The policy statement started with the acknowledgement of the noticeable change in the political landscape. On the same note, economic commentators are observing a noticeable change in SBP policy transmission as well as in the tone of MPS. In good old days of PML-N, easing monetary policy used to be over justified, and now it seems that the institution is leaning a little too much on tightening it.
After 150 bps increase in the last four months, the rational expectations were of a mild hike of 50 bps and to wait and see the transmission of previous rate hikes. But the hawks at SBP thought otherwise and came up with another 100 bps increase to take the policy rate at 8.5 percent while the headline inflation is at 5.8 percent (12M moving average at 4.4%) and core inflation at 7.6 percent (12M moving average at 6.2%).
Seeing from the inflationary lens, the stance is too hawkish. The argument for higher rate hike is that monetary policy is proactive and is based on future expectations of inflation and the steps taken today will ease the pressure in future. These higher inflationary expectations are based on second round impact of currency depreciation, upward revision in gas prices (and a possible hike in power tariffs) and high oil prices.
In my view, the timing drove the policy decision; it is the oil prices that are primarily on the minds of policy makers. The rally in oil prices gained momentum in last few days, and the oil is trading over $80 per barrel today. With more sanctions to be imposed on Iran in November 2018, the outlook is of even higher prices in weeks and months to come. This probably has sent jitters across the monetary policy committee resulting in a too cautious stance.
Taking higher oil prices out of the equation and looking at the positive real interest, the need was to have a close look at the efficacy of further tightening to bring macroeconomic stability.
The growth momentum has already slowed down, which is visible from over 30 percent decline in diesel consumption in July-August It''s a leading indicator as HSD is used mostly in commercial transportation; its decline is showing the slowdown in economic activities. The other shock to growth is possibly coming from less than targeted cotton production, which would not only hurt agriculture growth but also have its toll on services growth.
The SBP has revised down the GDP growth target to 5.0 percent for FY19 while ADB is forecasting at 4.8 percent. There is a fair chance that the real growth might come in the vicinity of 4-4.5 percent. Seeing this, another 100 bps hike in interest rates after 175 bps increase since January might not be the best option.
The immediate concern to the economic stability is to bridge the external financing gap and the monetary tightening can lower this gap by primarily curtailing the imported demand. There is a limit to the curtailment in demand - not all the imports are elastic and they might not keep on declining by mere increase in the interest rates.
Plus, the leveraging of the private sector is not much in the country to take full benefit of interest rate hike in order to slowdown the demand. Yes, this will put brakes on consumerism drive, mainly in automobile demand. The biggest adverse impact of higher rates is on federal government whose debt servicing cost would increase - both the exchange rate and interest rates adjustments increase the debt servicing cost of government and make it difficult to curtail the fiscal deficit.
The medium term sustainable solution to twin deficit problems is to enhance government revenues to lower the fiscal deficit, and to boost exports to cut down the current account deficit. Any other step would have symptomatic reliefs; and the marginal benefits of tightening dilute with successive aggressive adjustments.
The need of the hour is to have ''surgical strikes'' on lowering down import bill, boosting exports, generating fiscal revenues and lowering government expenditure. There is a limit to general exchange rate and interest rates adjustments, and these could be counterproductive beyond that.
The irony of the matter is that the same day interest rates are increased by another 100 bps, the government decides to keep petroleum prices unchanged for October against OGRA''s recommendation of Rs 4/liter increase. The impact of higher petroleum prices to curtail imported demand at this point would have been higher than 100 bps interest rate increase.
But perhaps the political repercussions of the former are more vocal. It seems that SBP is becoming independent from ministry of finance; the pressing need is to do the same with OGRA and NEPRA.