Monetary policy for now

Economic recovery will require continuity of expansionary fiscal policy, for next 2 to 3 years

After skipping the scheduled meeting of July 2020, Monetary Policy Committee of the State Bank of Pakistan met on September 21 and decided to keep the policy rate unchanged at 7 percent. This was expected and required. The outlook for growth and inflation, mainly backed by rising food prices, was cited as the major reason for keeping the status quo.

Previously, responding to the Covid-19, the SBP has slashed interest rate from 13.25 percent in March 2020 to 7 percent in June 2020. Overall, the monetary policy statement of September 21 seems to suggest end of the easy monetary policy and possibly a reversal.

Monthly data from Pakistan Bureau of Statistics (PBS) shows that inflation has started picking up after a slight dip during the pandemic. Monthly CPI inflation in August 2020 over July 2020 stood at 0.63 while the inflation in July 2020 over June 2020 was 2.50 percent. It has affected the inflation expectations.

The SBP expects average inflation to fall within the 7–9 percent range during FY21, according to monetary policy statement. Food inflation, which is more a governance issue, may raise the CPI inflation pushing the SBP to increase the policy rate prematurely.

Broadly, four major reasons are put forward to support no more slashes or to justify a possible reversal. First, any further cut can anchor higher inflation expectations. Second, a negative or low real interest rate can discourage capital inflows and motivate outflows distressing the rupee. Third, the economy is recovering; the lagging impact of stimulus will push the inflation high. This shall be matched by an interest rate increase. Fourth, the SBP has already provided the largest cumulative cut of 625 bps.

These are valid arguments for normal times. But not for once-in-a-century-crisis like the Covid-19. The pandemic has hit the productivity of the economy. The impact of support measures, both monetary and fiscal policy, will be smaller than expected as the pandemic has lowered the multiplier effect.

Also, uncertainty regarding the future course of the Covid-19 renders the impact of stimulus uncertain. An inflationary pressure seems less likely in the short run. Negative real interest is acceptable for the time being.

Finally, despite a cut of 625 bps, Pakistan still has the highest policy rate of 7 percent in South Asia. It is 4 percent, 4.5 percent and 4.75 percent for India, Sri Lanka and Bangladesh, respectively. The first and foremost priority of the monetary policy at this point must be to ensure expansionary liquidity at current interest and not to respond to conventional structural issues.

Those arguing “enough-is-enough” because of the highest interest rate slash of 625 bps of the region must not forget that it was an unusually high pre-Covid policy rate that provided this space. When the Covid crisis hit the country, Pakistan had a decade-high interest rate of 13.25 to attract foreign capital and keep the rupee strong and stable. This is the time to focus on economic recovery.

Recent literature clearly divides monetary policy response to the pandemic into two phases. In phase 1, the central banks were mainly protecting businesses and people from the immediate fallout of the pandemic, such as liquidity crunch, mass layoffs and resulting job losses. In this phase the authorities mainly focused on providing liquidity to the economy. Central banks across the globe led this phase. Fiscal policy followed with a lag.

The SBP has been very actively engaged and led this phase in Pakistan. Since March 17, 2020, it has cut the interest from 13.25 percent to 7 percent. Through its support measures, it has injected an estimated stimulus of Rs 1.58 trillion, or about 3.8 percent of GDP, in the cash flow of businesses and households.

The first and foremost priority of the monetary policy at this point must be to ensure expansionary liquidity at current interest and not responding to conventional structural issues. 

Phase two is meant to stimulate consumption and investment for economic recovery. Fiscal policy will be taking the lead. Instead of operating standalone, monetary policy must assist fiscal policy now. In addition to technical assistance, countries like Pakistan which face limited fiscal space will critically depend on central banks for financing the fiscal policy initiatives. This phase can span over 2 to 3 years. Overwhelming focus to correct the structural problems can compromise the efforts of fiscal policy. More so in Pakistan.

Fiscal policy in Pakistan already faces a trilemma. Covid-19 has reduced the space for revenue growth, at least in the foreseeable future. At the same time, it has pushed the governments to increase the expenditures to stimulate the economic activity. Most importantly, Pakistan is under an IMF programme which has some conditionalities including achieving a certain level of revenue growth year-on-year and keeping the deficits under a certain limit, as a ratio to GDP. The government may thus be pushed to revert to pre-pandemic stabilisation policies. Given a smaller fiscal space, the role of monetary policy will be very critical. Any premature reversal of monetary easing may hurt the economy.

Interest rate has a different role in Phase 1 and Phase 2. In Phase 1, slashing the interest rate served as tool for giving confidence to businesses and to reduce the burden of interest payments. In Phase 2, as businesses reopen, low interest rates will help support spending. Keeping the policy rate at its lower bound will be critical at this stage to support output and employment.

Economic recovery will require continuity of expansionary fiscal policy, for the next two to three years. This will need availability of liquidity in the market on which fiscal policy can build. Given lower fiscal space and limited options to raise revenues, the government will be relying on borrowing and issuing the bonds. A high cost of borrowing can cause a further deterioration in the government’s debt position.

Increasing the interest rate at this point can compromise the gains from expansionary fiscal policy delaying the economic recovery which has socioeconomic costs, such as prolonged suffering from poverty and unemployment. The SBP has led the Phase 1 excellently. In Phase 2, it must keep an expansionary liquidity position at present interest rate.

The SBP shall, therefore, clearly communicate with certainty that it will continue to provide the liquidity required to support economic recovery at present interest rate of 7 percent for a certain period, despite some tradeoffs. This will bring certainty helping fiscal policy to expand its support measures and support consumption and investment decision of the private sector.

There are other ways to compensate the tradeoffs. The SBP can motivate the government to improve the composition of fiscal stimulus. It can advise the government to spend in productive sectors, such as social protection, SMEs and health sector improvement. Similarly, the fiscal expansion can be aligned to SDGs agenda of the government and SDG targets having a larger multiplier effect can be prioritised. Finally, the SBP can incentivise green recovery through monetary policy as well as priority focus on environment-friendly fiscal stimulus.

The writer is a Research Fellow and heads Policy Solutions Lab at Sustainable Development Policy Institute [SDPI]. He tweets @sajidaminjaved. The views do not necessarily reflect the position of the SDPI

Pakistan's monetary policy for now