Pakistan’s monetary policy is increasingly being asked to do too much. It is carrying the burden of stabilising prices, defending the currency, and indirectly compensating for fiscal stress that now largely stems from debt servicing rather than primary spending. In that context, the question facing policymakers is no longer whether policy should remain tight. It is how tight is actually necessary.
On current projections, that answer appears clearer than the rhetoric suggests. If inflation averages around 8 percent in FY2026-27, as reflected in official budget assumptions, Pakistan’s 11.5 percent policy rate implies a real interest rate of roughly 3.5 percent. That is high by emerging-market standards and even higher relative to Pakistan’s own macroeconomic conditions. A more conventional central banking framework would place the appropriate real policy rate closer to 2 percent, implying a nominal policy rate near 10 percent.
The difference between the two is not academic. It is roughly 150 basis points of additional monetary tightening in an economy where fiscal space is already severely constrained.
Pakistan’s monetary stance cannot be assessed without reference to its fiscal structure. In the latest federal budget, debt servicing consumes roughly Rs 8-9 trillion, accounting for around 45-55 percent of total federal expenditure, depending on revisions and classification. It is by far the largest single line item in the budget, exceeding combined allocations for development spending, health, and education.
This scale matters because it links the policy rate directly to fiscal stress.
Most of Pakistan’s domestic debt is short-dated or frequently rolled over through Treasury bills and Pakistan Investment Bonds. As a result, changes in the policy rate transmit quickly into government borrowing costs. Higher rates increase interest payments, which in turn compress fiscal space and reduce the government’s ability to sustain development spending.
Recent fiscal data underscores the constraint. Development expenditure has been squeezed to roughly Rs 1 trillion in the federal PSDP, while debt servicing continues to absorb nearly half of total spending. In effect, Pakistan’s budget is increasingly structured around past borrowing decisions rather than current growth priorities.
This creates a reinforcing loop. Higher interest rates increase debt servicing, which reduces fiscal space, which limits growth-enhancing spending, which weakens the revenue base, increasing reliance on borrowing. Monetary tightening, this environment, does not only suppress inflation. It also amplifies fiscal fragility.
At 11.5 percent, Pakistan’s policy rate is high in nominal terms. But as stated earlier the more important metric is the real rate. With inflation projected at 8 percent, the real policy rate is approximately 3.5 percent. That places Pakistan well above the range typically observed in comparable emerging markets once inflation stabilises.
Even after the post-pandemic global tightening cycle, most inflation-targeting central banks have converged toward real policy rates in the 1-2 percent range once inflation expectations are anchored. A 3.5 percent real rate is more consistent with crisis conditions than with stabilisation.
By contrast, a 2 percent real rate would still represent a restrictive stance. It would preserve positive real returns, support currency stability, and anchor inflation expectations without imposing excessive financial compression. On that basis, a 10 percent policy rate appears broadly consistent with standard central banking practice.
Lower-middle-income economies that have successfully stabilised inflation do not typically rely on structurally high real interest rates.
India, under the Reserve Bank of India’s inflation-targeting framework, has generally operated with real policy rates around 1-2.5 percent during periods of macroeconomic stability. Indonesia’s post-Asian crisis monetary regime similarly converged toward moderate positive real rates once inflation expectations were anchored. Vietnam and Bangladesh have also maintained relatively contained real interest rates while prioritising investment and export-led growth.
The common pattern is not the absence of monetary discipline. It is the avoidance of persistent over-tightening once inflation is under control. Credibility, in these cases, is derived from institutional consistency rather than from maintaining unusually high real returns.
Pakistan’s deeper macroeconomic constraint is not excess demand. It is weak investment and low productivity growth.
Private investment remains subdued, credit growth is constrained, and the cost of capital is among the highest in the region. In such an environment, real borrowing costs above 3 percent materially affect the viability of marginal investment projects, particularly in manufacturing, export-oriented sectors, and infrastructure-linked private activity.
The impact is not immediate in inflation data, but it is persistent in growth dynamics. Lower capital formation today translates into weaker productivity and employment generation over time.
At the same time, the fiscal cost is direct and immediate. With debt servicing already absorbing close to half of federal expenditure, higher policy rates feed almost mechanically into rising government interest payments. This reduces the state’s capacity to invest in human capital and infrastructure at a time when private investment is also weak.
The key issue is therefore not whether Pakistan should maintain positive real interest rates. It must. Nor is it whether monetary policy should be relaxed aggressively. It should not.
The question is narrower and more technical: does Pakistan require a 3.5 percent real policy rate when inflation is projected at 8 percent and growth remains constrained?
If the answer is no, then a 10 percent policy rate becomes the natural equilibrium point. It preserves a 2 percent real rate, maintains monetary discipline, and reduces unnecessary fiscal pressure in an economy already dominated by debt servicing.
Pakistan’s monetary policy challenge is increasingly about calibration rather than direction. The stance is already restrictive. The question is whether it is excessively so relative to current inflation dynamics.
With debt servicing consuming more than half of the federal tax revenues, and with inflation expected to stabilise in single digits, maintaining an unusually high real interest rate risks reinforcing fiscal stress without clear incremental gains in price stability.
A policy rate of around 10 percent would still represent a tight monetary stance by global standards. But it would align more closely with Pakistan’s inflation outlook, reduce unnecessary fiscal strain, and bring monetary policy into better balance with the economy’s underlying constraints.
The case for 11.5 percent therefore requires a stronger justification than inflation projections alone currently provide. In its absence, the argument for a 10 percent policy rate becomes not only plausible, but increasingly difficult to dismiss.
Copyright Business Recorder, 2026
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