Analysis of monetary policy statement

The much-awaited Monetary Policy Statement (MPS) of the SBP was released a few days ago. It contains a review of the state of the economy and an assessment of the short-run prospects, based on which the Monetary Policy Committee (MPC) has decided on the policy rate of the SBP for the next two months.
The policy rate has been reduced by 75 basis points to 12.50 percent from 13.5 percent. There was generally on expectation in the business community and among independent economists that there was a need to bring down the prevailing rate by 200 to 300 basis points. The economy had remained mired in a recession and especially with the potentially large negative impact of the Corona Virus there was need to adopt a more expansionary monetary policy to prevent a further slowdown and loss of employment.
The key elements of the assessment by the MPC are, first, that the economy can still achieve a GDP growth rate of 3 percent. This is apparently even after the damage by the Coronavirus both to the global and the national markets and production. Consequently, there was only a 0.5 percent reduction in the projected growth rate of the economy by the MPC for 2019-20.
Second, the expectation of the Monetary Policy Committee (MPC) is that there will also only be a moderate decline in the rate of inflation, despite a huge fall in oil prices. For the next three months, the expectation is that the headline inflation will remain in the range of 11 to 12 percent forecast for FY-20, before falling to medium-term target range of 5 to 7 percent.
Third, the impact of the Coronavirus on the current account is expected to be mildly positive as the savings from low oil prices were likely to offset the potential weakness in net exports and remittances. Fourth, according to the MPC the process of fiscal consolidation remains on track, although there is recognition that going forward there are challenges in achieving the revenue targets for the year.
Therefore, the overall assessment by the MPC is, more or less, on the positive side regarding the short-run prospects for the economy. This is based on the view that 'the spillover effect of the Corona outbreak on global and financial markets will be moderate and short-lived' and that the 'decline in most economic sectors was bottoming out before the Coronavirus'. However, the MPC has emphasized that it is ready to take further actions if and when needed as more information becomes available on the outlook for inflation and growth.
An objective appraisal of developments in the economy in the last eight months leads to different conclusions. The growth trends in different sectors are more on the negative side, as indicated by the following:
(i) The large-scale manufacturing sector has been experiencing negative growth since the month of December 2018. According to the estimates released for January 2020, the sector has demonstrated a high negative growth rate of 6 percent on a year-to-year basis. Cumulatively, in the first seven months of 2019-20 the decline is 3.4 percent. The fall is widespread, with the majority of the 15 industrial groups showing only a slight increase or a fall in production.
(ii) The agricultural sector has already witnessed a big fall in cotton output of over 10 percent. Prospects for the sugarcane and wheat crops are not promising given the fall in the area under cultivation of these crops and a rust attack on the latter crop.
(iii) Construction activity remains depressed. Development spending is even below the real level attained in 2017-18 by 25 percent. Domestic consumption of cement is up by only 1 percent while it has fallen in the case of steel products by over 16 percent.
(iv) The largest sector of the economy, the wholesale and retail trade sector is, also in a state of recession due to the decline of over 15 percent in the volume of imported goods plus the fall or little growth in sales of a number of domestically produced goods like textiles, cigarettes, petroleum products, automobiles, tea, soft drinks, pharmaceuticals, etc.
(v) The transport sector is experiencing a contraction as demonstrated by the fall in consumption of High-Speed Diesel oil of as much as 11 percent and only a modest increase in sales by 3 percent of Motor Spirit.
(vi) The only sector which is likely to show a high positive growth rate is the banking sector with the high interest rates and large-scale borrowing by the Government from commercial banks. However, this is still a small sector with a share in the GDP of less than 4 percent.
Therefore, based on the above, it is clear that the economy was not performing well and even the modest growth rate of 2.4 percent in 2019-20 projected by the IMF was beginning to look unattainable. On top of this, the negative impact of the Coronavirus is becoming visible. Export orders are being cancelled and the flow of raw materials and intermediate goods for domestic industry has become restricted. Overall, the likelihood is that the GDP growth rate in 2019-20 will be less than 1.5 percent. This is much less than the growth rate of 3 percent projected by the MPC. There is need to recognize that the economy will remain in a deep recession for some time.
Turning to the inflation rate, there are indications that the inflation rate has begun to moderate substantially. It has already fallen from 14.6 percent in January to 12.4 percent in February. The Sensitive Price Index, which acts as a leading indicator, has shown a big fall in rate of increase in the overall price index of 51 major commodities, which have a weight of over 60 percent in the CPI. The rate of inflation was 16.1 percent in February which has declined very sharply to 12 percent in the first three weeks of March. This ought to be reflected in a decline in the headline rate of inflation in March.
The precipitate fall in the international price of oil could also bring down the rate of inflation significantly as identified by the MPC. This is likely to come through fully in the next two to three months. As such, if half the benefit is passed through in the form of lower domestic retail prices of petroleum products then this alone could bring down the rate of inflation by 1.5 to 2 percentage points.
Overall, there is a strong likelihood that from April onwards the headline rate of inflation could fall to a single-digit. As such, the MPC has set a policy rate which implies a high real interest rate of over 2.5 percentage points.
The bottom line is that with the impact of the Coronavirus the primary problem confronting the national economy will be a deepening state of recession and not a high rate of inflation. The appropriate recommendation of the MPC ought to have been a reduction in the policy rate by 200 to 300 basis points. This would have helped production units facing decline in either domestic or foreign sales to reduce their costs of working capital and thereby provide a buffer for not having to resort to large-scale retrenchment of workers. As indicated, the MPC needs to quickly review its decision on the policy rate.
(The writer is Professor Emeritus at BNU and former Federal Minister)