Interest rates reversal: Now or later?

The pressure is mounting on the central bank and monetary policy committee to go for a rate cut in upcoming policy. In the Sep-19 review, for the first time since Sep-17, a member from MPC voted for rate cut. However, still 8 out of 9 members were for no change.  Voting pattern can swing again – for instance in Jan-19, 3 members voted for no change and thereafter, SBP increased policy rate by 300 bps in three successive policy reviews and all the members were for rate increase.

The hawks dominated in May-19 and July-19 when every member was for higher quantum of increase in rates. This coincided with Raza Baqir assuming the role as Governor in May-19 and finalization of terms and conditions with the IMF. The other reason for change in MPC thinking from Mar-19 onwards is change in external members and some of SBP broad members on the monetary policy committee.

It seems like previous members appointed in the Dar time were more dovish and they were influenced by his stance. Back in 2017, the monetary policy decision was losing its creditability as the twin deficit problem was growing and reserves were falling like nine pins but during Jan-17-Sep-17, out of five reviews, four times there were votes for rate cut while the policy rate was kept unchanged at 5.75 percent. The language of MPS was changing poles in two months– from positive output gap to negative and back to positive.

It was absurd. Good that there is some sanity and a sense of policy direction. Both the changes in members and Governor have its impact on policy discourse and communication. The pattern is that usually data is shared with MPC members a night before the meeting and some data points are only discussed in the meeting. The staff members leave after presentations, and then the MPC members deliberate and vote.

Hence, the voting of members is somehow influenced by the way SBP team presents and describes economic conditions and outlook. In Jul-19 policy, when the SBP surprisingly increased the policy rate by 100 bps, the communication was clear in so many words that this is the end of tightening. And is Sep-19, the direction is slowly changing towards rate cut.

Let’s see how the members vote in upcoming policy in Nov-19. The market has already incorporated the rate cut of at least 50 bps with 3M papers secondary yield down by over 50 bps from what it was in Sep-19. The fall in 10Y paper is much more and the yield curve inversion is getting steeper. The latest PIB auction results are out and the weighted average 10Y cutoff yield is 11.26 percent, further strengthening the notion that a rate cut is imminent.

The IMF team is on the visit and the first review will be concluded before the announcement of MPS. Seemingly all the binary quantitative targets are being met for the 1QFY20, and the authorities may ask for some relaxations. The government may now move from stabilization to pro-growth policies. The LSM decline in 2MFY20 is highest since FY09, and the overall growth outlook is being compromised due to bad cotton crop.

The current account and imports numbers are encouraging which are showing that tightening is paying dividends. Another important data point – inflation is to be released in couple of days – it is expected to hover around 10-10.25 percent. And seeing that, 13.25 percent policy rate is too high. But reading from SBP Governor’s tone, he may like to wait more. A couple of months ago he said that central banks are like ocean liners and they take time to change direction. Hence, to establish SBP credibility, he may wait for Mar-20, as inflation may increase to 11-12 percent during Nov-Feb.

The other plausible reason for the wait could be to negotiate on some fiscal relief and other elements such as NDA targets with the IMF; rather than pushing for rate cut too soon.