Why monetary policy prudence is a virtue

The upcoming monetary policy announcement on September 12th comes at a time when headline inflation has dropped to single digits for the first time in nearly three years. With the current policy rate at 19.5 percent, real interest rates stand at 10 percent, both on the spot and in 12-month forward inflation projections, as most analysts predict single-digit inflation for the year ahead.

The good news is that inflation is falling faster than expected, driven by a significant slowdown in the domestic economy and softening global commodity prices. The Monetary Policy Committee (MPC) has already begun reducing the policy rate, cutting it by 250 basis points (bps) in the last two reviews. Another cut in the upcoming review seems almost certain.

The key question now is the pace of this decline. With inflation sharply dropping and international oil prices easing, the business community and stock market analysts are hopeful, speculating about a significant cut of 300 bps or more. However, the hawks on the MPC advocate for caution; this was evident when two members voted for only a 50-bps rate cut in the last review.

The argument for a gradual easing is to ensure that inflation remains low in the long term. Three critical factors must be balanced in Pakistan’s current economic situation: inflation, the external account, and growth.

The more pressing short-term issue is the external sector. Given Pakistan’s economic structure, the country cannot sustain growth above 3 percent without disrupting the external balance. A sharp decline in the policy rate could trigger a surge in imports, raising concerns about the balance of payments.

Economics is not an exact science, and decisions on monetary policy are not purely based on mathematical models. The MPC likely does not know the exact interest rate that would support growth without risking a balance of payment crisis. Therefore, a gradual easing of the policy rate is wise to reach a sustainable equilibrium.

If the State Bank of Pakistan (SBP) were to cut the policy rate to 14-15 percent in one go, it could stimulate economic demand and consequently increase imports. However, the country lacks the external reserves to finance a large surge in imports, especially since higher growth in Pakistan is closely tied to significant increases in imports.

Export growth, which could offset these imports, is a gradual process and unlikely to happen in the short term. Until export growth picks up, GDP growth will remain stuck around 3 percent or lower. Encouraging exports is a slow process; low domestic demand forces firms to explore new export markets. Keeping domestic demand subdued incentivizes firms to seek opportunities abroad.

To control imports and achieve an optimal interest rate level, the prudent approach is to reduce rates gradually. The balancing act is also fiscal; under IMF (International Monetary Fund) conditions, the government is expected to maintain a primary surplus, which will help stabilize the economy and provide room for private-sector growth within the country’s limits.

Stabilisation is slowly taking hold, and rushing into larger rate cuts could risk reversing this progress.

By moving gradually, MPC members can make more informed decisions about when to pause rate cuts. It would be more prudent to implement three 150bps cuts rather than a single 450bps cut to reach a 15 percent policy rate. If demand picks up sharply, the SBP could find itself in the uncomfortable position of reversing its stance.

Not long ago, when inflation peaked at 38 percent, real rates were negative at 16 percent, and that inertia may still influence the economy. Thus, maintaining a positive real rate of 10 percent can be seen as a balancing measure. Another perspective to consider is the SBP’s commitment to its medium-term inflation target of 5-7 percent. This target has been mentioned for years but remains elusive.

Maintaining high real rates could help achieve this goal. If sharper cuts are desired, the target may need to be adjusted upwards. The key is to ensure that inflation expectations are anchored, as the fear of hyperinflation was very real not long ago.

Given these dynamics, the IMF’s influence acts as a restraining force on the pace and magnitude of interest rate cuts in Pakistan. The SBP and the MPC must carefully weigh the benefits of rate reductions against the potential risks of violating IMF conditions and destabilizing the economy.

As Paul Volcker, former Chairman of the Federal Reserve, wisely noted: “The first duty of an institution is to survive.” In the context of Pakistan’s monetary policy, this means adhering to IMF guidelines to ensure economic stability and continued financial support. This caution aligns with a gradual approach to interest rate cuts, balancing the need for growth with the imperative of maintaining economic stability and meeting international obligations.

Copyright Business Recorder, 2024