22% For How Long?

SBP will maintain positive real interest rates despite falling inflation in Pakistan

On April 29th, the Monetary Policy Committee of the State Bank of Pakistan (SBP) maintained the policy interest rate, at the historically high level of 22%. This was the 7th consecutive rate hold instituted by the central bank.

At first glance, this seems out of step with the falling rate of consumer inflation in Pakistan: April data showed that inflation fell to 17.3% year-on-year from 20.7% in the prior month, the first time it has dipped below the 20% mark in 23 months. So why is the SBP insisting on continuing a policy of maintaining positive real interest rates in the face of high but tapering headline inflation? I will explain below, but first let’s identify which factors are contributing to a slowing rate of growth of consumer prices. ??????????

Both supply and demand factors are now tempering the inflationary spiral

Supply side:

• Food inflation is gradually coming down, with the 9.7% reading in April being the first single-digit one in the past 12 months. This is due to strong growth in agriculture, with the sector estimated to have grown by 6.8% during July-December 2023. In particular, increased harvests of rice and wheat - the two main staple crops - has likely enhanced supply in the market, resulting in the moderation observed in food price inflation. This is important because the food group has the largest weight (34.6%) in the basket of goods and services used to estimate the consumer price index.
• During the second half of 2023 and first quarter of 2024, global prices of key commodities have either fallen or levelled out. This has led to a mild reduction in supply-side price pressures, given Pakistan’s largely import dependent economy. The significant reduction in the headline inflation rate noted in April suggests that the knock-on effects of this are now being felt.

Demand side:

• There is enough evidence now to say with confidence that historically high inflation in 2022-23 coupled with the SBP’s long and severe monetary tightening cycle has come close to throttling consumer demand.
• Core inflation (excluding food and energy), taken as a proxy for aggregate demand, has been on a downward trajectory in both urban and rural areas. While still high, it is much lower than it was 12 months ago.
• Other economic data and market trends support this view. Large scale manufacturing contracted by 0.5% during the July 2023 - February 2024 period. While this was partly due to high borrowing and input costs, it also reflects depressed consumer demand. In March, auto loans contracted on a month-on-month basis for the 21st consecutive month. Sharp price cuts by some auto assemblers also point to low demand.

Key inflationary risks persist

If the apparent trajectory of consumer inflation is downward, what is making the SBP maintain its hawkish monetary policy stance? There are some good reasons.

• A fresh round of supply-side driven price pressures is likely to materialise over the next 3-6 months, as the government negotiates a new multi-year IMF programme. Gas prices were increased by up to 45% in February. As a direct result of this, in April, two major fertilizer producers raised urea prices by about 17%. And although large hikes in power tariffs were implemented in 2023, further adjustments cannot be ruled out.
• The ongoing tension in the Middle East, and the chance of a further escalation between Israel and Iran, has kept the risk of oil price hikes in 2024 high. Given Pakistan’s dependence on imported energy, the SBP’s cautious approach towards future inflationary expectations has merit.
• ?The third reason that the central bank has left the policy rate unchanged is to defend the Rupee, since the US Fed delayed its planned monetary policy easing. Cutting the policy rate prematurely could lead to a build-up of depreciatory pressure on the currency and foreign exchange depletion.??

What does this mean?

What will the implications be of the SBP’s current monetary policy stance?

• By the end of 2024, the trends moderating inflation are likely to outweigh those that can potentially stoke it further, although consumer inflation will persist at a high level. My rough estimate is that it will average between 15%-20% for 2024 as a whole, down from 30.9% in 2023.
• ?High interest rates will support the currency, but at the cost of continuing to throttle growth. The SBP’s estimated GDP growth rate range for this fiscal year (2023-24) of 2%-3% seems optimistic.
• ?High interest rates will also translate into higher domestic debt servicing costs for the government. Not only will this make it difficult to contain the fiscal deficit, greater budgetary borrowing by the government will increase money supply and stoke inflation – partly countering the SBP’s objectives.

What to watch out for ?

• Talks with the IMF for a new programme and the budget for fiscal year 2024-25, which will come out in June. New tax measures and even the partial removal of existing subsidies will slow the pace of inflation reduction.
• The next Monetary Policy Committee meeting of the SBP on June 10th. My assessment is that the policy rate will be held at 22% in that meeting, and is unlikely to be brought down before the last quarter of 2024.

About the author

Waqas A. Rana is a development economist and founding partner at Shared Pathways, an international development consulting and advisory firm. His core area of interest is the study of economic growth strategies for developing countries. Outside of work, he likes to read literature from around the world, lift weights, run, and hike. ?????