To cut or not to cut

The monetary policy committee is meeting today to largely deliberate on the policy rate. It is widely expected that inflation is going to taper off, and there are two options SBP has: either to cut the rate today or wait for some time. The rationale for the cut is that real rates on a 12M forward basis (on expected inflation) are positive and lowering the rates would help lower the fiscal deficit and financial strain on the private sector.

Well, the counterargument is that the current inflation readings are still much higher than the policy rate and the SBP reserves are not enough to even cover the two months of suppressed import cover. The country cannot afford, without additional debt/FDI flows, to run the current account deficit. Any cut in the rate can potentially cause a surge in imports that the country simply cannot afford until the reserves are built.

Thus, the one-liner message to the monetary policy committee is to keep the real rates high to keep the current account in check. Hence, wait for inflation readings to come down before easing the policy rate.

Somehow this message is being internalized by the market as well which was pricing in a rate-cut in November, as secondary markets spreads contracted by over 100 bps that month. However, seeing the latest inflation reading at 29.2 percent (which is higher due to gas price adjustment), the secondary market rates moved up, and now the spread contraction is below 50 bps.

The main objective of the monetary policy is price stability. That has not been the case lately in Pakistan, as headline inflation was 29 percent last year and is expected to be at 25 percent this fiscal year. The SBP has remained behind the curve for most of the time and that had a bearing on inflation expectations.

Finally, the expectations are anchoring, however, they are still fragile, and SBP should remain hawk to further stabilize the expectations. The key variable is to look at the exchange rate. Its slippage is primarily causing high inflation, and lately, the currency is being stabilized. Touch wood. Don’t fiddle with it, as any easing signal can spur demand and could result in pressure on the currency. And once the currency slips again the inflationary expectation can very much become uncensored, as not long ago, Pakistan was almost in hyperinflation (especially in food). It’s better to be patient.

Having said that, the global commodity prices are easing down, as the commodity Super cycle is over, and the global demand is coming down. That is good news for Pakistan and is helping to anchor the inflation expectations. However, the global interest rates are still up and are likely to remain high. Any premature cut in Pakistan can create currency depreciation pressure due to a lower interest rate differential.

Hence, to keep sanity in the exchange rate and to keep the current account in balance (zero CAD), a wise move would be to keep the interest rates unchanged.