Possibility of a cut in discount rate

There are some strong indications of a cut in the discount rate by the State Bank in the near future. In the latest auction conducted by the SBP on 17th June, 2009, banks offered a total amount of Rs 131.7 billion for investment in treasury bills but the central bank remained cautious and picked up Rs 58 billion for one year and Rs 5 billion for six months.
From the banks' bids for 12-month which exceeded Rs 114 billion, it seemed that they were in a race to invest maximum amount in T-bills of one year maturity, anticipating a further reduction in interest rate on government paper within weeks. State Bank also responded in a similar fashion by slashing the cut-off yield on 12-month T-bills by 100 basis points to 12.24 percent while six-month T-bills' rate was sliced by 71 basis points to 12.43 percent.
A higher reduction in yield on long-term government paper and banks' preference to invest in this instrument at a comparatively lower rate was a signal of a downward revision in the policy rate by the State Bank. Such a view was also reinforced by the SBP Governor in post-budget briefing to the Senate's Standing Committee on Finance when he said that mark-up rates might be reduced in the wake of a reduction in inflation, warning, however, that low interest rates, huge allocations for development spending and increase in wages might spur demand, leading to resurgence of inflation.
The State Bank's recent stance on monetary policy, though viewed by certain circles as extra cautious and too rigid, has been quite unambiguous. It does not want to ease monetary policy unless it is convinced about softening of inflationary pressures in the economy. The developments during the current year are indicative of such a strategy.
Discount rate, also called repo rate, was enhanced by two percentage points to 15 percent in November, 2008 when the country was faced with high inflation and this trend seemed to be entrenched. With the tightening of monetary policy backed by a complementary improvement in fiscal discipline, especially post-November, 2008, domestic demand decelerated and this together with certain favourable international and domestic developments had the desired impact on the price pressures.
However, as there were still doubts about the gains on inflation front, the policy rate was kept unchanged at the time of January, 2009 monetary policy statement (MPS). The easing of inflation in the later months, nonetheless, encouraged the SBP to gradually shift its policy bias towards supporting growth in the economy. Accordingly, the policy rate was reduced by 100 basis points to 14 percent effective from April 21, 2009. Apparently, the situation is now ripe for another rate cut and such a contention could be affirmed by the trend in the latest auction of T-bills and certain hints coming out from the SBP.
The argument could also be based on the expectation that on a monthly basis, inflation is likely to come down to 12.5 percent by June, 2009 and is projected to be lower at 9.5 percent during 2009-10. At the same time, shrinking of credit to the private sector is choking industrial growth and undermining export potential of the country.
It is, therefore, time to reverse the gear and make some downward adjustment in the domestic interest rate structure. A further reduction of 100 basis points or so in discount rate in MPS is likely to be announced in July, 2009. However, it needs to be pointed out that the commercial banks are not legally obliged to follow the lead given by the State Bank but they generally make the necessary adjustments in their lending rates as per the signals transmitted to them by the central banks.