ISLAMABAD: The International Monetary Fund (IMF) has strongly criticized the State Bank of Pakistan (SBP) for failing to respond to the build-up of inflationary pressures since 2020 through the tightening of monetary policy in a timely manner.
“The monetary policy fell behind the curve, as price pressures built up to five-decade high inflation and de-anchored expectations. Several pauses in the policy rate tightening cycle and the dramatic increase in the size of the SBP’s open market operations (OMOs) to maintain the policy rate within its corridor resulted in loose monetary policy conditions, at a time when inflation was already on the rise,” the IMF stated in its staff report following the approval of a $3 billion Standby Arrangement Programme for Pakistan.
The IMF report stated that consequently, inflation expectations became unanchored, with over 90 per cent of consumers expecting higher prices over the next 6 months in the SBP’s May survey. The Monetary Policy Committee increased the policy rate by 100 bps on June 26, bringing it to 22 per cent, while at the same time, the interest rates on its two main refinancing schemes (EFS and LTFF) similarly increased, maintaining the gap with the policy rate at 3 percentage points.
“The monetary policy needs to remain tight, proactive, and data-driven. The recent policy rate hike is welcome, but the tightening cycle should continue if needed to reduce inflation and facilitate external rebalancing,” the IMF stated, indicating the need for more hikes in the policy rate in the months ahead. In the short term, the forward-looking real policy rate should return to positive territory to re-anchor expectations and achieve the SBP’s inflation objective over the medium term, the IMF added.
Implementing the plan to phase out refinancing schemes will strengthen monetary policy traction and will bring transparency to these schemes. Importantly, the independence of the SBP should be strengthened and protected. A tighter monetary policy stance is critical to reduce inflation, re-anchor expectations and support external sector rebalancing through the exchange rate.
Although the latest policy rate move from the SBP is a welcome step, authorities have generally been sanguine about inflationary pressures quickly receding and returning to their 5-7 per cent inflation target range by end-FY25. The staff emphasized that the SBP would need to continue its tightening cycle to re-anchor expectations given that inflationary pressures are expected to persist over the coming year, including because the impact of exchange rate corrections will continue to reverberate through the economy. The SBP agreed to maintain a tight monetary policy stance
-- higher rates and prudent use of liquidity injections -- as needed, given incoming data, to achieve real positive interest rates, on a forward-looking basis, and place inflation and inflation expectations on a clear downward path.
At the same time, improving the monetary transmission and the monetary operation framework will be important. The SBP is also committed to not introducing new refinancing schemes and keeping the outstanding credit of refinancing facilities below their current limits.
The IMF says after nearly two years of steadily rising headline inflation, base effects from last year’s increase in fuel and electricity prices and diminished contributions from food items are expected to lower headline inflation from June onwards. But price pressures are projected to remain elevated, including as a result of the much-delayed monetary tightening, thus average headline inflation is expected to remain above 25 per cent in FY24, with end-of-period inflation falling below 20 per cent only in FY24.
Likewise, the core inflation is set to recede only very gradually in FY24 on account of elevated inflation expectations and the necessary tightening of policies operating with a lag. The deceleration of headline inflation is set to continue in FY25, with EOP inflation falling to single digits only in mid-FY26.
In the last six months, inflation has continued to rise, in part due to rising food prices and the pass-through from depreciation but also as the abovementioned shortages placed upward pressure on prices. Price dynamics became increasingly broad-based with core inflation reaching 22.8 per cent (yoy) and headline inflation reaching 38 per cent in May 2023, a record high, hurting especially the poor.
Despite the mounting pressures, actions by the State Bank of Pakistan (SBP) lacked clarity, as it kept its policy rate unchanged in Monetary Policy Committee meetings in August, October and early June, expecting that the price rises had peaked and would subside, but hiked rates in November, March, April and late June. The last hike brought policy rates to 22 per cent cumulatively, an 825 bps (basis points) increase since the beginning of FY23. This scribe contacted Dr Khaqan Najeeb, former adviser to Ministry of Finance, who said inflation had proven to be quite stubborn in Pakistan. Drivers of inflation have been depreciation, supply shocks as floods hit Pakistan, fiscal slippages and a delayed response on monetary tightening. The SBP’s administratively managed import restrictions and hoarding and cartelization are also areas which resulted in price hike. These are not easily solvable issues. He opined that in addition to maintaining a real positive interest rate, which could not be done from Jan 2020 to Jan 2023, other adjustments needed to be made related to fiscal and governance issues to tame inflation. An innovative policymaker could also work on expenditure management and initiate serious work on productivity and efficiency issues of the economy, he concluded.
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