The monetary policy announcement is set for Monday, with markets anticipating a significant 150 basis points (bps) rate cut. This expectation is reflected in the secondary market yields and the buoyant stock market, despite growing political noise.

Initially, concerns were that inflation might rise again after new taxes were introduced in the FY25 budget. However, July’s Consumer Price Index (CPI) is estimated to be around 11 percent, indicating a faster-than-expected decline in inflation, which supports the case for another rate cut following the previous 150 bps reduction. The projected inflation rate for FY25 is 11-13 percent, while the current policy rate stands at 20.5 percent, suggesting that a sharp cut may be warranted. It is likely that the International Monetary Fund (IMF) would not oppose a 150 bps reduction.

Fiscal policy in FY25 is contractionary, with the imposition of numerous new and additional direct and indirect taxes aimed at curbing demand by reducing disposable income. Any revenue shortfall is expected to be addressed by cutting development expenditures to achieve a primary surplus close to the 2 percent target. The overall disposable income for the urban lower and middle classes is shrinking, while rural income is impacted by lower wheat prices and a potential decline in crop output, especially cotton, due to adverse weather conditions. Consequently, rural demand is also expected to remain subdued.

Given the current inflation outlook and fiscal policy, a sharp rate cut seems imminent. However, the fragility of macroeconomic stability, particularly concerning the external account, must be considered. Any slippage could lead to currency depreciation, potentially reigniting inflation. Therefore, it is crucial to continue building the State Bank of Pakistan’s (SBP) foreign exchange reserves, as they serve as key buffer against external commodity price shocks or internal political instability.

The positive news is that SBP reserves have increased from a low of $3.5 billion in June 2023 to $9.4 billion in July 2024. While this is encouraging, the reserve levels are still insufficient for the SBP to consider accelerating growth. The focus should remain on building further reserves, which requires attracting foreign direct investment (FDI) and securing external commercial borrowing from both the public and private sectors. Currently, long-term investments in Pakistan are scarce, but short-term portfolio investments are becoming more appealing. One potential avenue is the inflow of “hot money” into treasury bills, with some marginal inflows observed recently. The SBP and Ministry of Finance should explore ways to attract more of these investments, and higher real interest rates may be the most effective strategy.

The key question is how positive do the real interest rates need to be in order to maintain external account stability while also building reserves. As economist Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon,” emphasizing the need for careful monetary policy management. The Monetary Policy Committee must consider global interest rate trends as well, opting for a cautious approach. This suggests a rate cut of 50-100 bps on Monday, with further gradual reductions based on data.