There was a strong noise of 150 bps increase; and it happened. The rumor had it as a prior IMF condition and this perhaps is good compliance. The stance is hawkish and the words seem not at all influenced by the Q Block, but surely have the IMF's tone.
The policy rate now stands at 12.25 percent and the discount rate is at 12.75 percent. The headline and core inflation In April stood at 8.8 percent (10M average 7%) and 7.0 percent (10M average 8.1%), respectively. The 12 Month moving average of core is 7.9 percent while headline is at 6.6%. The past trend suggest that CPI is increasing every month but the core is on the fall. In simple words, food and fuel prices - cost push, are on the rise while demand driven inflation is falling. Theory says that monetary policy tightening is meant to curb demand.
The word is that IMF condition is to keep minimum 2 percent real interest rates. Seeing yesterday’s decision, the spread is perhaps on future expected inflation deriving from macroeconomic models with no or little role of judgment. Economics is not a real science, and a standardized model cannot be run everywhere without adapting to domestic realities.
And the most critical role is of judgment of the economic manager where someone having domestic economic knowledge could have an edge. Another question is why urge for deciding on future expected inflation today when the central bank announces monetary policy every two months.
The inflation is expected to increase due to currency depreciation - which could be more, as the foreign reserves are too low and the exchange rate is now market based, passing on energy prices - not much impact on CPI as two third of consumers slabs are below 300 units consumption where prices are not expected to increase; and the rationalization of taxes. Let us see how high inflation goes, and it depends on how much currency further depreciates.
One rationale for hawkish stance could be that the central bank is overly cautious in correcting external imbalances, falling reserves position and slippery fiscal deficit. The fiscal side is in a mess and the deficit would be north of 7 percent in FY19. But how higher interest rate could reduce it further? Debt servicing is surely going to soar, but the IMF target is primary deficit - excluding debt servicing. The government has already cut down its development spending, in current expenditure administrative efficiencies can lower expenditures, but not interest rates.
The element of enhanced central borrowing is inflationary in nature. The borrowing is shifted from commercial banks as latter are not inclined to lend at prevailing rates. This is happening because central bank has given a put option to banks to park the excess liquidity at policy rate with SBP which is 50 bps below discount rate. The floor of corridor is 150 bps lower than the policy rate, but that is rarely used. If the central bank mops up the excess liquidity at floor, banks would be happy to lend to government at prevailing rates.
Last but not the least is external imbalance. The non-oil trade deficit is declining due to ongoing tightening, not much can be done for lowering oil trade deficit, but to hope for a fall in oil prices or ration consumption through load management (read load shedding).
The crucial part is the fall in foreign exchange reserves, and that has to be built. In Egypt, higher interest rates brought foreign portfolio investment in the country, and that jacked up reserves. Now with falling rates, the hot money is evaporating. IMF thinking could be to have a replica of it in Pakistan. The window to do tough reforms exists till those flows remain intact or till the interest rates remain high.
One big assumption is that like Egypt, foreign flows will come in Pakistan, but historically this never happened in Pakistan. A better option could be to excess global capital market directly, as in case of former, the economic slowdown at home is a little too high a cost.
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