The central bank has chosen to be optimistic that the political leadership will take on economic reforms on an emergency footing following negotiations among major political parties.
While knowing that windfall in export commodity prices and recent CSF flows, which have given a cushion to economy on the balance-of-payment front, the State Bank has appropriately placed the ball in the politicians'' court, and has aptly adopted a wait-and-see policy.
The mandate of the SBP is to check prices and spur growth as well. With one pricing factor (exchange rate stabilised) amid the impact of recent rate hikes has been visible on growth. Considering that the LSM index declined by 2.3 percent in the July-November period, the SBP''s decision to choose growth over pricing, for next two months, makes a lot of sense.
This appears to be a smart move based on following premises: one, the monetary policy review is a bimonthly exercise and economic indicators - BoP and inflation numbers - are not expected to be out of control in the two months. And so, despite the fact that ''inflationary expectations'' are building, keeping the discount rate at 14 percent may not adversely affect the equation.
Surging international food and commodity prices are also playing a role in intensifying expectations of rising domestic inflation. Thus, the revised projection of average CPI inflation for FY11 falls in the range of 15 to 16 percent, along with high probability of double digit inflation in FY12.
Second, the IMF has postponed the release of any further tranche till the RGST implementation, which is not likely before July, so it won''t impact the decision of the pro-tightening lender, while the rest of lenders and donors have pegged their support to IMF''s consent.
Third, it will exert pressure on political parties, now that the SBP has taken a populist decision, against the market expectations. And if the politicians deviate from economic reforms, the consequence could be higher fiscal deficit and inflation, giving the SBP a clear playing field to revert back to tightening stance in March.
In his speech on Saturday, the governor State Bank, Shahid H. Kardar asserted that the demand and supply gap is not narrowing, which is fuelling inflation. This also indicates that the State Bank can use its stick to manage demand by further increasing interest rate in future.
However, he rightly pointed out that despite three consecutive rate increases, aggregate demand is not being tamed, which implies that structural issues are diluting the impact of monetary policy stance thus far. However, he refrained, for the time being, from fire fighting and fully concentrated on structural economic reforms.
He is fully aware of that fact that inflationary expectations are building owing to delay in tax policy reforms and the failure to withdraw energy and petroleum subsidies. Such populist steps are hindering foreign flows and threaten to add problems to fiscal management.
But at the same time, Kardar is bold enough to accept that structural and policies frictions are making the monetary policy impotent.
Since earlier this year, the overhang of note printing is visible in inflation as SBP expects core inflation to rise in the coming two months. So, by no means inflation dragon is asleep.
However, despite these economic challenges the only silver lining in macroeconomic fundamentals ie balance-of-payment is enough for Kardar and his team to give the carrot to political leadership.
But, in the absence of tough political decisions, the SBP may revert to its stick of tightening. That will not only pressurise the fiscal situation by increasing debt servicing cost but also add pressure on politicians whose approach to even hardcore economic issue is often based on political posturing and misperception.
The theory gains dividends, as reportedly there was a split amongst monetary policy committee members on the decision, with technical people of SBP in favour of the rate hike, while the governor and external members lobbied against it.
The governor and external members are well abreast of the political realities and have vast experience of dealing with politicians. There are cognizant of fiscal gravity and the reforms in the pipeline, in the absence of which the finance minister fears the fiscal gap would cross 8 percent of GDP.
The governor also substantiated his optimism on the fact that the government''s outstanding borrowing from the SBP, on cash basis, which crossed Rs 1500 billion by mid December was back to Rs 1277 billion by January 25. Although he acknowledged that this was due to CSF inflow ($743m), the transfer of SBP profits (Rs 40bn) and more reliance on commercial banks, he is betting that the government would keep its promise to freeze its borrowing from SBP at current levels.
All this boils down to his hope that the government and the opposition will sit together to form and implement an economic agenda.
And if the government will not evolve consensus, which also requires the federating units to be on the same page, a bigger rate rise will be inevitable. Plus, it makes more sense to have a 100 basis point rise come March than having two hikes of 50 bps each. Who knows that might be at the back of mind of Kardar.
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