CAD, inflation: Interest rate hiked by 25 bps to 7.25pc

Karachi: The Monetary Policy Committee (MPC) of the State Bank of Pakistan (SBP) has announced to raise the key policy rate by 25 basis points (bps) to 7.25 percent to curtail the rising current account deficit and higher inflation expectations.

The policy rate was remained unchanged for the last 14 months to support the economic growth. Previously, MPC in its meeting held on 25th June 2020 decided to reduce the policy rate by 100 basis points to 7 percent and since then there was no change in the policy rate.

Scheduled meeting of the MPC was held on Monday with the chair of Governor SBP Dr. Reza Baqir and after reviewing the economic indicators, the committee decided to tighten the monetary policy. The committee has also insisted further policy tightening in the future to address the risks to economic growth. The committee believed that the stance of monetary policy is still appropriately supportive of growth.

The MPC said that it will continue to carefully monitor developments affecting medium-term prospects for inflation, financial stability and growth and stands ready to respond appropriately.

According to the Monetary Policy Statement issued after the meeting, in line with the current shift in the economic outlook, the MPC was of the view that the priority of monetary policy also needed to gradually pivot from catalyzing the recovery after the Covid shock toward sustaining it. The MPC also noted that this rebalancing would be best achieved by gradually tapering the significant monetary stimulus provided over the last 18 months.

First hike in over 2 years: SBP raises key interest rate by 25 basis points

The MPC was of the view that over the last few months the burden of adjusting to the rising current account deficit had fallen primarily on the exchange rate and it was appropriate for other adjustment tools, including interest rates, to also play their due role.

Since the last meeting in July, the MPC noted that the pace of the economic recovery has exceeded expectations and this robust recovery in domestic demand, coupled with higher international commodity prices, is leading to a strong pick-up in imports and a rise in the current account deficit.

Year-on-year inflation has declined since June, rising demand pressures together with higher imported inflation could begin to manifest in inflation readings later in the fiscal year. With growing signs that the latest Covid wave in Pakistan remains contained, continued progress in vaccination, and overall deft management of the pandemic by the Government, the economic recovery now appears less vulnerable to pandemic-related uncertainty. As a result, at this more mature stage of the recovery, a greater emphasis is needed on ensuring the appropriate policy mix to protect the longevity of growth, keep inflation expectations anchored, and slow the growth in the current account deficit, the Committee said.

The MPC noted that the stance of monetary policy is still appropriately supportive of growth, with real interest rates remaining negative on a forward-looking basis.

Looking ahead, in the absence of unforeseen circumstances, the MPC expects monetary policy to remain accommodative in the near term, with possible further gradual tapering of stimulus to achieve mildly positive real interest rates over time. SBP said that the pace of this possible further gradual tapering would be informed by updated information on the continued strength of demand growth and the stance of fiscal policy, amongst other factors.

During the meeting, the MPC considered key trends and prospects in the real, external and fiscal sectors, and the resulting outlook for monetary conditions and inflation.

According to the statement, with a supportive FY22 budget and accommodative monetary policy, LSM registered 1835 percent strong growth in June before moderating in August to 2.2 percent, in line with typical seasonal patterns. The services sector is also rebounding strongly; latest Google Community Mobility Reports show that activity across grocery stores, restaurants, and shopping centres during July and August rose above pre-Covid levels. In agriculture, the decline in the area under cultivation of cotton is expected to be compensated by an increase in area for rice, maize, and sugarcane. Based on these trends, growth in FY22 is now expected toward the upper end of the forecast range of 4-5 percent, notwithstanding some greater uncertainty with respect to spill-overs from the evolving situation in Afghanistan.

On the external sector side, the current account deficit rose to $0.8 billion in July and $1.5 billion in August, reflecting both vigorous domestic demand and high global commodity prices. While remittances remained strong, growing by 10.4 percent during July-August and exports also performed reasonably well averaging $2.3 billion per month, they were outstripped by imports. In response, the rupee depreciated by 4.1 percent since the last MPC meeting, the MPC noted that many other currencies have also depreciated recently as expectations of tapering by the Federal Reserve have been brought forward.

The MPC noted that the flexible market-based exchange rate regime has performed well since its introduction in June 2019, including through the Covid shock. It has overseen a healthy modulation of the current account and supported a critical build-up in the country’s gross and net FX reserves despite external pressures.

Under this regime, the SBP does not suppress an underlying trend in the exchange rate and any interventions are limited to address disorderly market conditions.

Encouraged by 'positive developments', SBP keeps interest rate unchanged at 7%

The MPC observed that while the flexible exchange rate has appropriately played its role as a shock absorber, it is important that its role be complemented by strong exports, targeted measures to curb non-essential imports, and appropriate macroeconomic policy settings to contain import growth.

On fiscal side, the committee noted that in FY21, prudent management of the public finances facilitated fiscal consolidation for the second year in a row despite Covid, with the primary deficit declining by around ½ percentage points to 1.4 percent of GDP.

This improvement largely stemmed from strong growth in tax and petroleum development levy (PDL) revenues, together with significant deceleration in non-interest expenditures. Following the seasonal end-year release of expenditure allocations, the fiscal impulse was strongly expansionary in the final quarter of FY21.

On monetary and inflation outlook, the MPC noted that accommodative financial conditions have provided significant support to the growth recovery since the start of FY21. Following historic cuts in the policy rate and the introduction of SBP Covid-related support packages, private sector credit grew by more than 11 percent during FY21, on the back of consumer loans (mainly auto finance and personal loans) followed by a broad-based expansion in credit for fixed investment and finally working capital loans.

The MPC felt that some macro-prudential tightening of consumer finance may also be appropriate to moderate demand growth as part of the move toward gradually normalizing monetary conditions.

Inflation fell from 9.7 percent in June to 8.4 percent in both July and August. In addition to favourable base effects, this decline reflects continued deceleration in administered prices of energy due to the reduction in PDL and sales tax on petroleum products. Core inflation also fell in both urban and rural areas in August.

In addition, inflation expectations of both households and businesses have drifted up and wage growth has picked up as the recovery has strengthened. Looking ahead, the inflation outlook largely depends on the path of domestic demand and administered prices, notably fuel and electricity, as well as global commodity prices.

Copyright Business Recorder, 2021