No change. No surprise. Monetary Policy committee (MPC) has kept the policy rate unchanged at 7 percent. The monetary policy stance is clearly accommodating with real interest rate remaining at negative 2 percent for FY21. The policy stance is aligned with global trends. Central bankers across the world have also maintained a similar stance. Global inflationary pressures are emerging. So is the case in Pakistan. The stance of global central bankers is that inflationary pressures are supply side and temporary. There is slack in the economies, thus accommodative monetary policy should continue. Pakistan is doing the same.
Nonetheless, between the lines, SBP has said that the policy rate may not remain unchanged for long. The interpretation may be that further lowering rates is completely out of question. For the past three policy statements, SBP has been offering forward guidance. In January 2021, SBP clearly stated that monetary policy stance shall remain “unchanged” in the near term. In March 2021, the statement was carefully reworded to “broadly unchanged in the near term”. In May 2021, the inflection point is coming closer – the MPC expects monetary policy to remain “accommodative” in the near term, and any adjustments in the policy rate “shall be measured and gradual to achieve mildly positive real interest rates over time”.
According to Governor Reza Baqir, central banks are like ocean liners, they take time to change direction. SBP is taking its time and preparing market for a change. Forward guidance over last three policy statements shows that change around the corner. The policy stance is of accommodative in the near term. The real rates are likely to remain negative. But the rates will remain accommodative in 7 to 8 percent territory if inflation remains higher than 8 percent.
If the COVID cases continue to subside, the economy (such as Large Scale Manufacturing) remains upbeat, the private sector credit growth becomes robust and inflation remains higher than 8 percent, SBP may act accordingly to move towards a neutral stance.
The second sentence of forward guidance in the MPS substantiates this argument. “If demand side pressures emerge as the recovery becomes more durable and the economy returns to full capacity, the MPC noted that it would be prudent for monetary policy to begin to normalize through a gradual reduction in the degree of accommodation”.
Thus, monetary policy is on the cusp of change. However, SBP will take its sweet time. The timing and quantum of rate increase depends upon fiscal expansion. SBP will closely monitor the increase in wages of public sector employees. It will also have a keen eye for any fresh tax reliefs. If the budget is too expansionary (not likely), then the monetary policy may have to react much quicker than the forecast of most analysts. For example, if wages increase by 25 percent, SBP must counter the potential wage-price spiral. However, if the wage increase is at 10 percent, that may not wake up the sleeping hawks.
In short, do not expect any change in the MPC meeting of July 2021. The recent inflationary pressures may continue for next two months. But these are mostly food supply shocks, due to energy price revisions and increase in global commodity prices. There is nothing much monetary policy can do to curb supply shock induced inflation.
Having said that, speed of economic recovery - GDP growth at 3.94 percent - has surprised many. Next year is expected to be even better led by increased PSDP spending. Output gap is shrinking. Though SBP still expects output gap to remain slightly negative in FY22. SBP believes that while demand may be resurging, production capacity of the economy is also moving up.
However, output gap may close faster than many expect. This coupled with increase in wages can trigger demand side pressures. When that happens, SBP must act accordingly. It hasn’t announced its inflation expectations for FY22 as the institution must wait for the budget. The government is targeting 8.2 percent. Keeping this in view, 50-100 bps increase in FY22 cannot be ruled out.
The real question is the timing of SBP’s shift from an accommodative to a more neutral stance. One element is Covid and the monetary stance of central banks in other regions. But for Pakistan, the critical indicator is current account position. If it remains manageable, hawks can sit back and relax. Once it starts slipping, both currency and interest rates shall move north.
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