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The State Bank of Pakistan (SBP) is due to announce its next monetary policy statement (MPS) on July 7th, 2022.

Recent surveys show that the vast majority of market participants (~80%) expect the central bank to hike rates again (by 1.0% to 1.5%) and understandably so. The last inflation reading came in at an eye-watering 21.3% with the month-on-month increase (6.3%), the highest on record.

Similarly, the PKR has lost 30.0% against the USD over the last 12 months as foreign exchange reserves have plunged from $20.1 billion in August to just $10.3 billion now. As a result, treasury bills and KIBOR are being quoted above 15.0%, the highest they have been this century.

Recall that the SBP has already raised the policy rate from 7.00% to 13.75% since September 2021. The 675bps hike in just eight months so far puts the current tightening cycle as one of the sharpest in history. Contrast that to the cycles in 2005 and 2018 where rates rose by 7.50% each but did so over a much longer time period (3.5 and 1.5 years, respectively).

The situation is similar to 2008-09 where Pakistan’s economy reeled from shocks to its external accounts as oil touched USD 140/barrel. Inflation averaged over 20% for the entire year (with a peak of 25%) while the PKR lost 19.1% in value (after losing 13.1% the year before).

We were forced to go to the International Monetary Fund (IMF) for a bailout and the SBP hiked the discount rate to 15.0%. The takeaway here is that despite inflation averaging over 20%, interest rates peaked at 15% so real rates remained negative for almost the entire year. Sound familiar?

The question is should the SBP hike rates again? Normally in such a situation, monetary policy aims to control inflation by inducing a slowdown in economic activity. It does this by increasing rates, reducing liquidity and making it more costly to consume/spend. In a nut shell, it targets demand. But does that make sense at this point?

Firstly, inflation is mainly being driven by commodities (food and energy) over which the SBP has little control. So while headline inflation is above 21% the core measure of inflation i.e. non food non energy (NFNE) is at a relatively more sedate 11.5%.

Nearly, 80% of the month-on-month jump in inflation came from food, electricity and motor gas. Similarly, ~60% of the year-on-year increase came from these 3 heads. This shows us that supply side issues are more of a concern at this point in time. A hike in rates to combat commodity prices is largely a futile effort.

Secondly, the rapid rise in prices is also due to fiscal consolidation. In the last few weeks, the government has increased petrol price from PKR 150/litre to almost Rs 250/litre and has in fact started to collect Petroleum Development Levy (PDL) of Rs 10/litre.

Similarly, subsidies on electricity and gas are being phased out which will further increase pressure on CPI. The latest budget has increased taxes across a large swathe of the documented economy and will result in a pass on to consumers by producers as they strive to protect their margins.

These actions while inflationary in nature will serve to strengthen the fiscal position by increasing revenue and reducing expenditure. They will also slowdown the economy as disposable incomes shrink due to higher taxes/prices. It makes little sense for the SBP to double down on inflation resulting from fiscal measures as the objective of slowing down demand is being achieved.

The SBP for its part has already taken some regulatory measures (export refinance, auto/mortgage financing, LC cash margins, etc.,) to complement the fiscal side. Financial conditions in effect have been significantly tightened.

Thirdly, in the past few weeks commodity prices have started to decline. Wheat, cotton, palm oil, sugar, urea, copper, gasoline, diesel, iron ore, oil have come off their highs. In fact the Bloomberg Commodity Index which tracks a wide range of commodities is now down ~14% off its recent peak.

At a time when central banks are aggressively tightening, global growth is slowing, companies are carrying excess inventory and retail activity is declining, it is not unreasonable to expect that commodity prices may start to stabilize. Yes, there is a war going on and supply side disruptions will remain but those have likely been priced in for the most part.

Domestically, we will also start to see a slowdown in high frequency economic indicators. The first signs came with an 11% month-on-month decline in the sales of petroleum products. This trend will soon spread to cement, autos and consumer financing as well. As a result, we should expect to see a significant deceleration in GDP growth for FY23.

FX flows have re-started with an inflow of USD 2.3 billion from China and the IMF staff level agreement is expected soon. The PKR has already recovered 3.5% against the USD as a result. With the IMF on board the SBP can confidently expect to rebuild FX reserves from multilateral and bilateral sources which will stabilize the currency as well.

The central bank tells us that monetary policy transmission takes up to 6 months. The fiscal side is now picking up the slack while an undervalued currency has served as a shock absorber for the external account. With a 400bps (basis points) increase in rates since April, the central bank should not over compensate but assess the impact on macroeconomic stability before deciding if it needs to tighten again.

Copyright Business Recorder, 2022

Mustafa O. Pasha

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

Comments

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Abdullah Jul 06, 2022 03:38pm
Completely disagree. Non-food inflation is still very high and this is evident from the fact that demand for auto sector is still running extra-hot and mortgaging/financing for it, albeit down, is still quite high. Secondly, central bank needs to consider the fact that other currencies have significantly strengthened especially safe havens like US dollar & Swiss Franc. Particularly, Fed's hawkish 75 basis point hike has led to heavy depreciation of rupee against US dollar - which will add onto inflation woes and worsen the current account in the short run. Moreover, State Bank has to factor in the further fact that Fed has a MPC meeting at the end of this month and the markets are estimating another 50 to 75 basis point hike, while Powell himself has said a further 50 basis points hike is on the cards. Important thing to note is State Bank's next MPC meeting (after tomorrow's) will be at the end of August so they will have to make forward-looking decisions. All in all, in the interest of the economy and people, at least a 150 basis point hike is a must (if not more). Financial markets will get hammered but they will recover. Inflation is the biggest problem right now.
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