For at least the past twelve years, the central bank has maintained an average real interest rate of 1.28 percent, after adjusting for outliers. During this time, real rates were negative for 38 months, or almost a quarter of the period under consideration. However, if only the last ten years are reviewed, average real interest rate was 1.97 percent, as most negative real rates were in the pre-2010 era.

A few quarters preceding the outbreak of the coronavirus pandemic, policy rates were increased drastically to tame inflation (largely cost-push), pushing real interest rates to as high as 5.5 percent, which is one of the higher levels in the twelve years under consideration. Following a post-lockdown monetary expansion, real rates were pushed into negative territory, in contrast to guidance provided by the State Bank of Pakistan to maintain positive real interest rates on a forward-looking basis.

Inflation in Pakistan is mostly cost-push, rather than demand-pull. Supply shocks emanating from food and energy prices, coupled with subsequent second-round effects have kept inflation in low-teens or high single-digits for most part of the last decade. Demand-pull inflation would largely materialize if private credit growth were to be stimulated through monetary expansion. However, private sector credit has been consistently declining as a percentage of GDP over the last twelve years.In such a scenario, monetary contraction can potentially do more harm than good, if inflation is triggered by extraneous shocks. An increase in the cost of borrowing drives up the overall cost of doing business, potentially leading to overall economic slowdown, insolvencies, and even more inflation, till high-base effect kicks in.

By adjusting inflation for food and energy prices we can get core inflation which is not affected by the volatility in food and energy prices, and can potentially be isolated from supply shocks, to a certain extent. Thus, the efficacy of monetary policy transmission can be better assessed through core inflation. Monthly core inflation over the last twelve years has had much lower volatility than general inflation, with a standard deviation which is two-thirds of general inflation. Lower volatility can be attributed to an absence of extraneous shocks emanating from food, or energy prices, while also providing a more grounded target for pegging interest rates.

Adjusting core inflation with prevailing interest rates can yield core’ real rates. It may be a more appropriate metric to track for economies where inflation is largely driven by cost-push factors, rather than demand-pull. Core real rates in Pakistan over the last twelve years have averaged around 1.60 percent, and have been negative for less than fifteen percent of that period.

The pandemic has provided an environment to steer away from the conventional policy of targeting real interest rates, and moving towards a metric which is partially isolated from extraneous shocks. Considering that the current core real rate is hovering around the historical average of 1.73 percent (even though real interest rate is negative 1.8 percent), tightening the monetary policy now, would be premature.

The central bank has, in recent times, shifted from targeting real interest rate in a historic range, towards the use of targeted, concessional facilities to encourage credit offtake. It has also acknowledged that food price shocks are an administrative problem, not a monetary problem. The factors guiding the central bank’s monetary policy actions are increasingly focused on core inflation.