The central bank of Pakistan believes that the medium-term inflation target of 5 – 7 percent shall be achievable by September 2025. In the January 2024 MPC meeting, the SBP publicly gave itself a hard target for the first time to reach the target inflation rate by a certain month, earlier setting the medium-term target, well, somewhere in the medium-term. The was followed by the Bank setting ‘7 percent’ as the threshold inflation rate for Pakistan’s economy, “beyond which there exists a negative relationship between inflation and economic growth” in the Special Section on Drivers of Inflation in Pakistan, published last month as part of its biannual State of the Economy report.
The recent declarations by the Bank on inflation deserve commendation, in so far as they demonstrate a willingness to listen to feedback and criticism on its various policy stances and respond to them with data and evidence-backed research. This is marked progress from the previous leadership of the bank which in 2023 got surrogates from private sector such as PBC and APTMA to fight its battle, when the Covid-era concessional finance scheme TERF came under criticism.
Although the bank setting itself a hard target on inflation is commendable, the path to medium term continues to appear tricky. On one hand, the economic authorities, including the IMF, expect inflation to average in double digits in the upcoming financial year of 2024-2025, using inflation forecast for FY25 as a justification to keep the monetary screws turned tightly off for the near term. Given both the Fund and the SBP have better visibility on drivers of inflation such as expected revisions in energy tariffs, or quantum of currency depreciation for example, keeping monetary settings tight makes sense – lest the hard won and still fragile monetary consolidation might unravel.
Yet, the math does not add up anymore. If annual inflation averages anywhere above 10 percent – which translates into average month-on-month of 1.15 percent and above – then inflation would in fact begin to creep back up last quarter of the next fiscal year, rather than continuing to fall towards the medium-term target.
If, however, inflation reading is to fall anywhere close to the medium-target of 5 – 7 percent by September 2025, then the pace of month-on-month increases will have to fall considerably, at least to 0.6 percent per month or lower. But here is the kicker: if the rate of change truly slows down to this level in the near term, then inflation target would be achieved much sooner: possibly even October 2024.
This is where things get even trickier, ever since Pakistan transitioned to a market-based exchange rate mechanism in 2019, the country has not witnessed an annual-average month-on-month inflation rate below 0.65 percent. In fact, the month-on-month inflation rate over the last 96 months has averaged above 1.08 percent. Although recent readings clearly pull that average higher, inflation truly lost its bearings in Pakistan ever since the rug was pulled from under the currency.
And this is the important point: during 2018-19, Pakistan’s exchange rate witnessed a correction of nearly 24 percent over the preceding fiscal year, which became the proverbial straw that broke the CPI’s back, raising average month-on-month run rate from 0.45 percent to over 0.65 percent the following year. The year before, currency depreciation of under 5 percent (on average) also doubled the month-on-month inflation run rate from 0.22 percent to 0.44 percent.
This is no econometric analysis. But the high level of sensitivity to exchange rate depreciation displayed by inflation over the last decade does indicate that the medium-term target will probably be out of reach if the currency witness’s significant depreciation – especially if the quantum of depreciation goes into double-digit territory. And if the vicious cycle of crisis of confidence in currency returns, then all bets of taming inflation down to medium term target could be off.
It seems the economic authorities either have their eyes closed or are simply being dishonest to themselves. If the market-based exchange rate is to be retained, then the medium-term inflation target is no longer realistic. SBP has taken the first right step by opening the discussion on threshold level of inflation. It should take the discussion to the logical ending, by laying out the path (and the steps needed) to reach that target, if at all possible.
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