The rate cut saga

LAHORE: Determining the policy rate is a critical responsibility of any central bank, as it directly shapes monetary conditions, economic stability and inflation targets. The recent 2.5 per cent cut in the State Bank of Pakistan’s (SBP) policy rate, however, has not pleased most businesses.

Despite mixed reactions, the primary beneficiaries of this rate reduction are the business sector and the government of Pakistan, which will see a significant decrease in debt servicing costs. This financial relief could help offset the shortfall in revenue collection.

Central banks worldwide consider multiple factors when determining policy rates to ensure balanced economic growth. Given Pakistan’s recent commitments to the IMF and a target of 3.5 per cent growth for FY25, further rate cuts may be possible in the next monetary policy review, provided inflation remains low. For now, the SBP appears to have taken a middle-ground approach, aiming to stimulate growth without triggering a resurgence in inflation.

Current inflation is well below the target set for this year, but there are concerns it could rise unexpectedly. The SBP’s cautious approach likely reflects these risks, as it seeks to retain a buffer against potential inflation and to stabilise the currency.

Economic growth, however, has been sluggish. A more substantial rate cut could risk overheating the economy. While full employment is generally desirable, central banks monitor unemployment as a key indicator of economic health. Achieving full employment without causing inflation is ideal, but high policy rates may be necessary to prevent excessive wage growth that could fuel inflation.

A higher policy rate can strengthen the local currency, impacting exports and imports. Central banks adjust rates to prevent excessive currency appreciation or depreciation, as policy rates affect borrowing costs for businesses and consumers alike. The SBP uses policy rates to avoid financial instability from asset bubbles or to encourage investment during economic downturns.

The SBP has resisted business sector pressure, as setting rates under such influence could undermine its mandate and lead to adverse consequences, such as runaway inflation due to excessive borrowing and spending. Another important consideration is currency stability; if the policy rate is set too low, it can weaken the currency, making imports more expensive and contributing to inflation through higher import costs. Furthermore, easy credit resulting from lower rates can fuel asset bubbles in real estate and stocks, leading to potential instability when these bubbles eventually burst.

Frequent rate changes due to external pressures could erode trust in the central bank, diminishing the effectiveness of monetary policy. Easy-money policies might also disproportionately benefit asset-holding sectors of society, potentially increasing income inequality and social tensions.

Higher rates can attract foreign investment and help stabilise exchange rates, which is crucial for economies dependent on foreign capital. The SBP continues to balance these factors carefully to manage inflation, support economic growth, and ensure long-term financial stability. Maintaining prudence, independence and a data-driven approach is essential for sustaining credibility and effective economic governance.