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There was no surprise. Majority of analysts were expecting no change based on the forward guidance State Bank of Pakistan (SBP) had spelled out in January. According to SBP’s Monetary Policy Statement (MPS), “In the absence of unforeseen developments, the MPC [Monetary Policy Committee] expects monetary policy settings to remain unchanged in the near term”. SBP lived up to its word despite market rates moving up between January and March. Now in March, the forward guidance is that “in the absence of unforeseen developments, the MPC expects monetary policy settings to remain broadly unchanged in the near term”.

This appears to imply that any major hike in May is ruled out. However, there is room for 25-50 basis points (bps) increase. The term ‘broadly’ implies that small increase, such as 25 to 50bps, is plausible. Back in 2019, the governor had remarked that “central banks are like ocean liners; they take time to change directions”. Now with pandemic fears settling down globally, the broad message is that going forward, volatility in policy rates shall be low. Unlike the case of increase in 2018-19 and the steep fall in 2020 – from 6.5 percent to 13.25 percent, and then back to 7 percent – policy rate has finally gotten off the roller-coaster ride.

There seems little chance that policy rate may fall below 7 percent in 2021 and 2022, based on inflation outlook and other parameters. It may only move up, but changes will be measured and gradual. Then SBP has offered forward guidance in near term to anchor the market rates and provide a direction for businesses to plan for near term working capital financing accordingly.

SBP believes that movement will be gradual and measured to achieve mildly positive interest rates. SBP is monitoring the headline inflation. If it anchors the rates to core inflation, around half of CPI bucket is out. That is not appropriate. But still, SBP is searching for demand side factors to address through monetary policy. The variables to monitor are wage-price spiral and other factors contributing to the second round of inflation.

The last paragraph of the policy statement carries another important message. The central bank will be closely monitoring government’s wage negotiations in the upcoming budget. Whatever the federal government does will have an impact on provinces and private sector wages. The path of domestic energy prices is equally important, as already there is an increase in electricity tariff while more is warranted in both gas and electricity. The third factor is international commodity prices, especially crude oil.

SBP will closely follow these indictors and react appropriately when needed. By May, the most critical element will be the direction of international commodity prices and the path the third Covid wave takes, as budget is likely to be presented and passed after that meeting.

Inflation will be invariably high during March to June because of low base effect and the recent increase in wheat, sugar, and electricity prices – half of past two months increase in headline inflation is attributable to these three items. If international oil prices do not fall to $50/barrel and the third Covid wave quickly dies down over the next two months, the 25-50bps increase in May is highly likely.

Budget negotiations and path of energy prices shall determine the future direction from thereon, as salary and energy prices could potentially lead to a second round of inflation. SBP expects core inflation in FY22 to be range bound between 7.2 - 7.4 percent. The output gap will be positive during FY22, meaning there will be no slack in the economy. Keeping this in view, the headline inflation may hover around 7-9 percent, closer to upper band in next few quarters.

This outlook - along with emphasis on measured and gradual increase to take real rates into slightly positive territory - the policy rate may come around 8 and 8.5 percent in 2022. In 2021, the rates are likely to move up towards 8 percent, albeit at a slow pace with some guidance from SBP. However, SBP is confident over its path to 5-7 percent inflation in the medium term (6 to 8 quarters).

Market rates currently depict that the expectations of rate hike were a little too aggressive. The yield curve is too steep with 3Y to 10Y secondary market yields at 9.39 percent and 10.45 percent, respectively. Bond yields may adjust downward next week as market shall re-anchor its expectations.

The story of growth is shaping up well. SBP has revised upward its GDP growth forecast for FY21 to 3 percent from 2 percent earlier. The economic recovery is faster than what SBP had anticipated. The sharp LSM growth momentum shall continue in the 4QFY21 due to low base effect from last year. Growth for FY22 is expected to be even better than FY21, around 4 percent or more.

These - along with monetary expansion during Covid - will bring some demand side pressures. The key is to be vigilant on the external front, where the current account position will play the role of a wild card. One of the reasons for the steep hike in policy rate during 2018-19 was to curb the current account deficit. That has been successfully achieved. CAD is projected at 1 percent of GDP during FY21. Foreign exchange market is currently oversupplied. That is why Pak Rupee continues to appreciate against dollar (although US dollar has depreciated against many other currencies as well).

In FY22, the current account may see slippages, and higher imports would place pressure to reactivate demand side management. Here, exchange rate shall come in handy. The appreciated Pak Rupee has allowed SBP room to let the currency depreciate as a first line of defense against the imported demand. With its arsenal well-stocked, the central bank is well-positioned to keep rate of change in policy rate ‘measured and gradual’.

Copyright Business Recorder, 2021

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Ali Khizar

Ali Khizar is the Head of Research at Business Recorder

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