The monetary policy is due on Friday; the question is after 25 bps policy rate increase in Jan18 to 6 percent, what the SBP would do this time. Based on inflation numbers and expectations, looking at the monetary demand including government borrowing from banking channels and private credit, monetary tightening is not warranted.
However, the market expects a 25 bps increase. Out of 11 research houses contacted by BR, seven are expecting 25 bps while others see no change. The market expectations are purely on the basis of change in policy stance singularly focusing on external imbalances.
Yes, it’s the output gap that is driving exchange rate and monetary policies decision making. The rupee has already depreciated against USD by 9.4 percent since Dec17 and due to USD weakening; the depreciation against other trading partners is much higher.
The objective of these adjustments is to curb imports and boost exports. However, the monetary tightening might be counterproductive for exports; the decline would be over compensated by currency depreciation. High growth in imports, which is the prime reason for burgeoning current account deficit, is going to be hurt by both measures.
The other element of policy rate hike is to maintain the gap between Pakistan and US rates. The reason for managing the gap is improved Real Effective Exchange Rate (REER). The adjustment is again more due to rupee weakening. The REER has moved down from 124 in Nov17 to 116 in Jan18 and it may come down further to 105-107 by Mar-April.
There is not much gain from monetary tightening on lowering current account deficit or reducing output gap as currency adjustment is doing the trick. Why is the market still expecting hawks to dominate?
In Nov17, eight of the nine members of MPC were of view of no change and in Jan18 eight of the nine members were in favour of view of 25 bps hike. What caused the change in heart at monetary policy decision making? Partially, this can be explained by getting different results from SBP economic model where the change of stance in US Fed rates is now indicating the need of monetary tightening in 3QFY18 from policy easing in 1HFY18.
The other reason for change in stance could be due to possibility of going back to the IMF programme and both monetary and exchange rate adjustments are to prepare groundwork for IMF programme. Let’s not delve in details of theory of IMF directive to tighten the economy, rather keep the focus on SBP model in light of how other emerging economies are reacting to USD currency weakening and rate hike. There is no other economy in the emerging group tilting to policy tightening but Pakistan.
Having said that, let’s focus on inflation which is the prime objective of monetary policy decision making. The good news is that inflation has remained subdued after the first round depreciation in Dec17. The SBP expects full year inflation to remain in the band of 4.5-5.5 percent, while FY19 inflation is expected at 6 percent.
The reason for low inflationary impact of currency depreciation is that major food and other commodities constituting CPI are already at premium to international prices. Thus, inflation largely will remain insulated to currency fall. But too much of depreciation could have an adverse affect. And more importantly, inflationary expectations are building up due to currency depreciation which can result in self fulfilling prophecy.
Hence, to have commutatively a 100 bps increase in policy rate by Dec18 is not a bad move - 25 bps of which is expected on Friday.
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