchange rates and Forex reserves must be brought forward as the barometers of monetary decisions.
Justifying the above argument, government borrowings have been unsustainable over the years. Candidly speaking, untargeted subsidies remain the real culprit of the unabated fiscal borrowings. If the government phases out subsidies too soon, prices will shoot up, triggering cost-push inflation.
Conversely, if the government reduces the subsidies gradually, as recommended by SBP in its MPS, it will keep relying on the domestic borrowings, crowding out private sector which in turn will trigger demand-pull inflation.
Hence, in the absence of a credible and reform oriented fiscal programme, solely relying on inflation numbers would not be a wise approach.
Now, moving on to the reliable indicators – Exchange rate and Forex reserves, which the SBP relied on, in its recent decision. The country received a net capital and financial inflows of $34 million during 8MFY13; however, these inflows are insufficient to mask a huge current account deficit of $700 million.
With no recovery of inflows in sight in the wake of energy shortages and waning security and law and order conditions, the SBP has to retire another $838 million in FY13. This would put further pressure on the Forex reserves with its direct impact on the exchange rate.
Thus, the recipe to keep the Forex reserves healthy is to keep rupee denominated assets sufficiently lucrative which wouldn’t be possible had the discount rate slid further. Besides, the impending IMF programme is yet another formula to keep the Forex reserves vigorous, and that also calls for a laundry-list of austerity measures including monetary tightening.
Given the fact that a rate cut of 450 bps in the past twenty months couldn’t revive the private sector borrowing, the SBP seems to hunt for other ways to boost GDP growth while keeping the discount rate rational so as to avoid any external account fiasco.