MPC clearly in a dilemma about how to respond to policy rate question

The State Bank of Pakistan (SBP) is set to announce its monetary policy decision today. Over the past six reviews, the central bank has slashed interest rates by a cumulative 1,000 basis points (bps), bringing the policy rate down to 12 percent.

However, the pace of easing has slowed significantly—after three consecutive cuts of 200 bps or more, the most recent reduction was a modest 100 bps cut.

The SBP has explicitly stated that evolving risks necessitate a cautious monetary policy stance to ensure price stability. Consequently, if there is any further rate cut today, it is likely to be limited to 100 bps or less.

The decision hinges on two sets of variables: inflation and economic growth on the one hand, and external account vulnerabilities on the other.

Inflation has fallen more sharply than anticipated, while GDP growth remains sluggish. Based on these factors alone, a 100-bps cut seems justified. However, the external account presents a more pressing concern.

Recent developments in the currency market indicate mounting pressure. Banks have tightened their management of inflows and outflows, leading to delays in import payments and friction in opening letters of credit (LCs).

Pakistan’s external vulnerabilities are well known, and memories of the country’s near-default situation are still fresh. Any misstep could trigger panic. Given this precarious environment, the SBP should seriously consider pausing the easing cycle.

The outcome is likely to strike a balance between these competing priorities. Proponents of a dovish stance argue that the decline in inflation is not solely due to a high base effect.

Month-on-month inflation averaged just 0.13 percent over the past twelve months, compared to 1.75 percent in the previous year. Four of the last twelve months, including February 2025, recorded negative inflation. Headline inflation stood at 1.5 percent year-on-year last month and 6.0 percent for the first eight months of FY25.

Looking ahead, average inflation over the next twelve months is projected at 5-6 percent, supported by easing international commodity prices, particularly oil, driven by expectations of a US recession fueled by Trump’s import tariffs.

However, core inflation remains sticky. In February, it remained unchanged at 8.85 percent from January. While energy and food prices have seen significant declines, other items have shown only modest reductions. Trimmed core inflation, though sharper, suggests that broader price pressures may catch up. Thus, inflation does not appear to warrant aggressive easing.

Economic growth remains elusive. First-quarter GDP growth was a mere 0.92 percent, with large-scale manufacturing (LSM) showing no signs of recovery. The rural economy continues to struggle due to the absence of a support price mechanism and adverse weather patterns, impacting both agriculture and related sectors.

Construction activity is sluggish, hampered by higher real estate taxes and abysmally low government development spending. With FBR revenues falling short, fiscal tightening has further constrained growth prospects.

The SBP expects GDP growth to range between 2.5 percent and 3.5 percent, but achieving even 2.5 percent would be a significant accomplishment.

To stimulate growth and employment amid continued tight fiscal policies (with two consecutive years of primary fiscal surpluses), some easing of monetary policy appears necessary.

Yet, the equation is far from simple. Pakistan’s biggest economic challenge lies in its external account, which remains on shaky ground. Pressures in the interbank market are evident, with treasury officials delaying payments and SBP forex purchases dwindling.

Foreign exchange reserves have declined by $800 million over the past two months, raising concerns among stakeholders. Formal businesses, once advocating steep rate cuts, are now urging caution.

While the current account deficit widened to $420 million in January, the surplus for the first seven months of FY25 stands at $682 million. Imports surged above $5 billion in December and January but fell below that threshold in February.

The earlier increase was due to cheap lending by banks to importers to avoid the ADR tax. This trend is expected to taper off as payment pressures ease with seasonal remittance inflows in March and April.

The real issue lies in the capital and financial accounts, where market-based inflows are virtually nonexistent. Hot money—whether in debt or equity—is also absent. Lowering interest rates may have little impact on attracting such flows. However, maintaining a current account surplus will require the monetary policy committee to exercise extreme caution.

One option is to adjust the currency. The PKR/USD exchange rate breached 280 (during intraday trade) on Friday for the first time in over a year and may depreciate by 2-3 percent by June. Yet, this might not suffice.

The delayed effects of the 1,000-bps easing cycle are beginning to translate into increased demand. People are gradually withdrawing funds from banks and fixed-income instruments, while firms and individuals are contemplating business modernization and discretionary consumption. This could push imports higher in the coming months.

Given these dynamics, the SBP should adopt a cautious approach. A 50-bps rate cut today would signal a measured response, though a 100-bps reduction cannot be entirely ruled out.

Copyright Business Recorder, 2025