THE State Bank’s decision to keep an easy monetary policy in place is a clear sign that it doesn’t want to upset the ongoing economic recovery. The decision signals the bank’s willingness to hold steady interest rates in the near term to support recovery until it becomes “more durable” and the economy returns to full capacity. Yet the bank has kept its doors open for “measured and gradual adjustments” to achieve mildly positive real interest rates going forward.

The State Bank’s dovish monetary stance is in line with broader market expectations, and the global trend of central banks supporting recovery from the effects of the coronavirus. It is, therefore, safe to assume that the low-interest-rate environment will continue for a while despite revival of the IMF programme and higher world oil and food prices fuelled by stronger global growth projections that could feed into domestic inflation.

In a departure from its pre-virus, contractionary monetary policy stance and with the average headline inflation expected to remain close to the upper end of the projected range of 7pc to 9pc this fiscal, the bank is maintaining interest rates in a negative territory at 7pc for the past nine months to help businesses fight the adverse impact of the pandemic, boost industrial output and avoid cancelling investment plans. Another major reason for the bank to maintain this policy is to offset the potential impact of the contractionary fiscal policy on economic growth and investment. “…[G]iven that fiscal policy is expected to remain contractionary to reduce public debt, it is important for monetary policy to be supportive [of growth and investment] as long as the second-round effects of recent increases in the administered prices and other one-off supply shocks do not materialise, and inflation expectations remain well anchored,” the bank noted.

Indeed, this response to the pandemic has played a key role in the economic recovery under way since last year. LSM has expanded by 7.9pc in the first seven months of the fiscal compared to a 3.2pc contraction during the same period the previous year. Yet output gap remains negative as LSM recovery is narrowly based. The external sector also appears stable and in spite of the rising trade deficit, the current account deficit is still projected to remain below 1pc of GDP. Encouraged by these developments, the bank has revised upwards its growth projection for the financial year to 3pc against the government’s target of 2.1pc on improved prospects for manufacturing output and stimulus to counter the effects of Covid-19.

However, risks remain because of the emergence of a virulent third wave of Covid-19, plus uncertainty regarding inflation and growth outlook. So far, inflationary risks have been outweighed by the uncertainty spawned by the pandemic in monetary policy determination. But for how long? The government’s failure to tackle the supply-side factors fuelling inflation could compel the bank to reverse its accommodative stance.

Published in Dawn, March 22nd, 2021