The monetary policy is due on Monday. The market rates (T-Bills and KIBOR) have already plummeted, making the monetary policy largely irrelevant in the short term. This is primarily due to the distorted ADR tax policy rather than a steep decline in inflation. The market is flushed with liquidity, and non-bank buying is pushing the rates further down.
Therefore, given the current market rates, a decline of 300 basis points (bps) in the policy rate appears plausible. This is energizing stock market enthusiasts, who are anticipating a minimum cut of 200 basis points. However, serious individuals in big banks’ treasuries are cautioning that the rate cut should be paused after a further reduction of 200-300 basis points. The State Bank of Pakistan (SBP) has the option to reduce rates to 12 percent in December alone or to split them between the December and January reviews. Thereafter there should be a pause.
The treasury folks at the banks are giving sane advice to the monetary policy committee, which should not be carried away by the distorted fall in market yields and undue pressure from the twin cities of Islamabad and Rawalpindi. They should rather focus on the fundamentals.
Everyone knows that inflation came in at 4.9 percent last month and may hover between 3.5–6 percent in the next three months. However, that does not mean that inflation remains at these low levels. There is a favorable chance of inflation being around 10 percent in the last quarter of the fiscal year, and SBP should pause and see the impact of the recent decline on the aggregate demand and eventual impact on inflation before bringing the policy rate down any further from 12 percent.
SBP has already lowered the policy rate by 700 bps in the last four policy reviews, and it’s likely to reach 900 bps by Monday. This is almost slashing the rates to half. This could potentially impact demand generation, which typically takes 6 to 18 months based on historical trends. Therefore, SBP should take a moment to assess the impact after raising the policy rate to 12—13 percent.
The monetary aggregate (M2) growth is currently at 15 percent, while the inflation rate is at 5 percent. This suggests a real M2 growth rate of 10 percent, resulting in an overhang that typically takes 6-18 months to translate into demand. This indicates that SBP should hold off on raising rates to 12-13 percent.
The headline inflation rate has dropped to 5 percent due to a sharp decline in food inflation, which is a result of a reversal in global commodity prices and the absence of domestic wheat support prices. The core inflation rate continues to hover around 10 percent, with urban areas reporting 8.9 percent and rural areas reporting 10.9 percent. Another factor contributing to the low inflation rate is the seasonal one, which may lead to monthly increases in the coming months.
However, a decline of 300 bps is already priced into the market yields due to the distorted ADR policy where banks are swaying away from the principles of banking. They are reducing deposits and lending at a negative spread, a trend that should reverse once the ADR tax issue is resolved.
SBP should be forward-looking and not reduce the policy rate to a level from which it has to reverse. It would reflect poorly, as central banks generally do not reverse the policy stance that quickly. The market rates might normalize by February, and inflation may start picking up from April onward.
The doctor’s order is to reduce by 300 bps in the coming two policy reviews—200 bps in December and 100 bps in January—and then take a pause for two quarters.
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