Recently, the State Bank of Pakistan announced a 100 basis points hike in the policy rate to 16 per cent, against the market expectations of the status quo. It was done in response to the inflationary pressures, which have been proven to be stronger and more persistent than expected.

For too long, we have relied solely on monetary policy to control demand and inflation to cool down the heated economic activities. However, the inflation we are facing is rather cost-push inflation which is not effectively addressed by monetary policy.

Short-term yields are already close to 16pc, which indicates that the hike is already priced in by the secondary market. Thus, the impact of monetary tightening should stay muted as yield might not surge a lot. But let’s assume yields will also increase by 100bps in response to the monetary policy decision.

In my opinion, this monetary tightening (and probably more to come) might yield some fruits to reduce pressure on external fronts but at the cost of a higher fiscal deficit.

A balance needs to be struck between the twin deficits, as we cannot let the fiscal budget go out of control while focusing on the balance of payments only

The revenue side is slowing down due to a slowdown in economic activity and interest expenses inflating due to higher interest rates. Therefore, we need to strike a balance between fiscal and external deficits, as we cannot let fiscal go out of control while focusing on the balance of payments only.

When we know that inflation is not 1) demand-pull making interest rates an ineffective tool, 2) demand has decreased already, easing pressure on import bills and 3) monetary easing is inevitable six months down the road, where is the need for tightening?

Private sector credit increased only by Rs86.2 billion during Q1 compared to Rs226.4bn in the same period last year, showing signs of a steep slowdown. The growth deceleration has also been eminent from the controlled current account deficit numbers. Furthermore, commodity prices are easing, which were rather expected to surge amid global gas shortages in winter.

Moreover, this high inflation period is transitory, and once the base effect starts to kick in, inflation is expected to enter the single-digit zone from June 23 and onwards. And then, even a 10pc interest rate will result in positive real rates, which is just two quarters away.

Can we not develop a targeted strategy to reduce import bills on an emergency basis? Possibly by restricting the completely build unit (CBU) imports of the auto sector, cutting energy electricity consumption by imposing full/partial work from home, early market closures, and slashing any nonessential imports that do not impact our exports and survival.

On the other hand, Sri Lanka had its monetary policy meeting on November 24, in which it decided to keep the rates unchanged at 14.5pc, even though its inflation rate was 66pc in October of 2022, lower than the record 69.8pc in September. The five-year treasury bills have been trading at over 30pc. Sri Lanka is talking with creditors about a debt restructuring necessary before receiving a much-needed $2.9bn bailout from the International Monetary Fund.

Possibly, the monetary policy is the easiest tool to use, even if it is not the most effective one, and thus was opted as the instrument of choice. Or it was International Monetary Fund pressure but clearly not the ideal thing to do. We need to have a targeted short-term policy to reduce imports on an emergency basis until we secure financing and work on medium to long-term policies to curb the trade deficit on a sustainable basis.

The author is the head of research at EFU Life

Published in Dawn, The Business and Finance Weekly, December 5th, 2022

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