The hike in discount rate yesterday may be as expected, and in accordance with what the central bank has been articulating since the last many quarters. But what makes yesterdays case different is the banks increasingly hawkish stance, visible from its monetary policy statement.
While the SBP has been warning of the inflationary dragon since it reinitiated its tightening cycle, it is for the first time the central bank cautioned that double-digit inflation could persist in FY12 as well.
"The rising NDA to NFA ratio of SBP balance sheet and its strong association with CPI inflation also suggest that inflation is likely to persist at double digit levels during much of FY11 and possibly in FY12," the MPS pointed out.
In conformity with its previous line of thinking, the SBP said the growing inflationary expectations mostly stem from continuous government borrowing that has been diluting the impact of previous rate hikes by the central bank.
"Of the Rs308 billion expansion in reserve money up till November, 19, 2010 since the beginning of the current fiscal year, Rs266 billion is due to government borrowing from the SBP, which has been on an increasing trend since January 2010," the SBP said, while making the government responsible as the "source of high inflation in Pakistan over the last year."
It is, therefore, after years of moral suasion to check fiscal borrowing, the SBP took a strong decision yesterday to limit it.
Soon-to-be-armed with explicit powers, the central bank has taken a principled decision to strictly implement the revised limits on borrowings of the provinces from SBP - "even if it involves stopping payments to the provincial governments".
Now thats a hard statement to make, and on the basis of which, it may be construed that eventually, the SBP will resolve to stop making payment to the federal government, by using the amended SBP Act. If that happens, in the absence of real benefits of the RGST, which the SBP doesn expect to materialise soon, further crowding out of the private sector, through government borrowing from commercial banks, can be expected.
Commenting on the external account scenario, the central bank said that assuming a real GDP growth of 2.5 percent and that the expected decline in private and public sector investment expenditures would be largely compensated by increases in public sector consumption expenditures, the external current account deficit is likely to be narrower in FY11 than earlier projections of 3.5 percent.
But this not the desired outcome because the SBP and the government need to increase the investment while using monetary tools and fiscal discipline respectively and then try to find out domestic savings avenues to finance the investment instead of relying on foreign savings.
However, perhaps the most interesting thing that ought to be noted is that it is probably the first time, the SBP tried to clarify its position to placate the stakeholders who will be bothered by the rate hike.
"Monetary policy is essentially a short term instrument with which emerging risks and uncertainties are managed. The impact of monetary policy on economic activity and inflation is indirect and operates with a lag, and unlike the case of fiscal policy that tends to be reactive, it has to be proactive," the SBP said in a rather un-central-bank-like manner that is known to be usually tight lipped about its abstruse affairs.
Does this mean that SBP is mentally preparing the stakeholders for further tightening? The answer may not be a resounding yes, but it is nevertheless a possibility.