Announcing the new monetary policy, the State Bank of Pakistan has increased the policy rate by 25 percent. At one time, the policy rate was as high as over 12 percent but over the last about one year it was brought down to 7 percent. The new rate now stands at 7.25 percent. In the present circumstances, the upward revision is the right decision to take.
The upward revision is not unexpected. It shows a desire to move ahead with slow, measured steps to positive real interest rates over time. One objective was to curtail the growing current account deficit. However, the SBP has not updated its current account forecast from 2-3 percent of GDP. It means there are upside risks which cannot be ignored.
On the face of it, the policy makers would wait to see the transmission of recent exchange rate depreciation on imports, which usually is quicker than the impact on exports through currency adjustment. In other words, any change in monetary policy in the future would be measured and gradual. It shows a clear departure from the past when a reactive monetary policy was adopted in days of current account slippages, and in such cases, the policy actions tended to be large.
All things considered, the current policy is better suited to ensure sustainable growth. A prime concern is how to achieve a higher growth rate. As we know, a growth level over 3.8 percent is prone to a balance of payment crisis. Hence, it is better to have measured growth of around 4 percent for a few years and allow the economy to move up the ladder of growth once structural reforms yield results in terms of enhancing exports and foreign direct investment.
There is a consensus of opinion among economic experts that the growing current account deficit is a serious matter, and it needs to be tackled with a strong hand. The SBP is treading a tightrope. Without having the ministry of finance on board, the course of action by the SBP could be more than what is warranted for having the right macroeconomic policy mix. That is why actions from the government are imperative.
Also to be taken into account is the fact that In recent months imports have risen enormously due to underlying price and demand factors. The prices of almost all kinds of imports have gone up. The higher increase is in petroleum products and crude import, where the demand is not checked to counter the rise in prices. The demand element is in the government’s control through altering petroleum prices. These are not changed; but the impact is visible on imports. One fourth of imports are petroleum. With no impact from pricing, the SBP ought to work harder on the other three fronts. It is imperative for the ministry of finance to make coordinated efforts with the SBP to contain the current account deficit and not let inflation surge through creeping currency depreciation.
There is also a need to keep an eye on the demand side of the economy. It has been noted that rapid demand growth is having an adverse impact on the balance of payments. The situation can be improved by revving up the growth engine. Concrete actions need to be taken in this regard.
However, the country cannot move on a sustainable growth path without structural reforms. No matter how much time it takes to implement reforms, till then the policy prescription is to accelerate the growth momentum. In this context, the SBP is expecting the output gap to be slightly positive in FY22. The output gap was negative for three straight years – FY19-21 and was significantly positive in FY18. The output gap shows clearly that the economy is not overheating.
One good thing is that lately the wages are growing higher relative to core inflation. Had commodity prices remained low, in a scenario of a slight positive output gap and wage incline, the SBP could have kept the policy rate unchanged. Had the government reacted on time and increased petroleum prices, the demand could have been checked slightly for the SBP to be comfortable. In view of the ground reality, measured increase in rates is the need of the hour.
Other factors impinging on the health of the economy include the fear of the Delta variant. The good news is that the positivity rates, new cases, and deaths due to COVID are much less than before. The other element is the economic problems of Afghanistan. Both factors have to be kept in mind while planning for the future.
The country is out of recession. The demand is growing higher than expected. That is a positive sign in a way as the economy is showing resilience and signs of continued growth. One way to smooth the way forward is to remove the structural impediments which have for long held the economy back. Pakistan’s economy holds immense potential. What is needed is the right mix of policies to unlock this potential.