The monetary policy statement for Sep 2019 showed that the State Bank of Pakistan was maintaining the status-quo. The policy rate for the next two months is unchanged at 13.25 percent. While for most it was expected, many did wonder what has changed compared to the last monetary policy when the rate, against all expectations, was hiked by 25bps.
Despite multiple rate hikes, the SBP-IBA Consumer Confidence Survey [CCS] of May 2019 showed that “overall inflation expectations increased 5.0 percent compared to the previous survey conducted in March 2019”. In March 2019, people in Pakistan expected inflation to soar in the next six months -- till Sep 2019. And it reached 10.6 percent in August 2019.
Most importantly, expectations for higher food inflation witnessed a surge and the index increased to 70.0 in May 2019 from 62.4 in March 2019. The same holds true for energy inflation. The index increased from 63.3 in March to 70.1 in May, 2019. Higher value of index shows that people expect higher inflation in next six months. If the past is any guide, inflation may touch 13 percent or go above that in December 2019.
At this point, it is interesting to note that the monetary policy statement of July 2019 justified the 25bps raise on the back of anticipated inflation from a one-off impact of increase in energy prices. Nothing has changed in this context form July to Sep 2019. People are expecting higher energy inflation in the next six months as well. There are two possible interpretations here. First, the SBP does not see expectations of energy inflation coming true. Second, it does not see any further hike in energy prices. Both interpretations can be seriously questioned.
Leaving the expectations part aside, experts see future energy price hikes on the cards. Recent talks with the IMF in the backdrop of missing revenue targets and efforts for fiscal stability increase the likelihood of energy price hikes further. The attacks on Saudi Aramco which resulted in a 10 percent rise in crude oil prices will add further pressure on petroleum prices in Pakistan. This may be short lived, but the rupee may come under pressure. All this limits the space to preclude a future rise in prices of energy and associated products. Overall, it is hard to see inflation slowing down in the near future.
One thus finds it hard to explain changes in the monetary policy based on inflation, expected or otherwise. Inflation has lower weight than it appears to have on changes in policy rate. Some other factors seem to be guiding the monetary policy in Pakistan. Movements in exchange rate may be a possible candidate. The deprecation of the rupee seems to have guided monetary policy indirectly till July 2019, and emerges as a direct factor shaping policy rate decision in Sep 2019.
The monetary policy statement of July 2019 clearly reads that “The decision [off 25bps hike] takes into account upside inflationary pressures from exchange rate depreciation”. This, I fear, led the over-response to “expected inflation” and we witnessed a 25bps hike against all expectations. The authorities seem to have read that depreciation translates to inflation by a relation of one-to-one. Obviously, evidence does not support it.
Higher than required weightage to depreciation of the rupee, therefore, may be explained by Pakistan’s long resistance to lower side adjustment of the rupee which is mainly rooted in an obsession with overvalued exchange rate and fear of depreciation. Further, Pakistan had to let the rupee adjust to its fair value as an IMF prior. Also, direct interventions were not possible in the money market. The authorities, in this situation, seem to have decided on a higher interest rate to manage exchange market pressure.
This may explain a bit the higher real interest rate in the country. While there is no source to be claimant, monetary policy in Pakistan seems to have been compensating politico-economic uncertainty through offering additional base points of real interest rate. The higher than required policy rate helped manage exchange market pressure by discouraging capital outflows and encouraging foreign capital inflows building the reserves. This potentially led to slightly undermining the domestic debt servicing, cost of doing business and economic slowdown effect of policy rate hikes.
Keeping this in mind helps us understand why thepolicy rate hike was not announced in the Sep 16 statement. The statement itself leaves nothing to the speculation. The burden of no change in the policy rate is almost entirely shifted to the stable exchange market. The committee finds that the initial volatility in exchange rate is settled; interbank foreign exchange market has adjusted relatively well and the forex position is improved, with some inflows from Saudi Arabia. Owing to this and improvements in the current account, “the rupee had strengthened modestly against the US dollar since the last MPC”. So, no rate hike. Keep the status quo.
One can, therefore, anticipate that the rupee will drive policy rate decisions mainly. Pressure on the rupee will most likely translate into rate hikes and vice versa. Exchange market pressure management is likely to remain the major concern behind decisions about changes in rate. Inflation will weigh in, but mainly through depreciation as in the past. The higher cost of domestic debt, associated budget deficit, rising cost of doing business and economic slowdown are likely to continue to be second-tier influencers of the policy rate decision. Stability of the rupee will define the influence of these factors on changes in policy rate. And this will determine the direction of the monetary policy.
The writer is a research fellow and heads the Policy Solutions Lab at the Sustainable Development Policy Institute (SDPI), Islamabad.
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