Another hike in policy rate

The Monetary Policy Committee (MPC) of State Bank in its meeting held on 29th March has again decided to increase the policy rate by another 50 basis points (bps) to 10.75 percent with effect from 1st April, 2019. Explaining the decision, the Monetary Policy Statement (MPS) has stressed "that sustainable growth and overall macroeconomic stability requires further policy measures as (i) underlying inflationary pressures continue; (ii) the fiscal deficit is elevated and (iii) despite an improvement, the current account deficit is still high." Talking of inflation, the MPS says that CPI inflation reached 6.5 percent in July-February, 2019 compared to 3.8 percent in the same period of last year. YoY inflation rose considerably to 7.2 percent in January and further to 8.2 percent in February, 2019 -- the highest YoY increase in inflation since June, 2014. The pressure on prices was explained by adjustments in the prices of electricity and gas, a significant increase in the prices of perishable food items and the unfolding impact of exchange rate depreciation. Overall, CPI inflation was projected to fall in the range of 6.5-7.5 percent during 2018-19. In the real sector, growth in LSM has declined by 2.3 percent during July-January, 2019 as against 7.2 percent growth recorded in the same period of last year. This together with lackluster performance in the agriculture sector and consequent slowdown in the services sector is likely to reduce the GDP growth rate to 3.5 percent in FY19.
In the external sector, C/A deficit has narrowed to dollar 8.8 billion in July-February, 2019 compared to a deficit of dollar 11.4 billion in the same period of last year - a fall of 22.6 percent. This reduction was driven mainly by a reduction of 29.7 percent in trade deficit as well as a strong growth in home remittances. The reduction in trade deficit was in large part due to import compression. The narrowing of C/A deficit has translated into some stability in foreign exchange market. SBP's foreign exchange reserves have gradually recovered to dollar 10.7 billion by 25th March, 2019. "As enunciated in the previous statement, concerted structural reforms are required to reduce the trade deficit by improving productivity and competitiveness of the export-oriented sectors," says the MPS.
Fiscal deficit for the first half of FY19 at 2.7 percent of GDP was higher when compared to 2.3 percent in the same period of last year. In view of the shortfall in revenue collections and escalating security-related expenditures, the fiscal deficit target for FY19 would be breached. Fiscal deficit was financed through borrowings from SBP, which if continued, will not only complicate the transmission of monetary policy but also dilute its impact and prolong the ongoing consolidation efforts. Overall, money supply grew by 3.6 percent during 1st July-15th March, 2019 against a 2.4 percent increase in the same period of last year.
Coming to the rationale behind the decision of a modest rise in the policy rate, we feel that the MPC, under the circumstances, is fully justified in tightening the monetary policy further. No central bank can afford to reduce or keep the policy rate unchanged when inflationary pressures are accentuating or building up in the economy, budget deficit is deteriorating fast, external sector continued to be under a great deal of pressure, GDP growth rate is slowing down and overall macroeconomic stability is under threat. Unfortunately, however, whatever the claims of the government, these aggregates are not likely to improve soon but could aggravate further if appropriate policies are not adopted in the near future. Inflation rate, for instance, is not going to reduce in the coming months. Rising input costs on the back of higher energy prices and the lagged impact of exchange rate depreciation are likely to maintain upward pressures on inflation despite a moderation in aggregate demand on account of proactive monetary management. Fiscal policy is likely to be quite expansionary in the remaining part of the year due to a shortfall in revenue receipts and a sharp increase in security-related expenditures which cannot be curtailed due to persistent threat on the eastern border of the country. The irony is that instead of curtailing expenditures, the government is initiating financing schemes like concessionary loans to special persons and "Ehsaas" to get some political mileage in a difficult situation. The MPC seems to be somewhat satisfied and relieved by some improvement in the C/A deficit but it must be noted that the gap in the external sector is still huge and unsustainable. The assistance from friendly countries to finance the C/A deficit is also a one-time affair and cannot be relied upon to provide support to the balance of payment position year after year. In a situation like this, Pak rupee is likely to depreciate further. There is also a likelihood that prices of POL products would rise further with effect from 1st April, 2019. The rising inflationary pressure in the country could have been moderated or diluted to a certain extent if availabilities in the economy as measured by the GDP growth rate were adequate to cushion the impact of other negative factors. Since the GDP growth rate is also likely to be much lower than last year, it would add to the inflationary impulses in the economy. The government had targeted CPI inflation at 6.0 percent during FY19 and the SBP has now estimated it to be in the range of 6.5 percent to 7.5 percent. We are afraid that it could be somewhat higher than this range due to the persistence of a wide range of negative factors, forcing the SBP to keep tightening the monetary policy further. A programme with the IMF will almost ensure that this line of action is adopted to stabilise the economy and keep the demand pressures in check. Obviously, the tightening of monetary stance is more likely to yield the desired objectives if the fiscal policy of the country is also supportive.
The SBP, in our view, also needs to support some other measures if the full impact of tightening of monetary stance is to be realized. For instance, to promote savings and curb consumption in the economy, the SBP should advise banks to reduce their spreads between deposit and lending rates and offer more lucrative rates to depositors to change their saving behaviour. Also, the SBP should not be a party to government's social objectives. The advice of the government to the SBP to initiate concessionary schemes for priority sectors and special class of people is not only unfair but could also blunt the efficacy of the policy rate instrument to a certain extent. There are reports that IMF has asked the government to enhance the autonomy of the SBP. If this is done, the government may be barred from interfering in the monetary policy formulation processes directly.