KARACHI, Dec 22: Average yield on three-month treasury bills rose to 3.92 per cent on Wednesday, up 14 basis points, as the State Bank reinforced its earlier signals of a gradual tightening of interest rates.

The central bank allowed a modest increase in the yield, signalling that it would continue gradual hiking to interest rates and avoid raising them sharply to combat inflation.

Inflation in July-November 2004 increased by 9.1 per cent year-on-year, against the full fiscal year target of five per cent despite a measured tightening of interest rates by the central bank.

Central bankers believe that supply-side factors like shortage of food items are fuelling inflation more than the expansion of monetary assets, thus justifying the apparently low impact of its gradual tightening of monetary policy on inflation. That is why it continues to raise the interest rates in a measured fashion to keep inflation in check.

The central bank has been averse to raising interest rates aggressively also because this can block economic growth. Pakistan's economy is projected to grow by 6.6 per cent during this fiscal year ending in June 2005, up from 6.4 per cent in the last year.

Recent indications are that the economic growth may surpass the target and reach seven per cent. If that happens then a more-than-projected increase in inflation would not look as awkward as it would if the GDP growth only meets the target.

While the central bank raised the three-month yield modestly in the Wednesday auction, it had to scrap all the bids received for one-year bills to avoid the one-year yield rising too fast.

Scrapping the bids received for T-bills of a particular tenure has become an effective way of signalling to the market that the central bank does not want to raise the yields to the levels being desired by the market, the SBP has used this ploy quite frequently in the last six months.

But in doing so, the central bank has often missed the pre-determined sales target of T-bills, making liquidity management difficult for banks. At times, it has also sold lesser than targeted amount of T-bills to limit the increase in the yield, when scrapping the entire bids has not been possible.

On Wednesday also, the central bank missed the auction target of Rs20 billion even though the auction of three-month and one-year bills had generated a total demand of Rs33.3 billion.

Whereas the central bank has been raising treasury bills rates since the middle of February 2004, it has not touched its discount rate that has remained unchanged at 7.5 per cent since November 2002.

The central bankers think it is premature to say when the SBP would go for raising discount rate, but they do not rule out the possibility of increasing it in the second half of this fiscal year.

They say increasing the discount rate would depend much on when the SBP feels that it now required a mix of discount rate increase and T-bills yield hiking to tighten interest rates.

The SBP will issue its monetary policy statement next month for January-June 2005. Financial market players say they might get a clue about the increase in discount rate in that statement.