Money Matters

Forward guidance effectiveness

Money Matters
By Aadil Jillani
Mon, 01, 22

Forward guidance is a global practice of central banks, which provides information about its future monetary policy ‘intentions’. This forward guidance is based on detailed assessment of trade, inflation, and balance of payment, forex reserve and repayments etc.

Forward guidance effectiveness

Forward guidance is a global practice of central banks, which provides information about its future monetary policy ‘intentions’. This forward guidance is based on detailed assessment of trade, inflation, and balance of payment, forex reserve and repayments etc.

When a central bank gives its forward guidance, it should be credible and consistent for the markets and the economy. Therefore, not only should it be followed by the central bank’s actions, the way it gets communicated is also important as it is supposed to help market participants take decisions as well.

For example, if a central bank reveals that it will keep on pursuing an accommodative monetary policy and interest rates will likely remain low in the near future, both businesses and individuals will make their investments or spending decisions accordingly. Such clear guidance will also bring stability in the markets and/or prices.

Pakistan’s central bank has also been pursuing this practice of “forward guidance’’. The trend is encouraging; however, it seems that either the content of the State Bank of Pakistan’s forward guidance is ‘ambiguous’ or not ‘communicated’ effectively to the markets, as underlying uncertainties in markets keep resurfacing and have deteriorated sentiments.

This uncertainty has impact Pakistan’s macroeconomic stability. Here, one must ask, what went wrong?

This article intends to highlight gaps in the SBP’s Forward Guidance and share an opinion as to why clarity is required in the central bank’s forward guidance to calm down the markets and address ongoing uncertainties.

SBP has departed from its policy intention on November 19, 2021 contrary to what was revealed in the Monetary Policy Statement (MPS) on July 27, 2021 and September 20, 2021.

Let us recap briefly what happened on July 27, 2021. According to the SBP’s ‘forward guidance’ in its MPS on July 27, 2021;

“MPC (Monetary Policy Committee) expects monetary policy to remain accommodative in the near term, and any adjustments in the policy rate to be measured and gradual to achieve mildly positive real interest rates over time. If signs emerge of demand-led pressures on inflation or of vulnerabilities in the current account, the MPC noted that it would be prudent for monetary policy to begin to normalise through a gradual reduction in the degree of accommodation.”

Policy Rate remained unchanged at 7 percent mainly due to; a) continued domestic economic recovery and b) improved inflation outlook. SBP projected that GDP growth will remain 4-5 percent in FY22. Imports were projected to surge but export and remittances resilience augment CAD, which will remain in the range of 2-3 percent of GDP in FY22 (CAD was lower than FY18 and FY17). The forex reserves expected to improve due to adequate availability of external financing of $20 billion.

According to SBP’s Forward Guidance in MPS on September 20, 2021, this is hereafter;

Looking ahead, in the absence of unforeseen circumstances, the MPC expects monetary policy to remain accommodative in the near-term, with possible further gradual tapering of stimulus to achieve mildly positive real interest rates over time.

Policy rate increased by 25bps to 7.25 percent on September, 20, 2021. SBP was of the view that ongoing economic growth exceeded expectations mainly due to robust domestic recovery coupled with international oil prices, which could push strong pick in imports and lead to rise in CAD.

SBP was signalling to the markets in both instances that despite overheating in Pakistan’s economy that; a) ongoing monetary tightening will be gradual and b) policy actions will remain broadly accommodative in near-term.

Interestingly, policy rate suddenly jumped by 150bps from 7.25 percent to 8.75 percent on November 19, 2021, which was contrary to the previously given indications. After increasing policy rate by 150bps, the very next working day, the International Monetary Fund (IMF) released its much-awaited press release over Pakistan-IMF critical talks for 6th Review, and lauded Pakistan’s economic progress.

On the flip side, policymakers took several measures restricting ongoing overheating in the economy. This includes a) increase in average cash reserve requirement (CRR) of the scheduled banks from 5 percent to 6 percent (maintained during a period of two weeks) and daily maintenance limit of CRR increased from 3 percent to 4 percent b) tightening of auto financing c) imposing limits to dollar outflows and biometric proof for buying $500 or above and c) increasing 100 percent cash margin limits on imports.

At this point of time, Pakistan-IMF authorities had several policy level discussions on 6th review under EFF (Extended Fund Program) implementing prior actions for the subsequent releases. This has already negatively impacted stock market, exchange rate and led to high imports/CAD. SBP has already tightened screws to suppress overheating and underlying demand in the economy.

Pakistan’s high import growth, around 70 percent as compared to 25 percent exports during July-November FY22, has widened the trade deficit to alarming levels of $20.64 billion, hitt the current account deficit the hardest, and increased imported inflation. This had to be restricted by the Finance Ministry but it seems they could not read the “pitch” well. Consequently the markets were impacted negatively, creating unnecessary “policy imbalance”.

At this point, the SBP raised its policy rate by 150bps to appease the lender of the last so the programme could be resumed. This was a departure from its forward guidance stance taken in July 2021. Furthermore, SBP has been aggressively pursuing monetary tightening to counter inflationary pressures at the cost of economic growth. There should be a balance between both for economic sustainability.

In addition to this, frequency of monetary policies has also increased from six to eight. This also contributed in fuelling ongoing uncertainty in Pakistan’s equity, money and forex markets. It could have been part of forward guidance in July 2021, when the markets were relatively stable. However, this policy insertion was made when uncertainty had elevated due to IMF programme delays, aggressive monetary tightening, and high import growth, which deteriorated the CAD and reflected in the exchange rate slide. In anticipation of further hike in the monetary policy, banks bid higher in the Treasury bill auction on December 1, 2021. This appreciated three months T-bill yield by 228bps to 10.78 percent, which was 203bps higher than policy rate. SBP’s MPC said in policy statement that “this increase appeared unwarranted”

Nonetheless, aftershocks kept on fuelling negative sentiments, and as expected, the SBP increased its policy rate by 100bps to 9.75 percent on December 14, 2021. This rate changed happened within 18 working days, which SBP adjusting its stance by saying “end-goal of mildly positive real interest rates on a forward-looking basis was now close to being achieved and policy rate to remain broadly unchanged in near-term”.

SBP’s report showed that three months T bill-yield remained absolutely flat at 10.78 percent on December 15, 2021. Participation was skewed towards short-term papers, implying market anticipated further hike in policy rate.

This prompted SBP to opt for a rare move. It conducted two reverse open market operations (OMO) for 63-days within a week at 9.9 percent and 9.85 percent to cool-off the markets and address ongoing uncertainty. So far, the accepted amount in 63 days tenor crosses over Rs1 trillion. The secondary market yields are still lower than three months cut off yield of 10.78 percent. This would adjust the market’s overreaction on interest rate and bring in calmness. After the SBP’s forward guidance, it was expected that monetary policy rate would remain unchanged in January 2022. It has signalled to the markets that SBP is ready to take on banks. But damage has already been done.

In order to address ongoing volatility and uncertainty in markets and future inflationary expectations, firstly, SBP must revisit its forward guidance content to make its monetary policy more prudent, transparent and effective, and also ensure that it is communicated well to the markets. Secondly, coordinated and coherent monetary and fiscal policy actions are required, with the larger objective of price stability and growth.


The writer is a freelance columnist