Another hike in sight?

Hold on, another round of policy rate hike is expected in the next two months. Instead of playing catch-up or adopting an approach or a strategy intended to overcome a disadvantage with a larger rise, SBP intends to keep the real interest rate positive as negative rates have adverse implications for foreign exchange reserves.
The monetary policy is out, and the fly on the wall says that two independent economists on the policy committee reportedly engineered the decision against the market expectations. It wasn't a unanimous decision; though, an overwhelming majority (6 versus 2 while the ninth member attending the meeting did not vote.
However, he expressed his opinion in favour of a hike) with influential members in the monetary policy committee (MPC) favoured the continuation of tightening. The central board of directors of the State Bank, however, unanimously voted approval of the MPC decision, sources close to SBP revealed.
Excessive government borrowing in the first quarter of this fiscal year left no option to the MPC with no option but to further tighten the government screws by increasing the policy rate by 50 basis points (bps), sources within the committee revealed. The government borrowed Rs 220 billion between July and September 24, 2010 as against Rs 126 billion borrowed in the corresponding period last year.
"This is against the spirit of macroeconomic stabilisation, since the elimination of government borrowing from the SBP was one of the main commitments of such a program" MPS stated, while referring to the IMF's requirements. Fresh government borrowing from the banking system along with the rollover risk, owing to heavy short-term borrowing by selling T-Bills to scheduled banks, amid the absence of a proportionate increase in tax revenues is imminent. "This entails substantial risks to economic stability in the immediate future and places a considerable pressure in the medium term on the already high debt burden of the country," the MPS stressed.
The central bank acknowledged that the recent inflationary pressures are due to floods and it may take two to three months for inflation to return to normal levels. However, the central bank estimates CPI for FY11 to fall between 13.5 -14.5 percent - one which appears on the conservative side given mounting uncertainty.
"Likely increases in electricity prices, induction of the Reformed GST and continued reliance of the government on borrowings from the SBP only add to the uncertainty surrounding inflation expectations", the MPS stated in a cautionary note. Supportive and sustained financial efforts over the next two years are imperative for bringing inflation down to single digits.
"How the fiscal policy response to the floods is incorporated in the revised budget remains to be seen, but it is clear that even attaining the deficit of 5.2 percent of GDP will require considerable adjustment in the key fiscal parameters", the MPS added, while pointing out that 7.5 percent growth in tax revenues during July-August FY11 compared to the full year budget target of 25.6 percent does not instil much confidence.
There are also pressures on the external front, with more reliance on foreign borrowing due to continuous decline in domestic national savings and foreign private investment. "The expected increase in the external current account deficit and uncertain foreign inflows could put pressure on SBP's foreign exchange reserves and exchange rate in FY11", the central bank warned.
This might worsen the ratio of net domestic assets to net foreign assets and the overall inflation outlook. "More is expected from the fiscal authority to articulate and implement a coherent strategy and the market continues to look to government for greater fiscal discipline to allay expectations of rising inflation", the bank asserted.
Lastly, rising non-performing loans of the banking sector and low private sector demand may incentivise already risk shy banks to lend more to the government. This was pretty much summed up by SBP, by highlighting that a tightening of the stance is thus called for, in full recognition that the difficulty to contain fiscal deficit has resulted in the private sector bearing the full brunt of such an adjustment.