Hawkish Fed haunts SBP

Now you know why the State Bank of Pakistan (SBP) implied that the monetary policy committee (MPC) might meet before its next scheduled meeting on 19 April 2022 if necessary. The Federal Reserve, America’s central bank, raised its benchmark interest rate by 25 basis points this past week; in keeping with expectations. And since there’s no butterfly effect quite like the one that’s unleashed when hawks dominate the monetary policy of the world’s largest economy, emerging and frontier markets are the first to fix their gaze on trends reflecting inflation as well as flight of capital — to know when to raise their own rates as well.

Therefore, there’s a good chance that the MPC’s wait-and-see policy has already run its course because a lot of forces are going to pressure it at once. The Fed rate hike is already strengthening the dollar, which will further squeeze currencies like the Pakistani rupee. It’s an entirely different thing that domestic political instability and the external commodity supercycle have already pushed it to its weakest level in history. Now that those pressures will continue, and the interest rate influence will further boost the dollar, it’s anybody’s guess where the rupee will ultimately settle.

This will definitely inflate the foreign debt, and deflate the local economy, in dollar terms. It will also route more development funds towards debt servicing and weaken the country’s position with international lenders. Upsetting the IMF (International Monetary Fund) and endangering the EFF (Extended Fund Facility) at this time, that too because of an untenable, politically-driven “relief package”, no longer seems like a good idea, does it?

The current account will also come under more strain. Supply side commodity price shocks were already stretching the budget, now a stronger dollar, and a weaker rupee, because of the Fed hike will further increase prices of imports. It’s a shame that exports have never responded well to devaluation, no matter how steep, in Pakistan. In fact, since some if not most exports need imported inputs, the effect is quite the opposite most of the time.

That’s not all. Diminishing interest rate differential also cuts the so-called carry trade, where investors borrow in low interest rate currencies and invest in higher ones for better returns. Much of the foreign portfolio investment (FPI) that flooded into Pakistan in the last couple of fiscals was in fact carry trade hot money. Now, as higher interest rates increase returns on investment in bigger and better economies, FPI in emerging and frontier markets is duly beelining for the exit lounge. With FDI and FPI both on the run, and the currency falling and inflation rising, surely SBP will feel pressured to raise rates once again.

The Fed’s decision was telegraphed well in advance — by at least six months or so. Yet the uncertainty caused by the Russia-Ukraine war, especially supply chain constraints, might have caused it to raise less than it would have otherwise; since inflation in the US is the highest in more than four decades. With global demand outstripping supply because of the war, and energy prices tearing through the roof because of all the sanctions and counter-sanctions, there is now a fear that tightening monetary policy too sharply too quickly might cause stagflation on a very large scale; hence the caution, of sorts, and only a 25bp increase.

Pakistan’s problems are similar, but much bigger. The government desperately needs to stimulate the economy, for which monetary policy would have to complement fiscal policy. But whenever it tries to sneak expansionary fiscal provisions past the IMF, it has to take two steps back soon enough. And now SBP will, most likely, not even be able to hold rates steady any longer; even if supply-side pressures, not quite roaring demand, are stoking inflationary pressures. That could lead to visible stagflation by the time this fiscal is over.

You can be sure that neither political uncertainty nor the commodity price rush, which were squeezing the rupee and raising prices till the hawks in the Fed also started haunting the SBP, will have dissipated till then. It’s a safe bet, then, to expect the screws to tighten further next time.

Copyright Business Recorder, 2022