THE State Bank’s decision to raise its key interest rate by 25bps to 7.25pc underpins its acceptance of emerging upside risks to external-sector stability and the inflation outlook going forward. Yet this slight hike signifies that the bank doesn’t intend to put the brakes on economic recovery; the shift from an accommodative policy to a somewhat tighter monetary stance will be gradual. This means that the real interest rate will remain negative at least in the near term, with future hikes largely depending on how the economy moves and how well the government manages the fiscal front. So, what has changed in the last couple of months to force the bank to send signals to the market that it could change the monetary policy’s direction? Primarily, the bank seems worried about the growth in domestic demand and imports driving up the current account deficit and weakening the exchange rate in response to balance-of-payment pressures.

This has triggered concerns that higher imported inflation and a potential increase in the administered prices of energy could push up the headline inflation reading further later this fiscal year. Apart from worries over the widening current account deficit and higher inflation expectations, the decision to move up the rate after a pause of 15 months is also driven by the bank’s reading that “economic recovery now appears less vulnerable” to Covid-related uncertainty as the latest wave in Pakistan remains contained. Hence “…at this more mature stage of economic recovery, a greater emphasis is needed on ensuring an appropriate policy mix to protect the longevity of growth, keep inflation expectations anchored, and slow growth in the current account deficit”. Thus, the priority of the policy from now on has to be to sustain growth by decelerating the pace of increase in domestic demand rather than catalysing recovery from the Covid shock.

The pressures on the balance-of-payments position are not unexpected. With growth in imports on strong domestic demand supported by an expansionary budget and a loose monetary stance outstripping the increase in remittances and exports, many experts had been warning of a negative impact on the current account deficit and exchange rate. Although the bank’s revised growth projection is 4pc-5pc this fiscal, despite the potential uncertainty spillovers from Afghanistan, the deficit on the current account is anticipated to shoot up beyond the initial estimates of 2pc-3pc of GDP. With foreign exchange reserves not enough to sustain large current account deficits, the growth story may unravel unless measures are implemented. Still, the ‘directional’ rate hike can do only so much to curb domestic demand and imports unless it is accompanied by fiscal actions to slow down the pace of economic recovery by the government. As warned by the bank, any unforeseen slippages in the fiscal stance would further bolster domestic demand, imports and inflation, necessitating abrupt rate hikes.

Published in Dawn, September 22nd, 2021