Tightening goes on

Policy rate is up by 125 bps to round it off at 15 percent. It was not an easy decision. The SBP expects FY23 (next twelve months) average inflation at 18-20 percent. Based on that assumption, SBP is keeping negative real rates. The gist of SBP decision and communication is in concurrence to the policy prescribed in this space with degrees of separation.

And there are risks to SBP’s inflation forecast – such as global commodity prices, domestic fiscal stance, and exchange rate. Seeing these risks, SBP is not giving any firm forward guidance, saying that going forward, MPC would be data driven. This means, if any of three factors go south, expect further tightening.

And these variables are linked. For instance, if global commodity prices move up, it would be hard for government to pass on the impact, and without it, the currency could go haywire. That brings inflation – through higher global prices and PKR depreciation. To counter these, monetary tightening becomes inevitable.

Then, global tightening (in advanced economies) is putting pressures on the emerging economies currencies. The depreciation to bring inflation and to counter currency fall (which is inflationary in nature), the SBP must increase the interest rates further. That risk can be managed, if the international commodity prices come down due to global tightening. Then there is global politics (Ukraine war has a role to play).

Third variable is domestic political risk. Ever since, the vote of no confidence (VoNC) was about to be tabled, successive governments have started taking economically unwise decisions. This all started with no change in the petroleum prices by PTI government in March and then carried froward by the incumbents. Even today, after taking difficult decisions, perhaps SBP is still giving weight to the fact that political compulsions in the short run can jeopardize economic sustainability, as the domestic political landscape is not stable yet.

The point is that there are too many ifs and buts in the equation. There are numerous domestic and international economic and political factors in play which all have repercussions on the domestic politics. And the most important factor is the continuation of the IMF programme. As without it, the SBP foreign exchange reserves would fall to dangerously low levels which could trigger a run-on currency and hyperinflation. To counter that, SBP should be extra vigilant. That is perhaps the reason, SBP has put its weight on the tightening this time and has refrained from giving any firm forward guidance.

Then SBP is dealing with another dilemma. That is of monetary policy credibility. For the past few reviews, SBP has been following the market. The market rates (almost consistently) remained higher than the policy rate and the SBP’s policy rate kept on following the market rates. SBP doesn’t not want this gap to continue. And once again, SBP matched the market rates by reaching to the levels of market rates.

Its not an easy job for SBP. The liquidity in the market to finance government borrowing is primarily relying on SBP’s injections through open market operations (OMOs). That toll is now approaching Rs5 trillion. The other avenues of financing are dried. Banks are the one to lend. And banks are worried on the mark-to-mark losses on government papers, as interest rates are moving ahead. Their interest is confined to three months paper and to fund on spread over OMOs injection. The shortening of debt maturity profile is another headache.

The situation is still fluid. However, the fiscal and monetary policy responses currently are in the right direction. Given, the IMF is back, after the government to remaining adjustments and agreeing to the structural reforms, and the global commodity prices to not go further up, there should be no reason for any further rate hike.

Demand tightening ability of SBP diminishes with incremental rate hike at such high rates. Having said that, SBP is still worried on the demand which has stopped growing; but has not started falling and staying at high levels. SBP may need to wait and see the impact of fiscal contractionary policies adopted in June to reflect in numbers in coming months.

Thus, it makes sense to live with negative real rates this year. However, some may argue that savers are at a disadvantage, as they are not able to cover inflation through putting money in fixed income instruments. That is one trade-off that might be better for the economy at large.