Enough belt-‘tightening’

The monetary policy decision is day after tomorrow. Seeing the higher-than-expected inflation in June (at 21.3%) market expects 100-150 bps hike in rates. The secondary market rates have adjusted to 150 bps rise. The policy rate is currently at 13.75 percent and the next 12-month average inflation is expected to remain around 18-21 percent with monthly number peaking at 25-28 percent in the coming quarter. Does this mean a similar monetary tightening is warranted to keep the real rates positive (or close to zero in negative territory)? The short answer is “no”.

There is a limit to everything, and monetary tightening is no exception. Beyond certain level, the monetary tightening could prove counterproductive. In the last high inflation cycle (2008-09), the inflation peaked at 25 percent and averaged at 21 percent in FY09, the discount rate of SBP peaked at 15 percent. Today, SBP’s discount rate is at 14.75 percent (policy rate 13.75 percent). Seeing that historic perspective, there is no need to increase the rates as such from the current levels.

One reason for recent tightening (since April 2022) was to counter the fiscal expansionary policies. Prior to that, SBP maintained negative real rates due to tightening fiscal stance. There is a trade-off. If fiscal is expansionary, monetary policy must complement with contractionary stance. And once the fiscal is contractionary, the monetary policy could move the other way. That is the case today.

Then (from March 22) onwards, the expansionary fiscal policy not only resulted in higher fiscal deficit but also kept the crucial IMF programme at bay. That strained the external front and the currency depreciated. And to counter falling currency, the monetary policy had to be tightened. There is a trade-off between monetary and exchange rate policies. Now, that the IMF programme is in sight, and the currency is appreciating. That diminishes the need for further tightening.

After weighing the trade-offs and historic limits of peaking rates, SBP needs to be dovish in FY23. The fiscal policy is finally on the right track. And that is the prime reason for high inflation. The petroleum subsidies have ended. Electricity and gas subsidies have a similar fate. There are higher income taxes (to lower the disposable income) for individuals and firms. Then there are taxes on real estate and the market is flattening. There is a case for demand destruction. And this is visible from high-frequency numbers (SBP must appreciate that fact).

The high inflation in June and the next few months are due to pass on of subsidies to consumers at the time of global commodity super cycle. That is the right policy. However, that is to bring inflation. Then there are imported external factors. Such form of inflation and external slippages cannot be curtailed by interest rate hike beyond certain level.

Pricing and taxation are doing the job of demand curtailment. If that is not enough to curtail the current account deficit, government should enhance the administrative measures by closing shops and malls on weekends, by promoting work from home culture and increasing load-shedding. Some measures are already in place and more should be done, if required.

The point is that the current account control is not in the hands of monetary policy at such high rates and crazy international prices. The monetary policy must be supplemented by other factors which are in effect now. SBP should take a note and make sure to communicate in its policy statement and post-policy analyst briefing.

Having said that, SBP perhaps has the fear that it may lose creditability by not doing much. In the last fiscal year, SBP had changed the stance twice. And that was due to change in the fiscal stance. And the fiscal stance had changed due to political changes and uncertainty. SBP may be of the view that there could be another shift in the political landscape which would be in the form of change in the fiscal policy stance. And that could have bearing on the monetary policy. That is one political trade-off that must be in SBP’s mind.

The risk of this change perhaps is not much given the need for IMF programme. SBP must think of a firm stance. It should not increase rates by much. A better policy could be no increase at all. However, seeing the market movement, SBP may increase by another 100-150 bps.

In any case, SBP should come up with forward guidance to calm the market and should mark a full stop on further rate hikes beyond July. It should communicate the fiscal risks and make a call to give the right direction to the market in tough days.