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Interest rate hiked amid warnings of inflation, deficits

Updated September 30, 2018

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A view of the State Bank of Pakistan's headquarters in Karachi. ─ APP/File
A view of the State Bank of Pakistan's headquarters in Karachi. ─ APP/File

KARACHI: Pointing to continuous rises in inflation and the “twin deficits”, the State Bank on Saturday hiked the key target policy rate by 100 basis points, or one percentage point. This is the second consecutive hike of a full percentage point in interest rates — an action that will send ripples of anxiety through the economy.

The target policy rate affects all other interest rates in the economy, eventually making it more expensive to borrow, and serving as a brake on the pace of economic activity. The State Bank pointed to “rising inflation and large twin deficits”, both fiscal and external, as the main reason behind the continuing tightening of interest rates, saying these “are likely to compromise the sustainability of the high real economic growth path.”

The SBP pointed to surging oil prices, rising inflation and global developments that are sending an oil price shock as well as fueling protectionist trade policies as the biggest challenges facing the economic managers.

It downgraded the growth forecast of the economy to 5pc. In the last monetary policy statement released in July, the SBP had forecast GDP growth at 5.5pc, still below the government target of 6.2pc. The continuous downgrades in the growth forecast suggests a sharply decelerating economy.

Inflation has jumped from 3.2pc in the first two of last fiscal year to 5.8pc this year, said the SBP, adding that “the jump is even more pronounced in core inflation”, whose forecast range has been revised to 6.5 to 7.5pc, due to higher prices for imported oil and domestic gas, increase in regulatory duties and continuing exchange rate depcreciation. In July, the SBP had projected core inflation around 7pc, slight lower than the projection in the latest monetary policy statement.

SBP acknowledged the government’s effort at stabilization through the finance act, saying its impact “is likely to affect Large Scale Manufacturing”. Added to this, the agriculture sector is showing a weak outturn of cotton. Despite some improvement in the export led sector and higher fertilizer production, the net effect on the economy will be negative, pulling growth down even further than what projections in July were showing.

“The current account deficit continues to pose a challenge” the monetary policy statement said. This is despite the fact that the first two months of the fiscal year – July and August – have seen growing remittances and exports. “[A] notable increase in the value of oil imports has kept the current account deficit at US$2.7 billion, as compared to US$2.5 billion” in the same period last year, causing a net drop in liquid foreign exchange reserves to $9.0bn, down by $800 million from last year.

Rising interest rates present stark challenges to growth as well as raising the cost of debt servicing for the government. They are part of an adjustment that economic managers have to undertake during times when the economy is riddled with deficits, particularly in the fiscal and external accounts. Other measures that are part of this adjustment include raising revenues, cutting expenditures and exchange rate depreciation.

Published in Dawn, September 30th, 2018