The State Bank of Pakistan (SBP) increased the key interest rate by 125 basis points, taking it to 15%. This was announced on Thursday by SBP Acting Governor Dr Murtaza Syed during a press conference held on the Monetary Policy Committee's (MPC) decision amid expectation of further tightening due to a higher inflation outlook.

The SBP's latest move to increase the key interest rate takes it to its highest level since November 2008.

"At today’s meeting, the MPC decided to raise the policy rate by 125 basis points to 15 percent," said the Monetary Policy Statement (MPS) released at the same time.

"In addition, as foreshadowed in the last monetary policy statement, the interest rates on EFS and LTFF loans are now being linked to the policy rate to strengthen monetary policy transmission, while continuing to incentivise exports by presently offering a discount of 500 basis points relative to the policy rate."

The MPS added that the combined action continues the monetary tightening underway since last September, which is "aimed at ensuring a soft landing of the economy amid an exceptionally challenging and uncertain global environment".

Also read: Here is a look at SBP's previous monetary policy announcements

Adjustment is difficult but necessary in Pakistan, as it is all over the world. However, in the interest of social stability, the burden of this adjustment must be shared equitably across the population: Monetary Policy Statement

It added that since the last meeting, the MPC has noted three encouraging developments.

"First, the unsustainable energy subsidy package was reversed and an FY23 budget centered on strong fiscal consolidation was passed.

"This has paved the way for completion of the on-going review of the IMF programme, which will ensure that tail risks associated with meeting Pakistan’s external financing needs are averted.

"Second, a $2.3 billion commercial loan from China helped provide support to FX reserves, which had been falling since January due to current account pressures, external debt repayments and paucity of fresh foreign inflows.

"Third, economic activity remains robust, with the momentum of the last two years of near 6 percent growth carrying into the start of FY23. As a result, Pakistan faces a significantly lower trade-off between growth and inflation than many countries where the post-Covid recovery has not been as vigorous."

However, it noted that several adverse developments have overshadowed this positive news.

"Globally, inflation is at multi-decade highs in most countries and central banks are responding aggressively, leading to depreciation pressure on most emerging market currencies. This strong monetary tightening has occurred despite concerns about a slowdown in global growth and even recession risks, highlighting the primacy that central banks are placing on containing inflation at this juncture.

"Domestically, as energy subsidies were reversed, both headline and core inflation increased significantly in June, rising to a 14-year high. Inflation expectations of consumers and businesses also rose markedly. At the same time, the current account deficit unexpectedly spiked in May and the trade deficit continued its post-March widening trend to reach a 7-month high in June, on burgeoning energy imports. As a result, FX reserves and the Rupee remained under pressure, further worsening the inflation outlook."

Pakistan is facing a large negative income shock from high inflation and necessary but difficult increases in utility prices and taxes. Without decisive macroeconomic adjustments, there is a significant risk of substantially worse outcomes that would compromise price stability, financial stability and growth: Monetary Policy Statement

The MPC said it noted the importance of strong, timely and credible policy actions to moderate domestic demand, prevent a compounding of inflationary pressures and reduce risks to external stability.

"Like most of the world, Pakistan is facing a large negative income shock from high inflation and necessary but difficult increases in utility prices and taxes. Without decisive macroeconomic adjustments, there is a significant risk of substantially worse outcomes that would compromise price stability, financial stability and growth.

"This could take the form of runaway inflation, FX reserve depletion and the need for sudden and aggressive tightening actions later that would be significantly more disruptive for economic activity and employment.

"Adjustment is difficult but necessary in Pakistan, as it is all over the world. However, in the interest of social stability, the burden of this adjustment must be shared equitably across the population, by ensuring that the relatively well-off absorb most of the increase in utility prices and taxes while well-targeted and adequate assistance is provided to the more vulnerable."

Previous MPC meeting

In the previous meeting held in May, the MPC raised the policy rate by 150 basis points (bps) to 13.75%, aimed at containing rising inflation and mitigating the risks to external stability.

Back then, the central bank had said that as electricity and fuel subsidies are reversed, inflation is likely to rise temporarily and may remain elevated through FY23 before declining sharply during FY24.

In June, Pakistan reported inflation at 21.3% on a year-on-year basis compared to an increase of 13.8% in the previous month and 9.7% in June 2021. Most analysts saw this number as higher than expected.

Expectations on announcement

Although analysts had mixed views on the upcoming policy, most of them expected a further increase in the key policy rate. A poll, conducted earlier by Topline Securities, found that around 45% of the participants expected the policy rate to increase by 100bps, 30% anticipated an increase of 150bps, while 5% expected an increase of more than 150bps.

Monetary policy: majority expects at least 100bps hike as inflation highest since Dec 2008