State Bank raises key policy rate by 150 basis points to 8.75%

KARACHI: In a surprise move, the Monetary Policy Committee of the State Bank of Pakistan (SBP) on Friday decided to raise the policy rate by 150 basis points, or 1.50 per cent, to 8.75 per cent for the next two months.

The decision is above the market expectation. The market was expecting an increase in the policy rate between 75 basis points and 100 basis points.

The State Bank said since the last meeting, risks related to inflation and the balance of payments have increased, while the outlook for growth has continued to improve.

The heightened risks related to inflation and the balance of payments stem from both global and domestic factors. Across the world, price pressures from the Covid-induced disruptions to supply chains and higher energy prices are proving to be larger and long-lasting than previously anticipated.

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In response, the central banks have generally begun to tighten monetary policy to keep inflation expectations anchored. In Pakistan too, high import prices have contributed to higher-than-expected Consumer Price Index (CPI), Sensitive Price Indicator (SPI), and core inflation outturns.

At the same time, there are also emerging signs of demand-side pressures on inflation and inflation expectations of businesses have risen on account of further upside risks from the domestic administered prices.

With respect to the balance of payments, the current account deficits in September and October have been larger than anticipated, reflecting both rising oil and commodity prices and buoyant domestic demand.

The burden of adjusting to these external pressures has largely fallen on the rupee. As a result of these developments, the balance of risks has shifted away from growth towards inflation and the current account faster-than-expected.

Accordingly, the Monetary Policy Committee was of the view that there is now a need to proceed faster to normalise the monetary policy to counter inflationary pressures and preserve stability with growth.

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“Today’s rate increase is a material move in this direction. Looking ahead, the MPC reiterated that the end goal of mildly positive real interest rates remains unchanged and, given today’s move, expects to take measured steps to that end,” the SBP said.

In reaching its decision, the Monetary Policy Committee considered key trends and prospects in the real, external and fiscal sectors, and the resulting outlook for the monetary conditions and inflation.

The SBP said the economic recovery in progress since the start of FY21 continues, as reflected in most high-frequency indicators of the domestic demand, including automobile sales, POL [petroleum, oil and lubricants] sales, and electricity generation, as well as the strength of imports and tax revenues.

Notwithstanding some moderation in September due to a high-base effect and some supply chain disruptions, LSM registered broad-based growth of 5.2 per cent (y/y) in the first quarter of FY22, led by production of consumer goods (both durable and non-durable), construction-allied, and export industries.

In agriculture, the production levels of all major Kharif crops except cotton are estimated to have reached an all-time high.

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Cotton production has also rebounded, with arrivals at ginneries growing 80 per cent as of November 1, 2021, compared with the same period last season.

Overall, the economic recovery appears increasingly durable and self-sustaining against the backdrop of the rapidly falling Covid cases and the government’s vigorous vaccination roll-out. Looking ahead, the rising input costs and normalisation of macroeconomic policies are likely to lead to some moderation in the growth of industrial activity.

Nevertheless, this could be more than offset by the improved outlook for agriculture, such that risks to the growth forecast of 4 per cent to 5 per cent in FY22 are tilted to the upside.

Persistently high international commodity prices and strong domestic activity kept the current account deficit elevated at $3.4 billion in the first quarter of FY22.

The deficit widened to $1.66 billion in October from $1.13 billion in September due to high energy prices and an uptick in services imports, despite some moderation in the non-energy imports.

There was also a moderate month-on-month decline in exports and remittances. The current account deficit for FY22 is expected to modestly exceed the previous forecast of 2 per cent to 3 per cent of GDP.

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While the market-based exchange rate has played its due role as a shock absorber, it has borne a considerable burden in terms of adjusting to the widening current account deficit.

The rupee depreciated by a further 3.4 per cent since the last Monetary Policy Committee meeting. The US dollar also appreciated against the most emerging market currencies since May, as expectations of tapering by the Federal Reserve have been brought forward.

However, the fall in the rupee value since May has been comparatively large. As other adjustment tools normalise, including interest rates and fiscal policy, pressures on the rupee should abate.

The overall fiscal deficit improved to 0.8 per cent of GDP in the first quarter of FY22 from one per cent in the same period last year. This was driven by above-target growth in the Federal Board of Revenue’s (FBR) tax revenues (38.3 per cent on a year-on-year basis), despite higher refunds and significant reduction in the sales tax rate on POL products.

However, non-tax revenue fell 22.6 per cent (y/y) due to a sharp decline in the petroleum development levy (PDL) collection. In addition, the primary surplus was 28.6 per cent lower than in the first quarter of FY21 due to a 33 per cent (y-o-y) growth in non-interest spending.

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Looking ahead, it will be important to achieve the fiscal consolidation planned in the budget to help restrain domestic demand. A higher-than-planned primary fiscal deficit would likely to worsen the outlook for inflation and the current account and would undermine the durability of the recovery.

Real money supply growth has accelerated in recent months to above trend levels. With the economic recovery on a sound footing, there is a need to pare back this growth as part of the broader move towards normalising the monetary conditions.

The Monetary Policy Committee noted the recent increase in the banks’ cash reserve requirements would help, in this regard.

Inflationary pressures have increased considerably since the last meeting, with headline inflation rising from 8.4 per cent (y-o-y) in August to 9 per cent in September and further to 9.2 per cent in October, mainly driven by higher energy costs and a rise in core inflation.

The momentum of inflation has also picked up significantly, with an average m-o-m inflation in the last two months at an elevated 2 per cent and all sub-components of the CPI basket showing an acceleration.

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The core inflation has also picked up in the last two months, rising to 6.7 per cent (y-o-y) in both urban and rural areas on the back of house rents, cloth and garments, medicines, footwear, and other components.

In addition, inflation expectations of households remain elevated and those of businesses have risen sharply. Looking ahead, the global commodity prices and potential further upward adjustments in administered prices of energy pose an upside risk to the average inflation forecast of 7 per cent to 9 per cent in FY22.

The Monetary Policy Committee will continue to carefully monitor the developments affecting the medium-term prospects for inflation, financial stability and growth and stand ready to respond appropriately.