KARACHI, March 30: The State Bank in its second quarterly report explains in detail why it is maintaining its loose monetary policy stance. But at the same time it warns that if "inflation does accelerate" it stands ready "to move aggressively and adjust monetary policy accordingly."

The report says that in the short term CPI inflation will remain in the range of 3.8-4.2 per cent. But it says that in the medium term the monetary overhang is likely to increasingly contribute to the gradual upward creep in non-food, non-oil- inflation, "suggesting caution on monetary expansion going forward. This in turn, suggest some caution in the adjustments to the SBP monetary stance."

"SBP continues to closely monitor price trends and stands ready to respond aggressively to contain any surge in inflation beyond tolerable limits," the report says.

Giving background of maintaining a loose monetary policy stance in the second quarter the report says that the market was anticipating tightening of the policy for several reasons.

These include (i) the evidently weakening remittance inflows through the first half of this fiscal year which implied a slowdown in liquidity injections by the SBP through forex purchases); (ii) the exceptionally strong private sector credit demand that became very evident by October 2003 onwards; and (iii) the anticipated strong government demand for credit (driven by both the increase in debt payments and the very weak net investments in national saving schemes.

The impact of these market liquidity considerations was compounded by the acceleration in headline inflation through the first half of this fiscal year. On the other hand, from the central bank's perspective, the fundamentals did not justify any immediate shift in the monetary policy stance.

In the judgment of the SBP, the market liquidity was likely sufficient to accommodate the increasing demands from both, government and private sector, without significantly impacting domestic interest rates.

Thus, the arguments for a tightening of monetary policy hinged significantly on assessing the threat posed by the apparent rise in inflationary pressures. These reduced to two hypothesis:

(i) The evident inflationary pressures stemmed principally from easy monetary policy stance of SBP, and (ii) The threat posed by these inflationary pressures was sufficient to require an immediate tightening of the monetary stance.

The SBP report says the evidence does not strongly support the both hypothesis. "In particular, food inflation played a significant role in the acceleration in CPI inflation" during the first half of this fiscal year "much of which stemmed from supply shocks rather than monetary policy."

"Moreover, SBP estimates suggest that food inflation was likely to decelerate in the months ahead. Significantly, non- food, non-oil inflation remained quite subdued ranging between 2.3-3.5 per cent" throughout the first half of this fiscal year.

"Similarly, SBP's perception that small acceleration in inflation was tolerable for the economy is based on the argument that inflation, as yet, too low to cause serious damage."

"Another confounding element is that monetary pressures typically impact domestic inflation with considerable lags, and it is also likely that these lagged effects may be subdued due to the improved supply conditions."

In light of these factors, the SBP considered it appropriate to maintain its monetary stance, to support the economy's progress towards a higher long-term growth trajectory. "This said, the SBP has clarified that if inflation does accelerate it stands ready to move aggressively and adjust monetary policy accordingly."