MPC meeting: navigating between disinflation and external fragility

Monetary policy decision is due today. Three macro variables are making a compelling argument for a big rate cut. These include sharply falling headline inflation, consistently running primary fiscal surplus, and anemic economic growth. However, the story is not complete without the fourth—external account — where falling SBP forex reserves are calling for a cautious stance.

There are uncertainties about the implications of Trump’s tariffs and growing risk of escalation with India. These, along with a net negative balance of payments in the last four months, demand holding the policy rate or opting for a marginal cut. Nonetheless, the chances of policy rate reaching 9–10 percent by year-end are growing.

The headline inflation fell to a multi-decade low of below just 1 percent in the last two months. The month-on-month reading is negative in four out of the last twelve months. Analysts expect CPI to remain below 5 percent in the next 12 months. SBP is on track to keep headline inflation well within its medium-term target of 5–7 percent.

However, core inflation is not falling in tandem with the headline. It rose by 1.2 percent MoM in April, whereas the headline fell by 0.8 percent. Core inflation is sticky—standing at 8 percent in April and averaging 9.9 percent in 10MFY25 compared to CPI’s 4.7 percent. The second round of inflation is in play. Wages are expected to rise decently in the next fiscal year, which will keep the core decline tame.

Inflation has been highly volatile in recent years—so is the case with the fall in the ongoing fiscal year. Food and energy are the main drivers. Wheat prices dropped from Rs4,500 to Rs2,500 per bag in a short time. This may have adverse implications on general economic demand. Farm income is suppressed, which is not only keeping agricultural growth low but also curbing money supply growth and its multiplier impact through subdued demand for other goods and services.

Low wheat prices are not sustainable for the farm economy, and they will reverse sooner or later. Global prices are low now and expected to remain depressed due to better global supply. However, wheat moving up to Rs3,000 in a few months cannot be ruled out—and that could revise the inflation forecast upwards.

Then, energy prices are lower due to falling global prices of oil, gas, and coal. The outlook is to remain low. That bodes well for Pakistan’s inflation and imports. However, energy supply chain inefficiencies persist, and that limits the decline in power prices. Anyhow, there is no major risk of an upsurge in prices without a global price reversal.

The lower prices are giving the government an opportunity to collect tax revenues (including petroleum levy). Authorities are doing it to bridge the gap in FBR tax revenues. That is making it easier to manage the primary surplus. There was a surplus last year, and this year is so far on target—and IMF rightly demands a surplus in FY26. This may offer space to the monetary policy committee to cut rates.

It has done so by cutting rates by 1,000 bps in a brief period from June to December 2024. Apart from fiscal discipline and falling inflation, SBP had earlier gained confidence from rising forex reserves, which moved up to $12 billion by December 2024 from a low of $3 billion in February 2023. However, SBP became cautious with reserves falling since December, now standing at $10.2 billion.

SBP forex reserves play an important role in building inflation expectations. It expects reserves to reach around $14 billion by June-end. IMF money is expected next week. However, last month’s imports, at $5.5 billion, brought import cover below two months. The trade deficit in April is the highest since September 2022.

SBP should keep this in mind, as the translation of a 1,000 bps decline on demand is going to be pronounced in the coming months. There might be a case of dumping by Chinese exporters due to Trump’s tariffs. The dollar appears to be short in the interbank market despite a record current account surplus in March, as SBP is buying whatever it can to service government debt.

That puts some pressure on the currency, which is marginally down against the USD. With the USD falling, the PKR is depreciating against other major currencies. This, along with negative MoM inflation, may bring REER between 100–101 as of now. Thus, there is no immediate pressure on the Rupee, and this gives SBP some room to further ease monetary policy.

However, there are uncertainties about global trade wars and actual war with India. These could put pressure on both the fiscal and external fronts. SBP reserves are yet to rise. The taxes in the upcoming budget could have implications. It is best for SBP to wait and watch. Having said that, a 50 bps cut cannot be ruled out either, without tipping the balance too much.

Copyright Business Recorder, 2025