KARACHI: The State Bank of Pakistan (SBP) on Monday raised the key policy rate by 150 basis points to 13.75 per cent from the existing 12.25 per cent.

The massive hike is as per the market expectations on the backdrop of severe economic crisis and a sharp fall in the rupee value.

The SBP said in today’s meeting, the Monetary Policy Committee (MPC) decided to raise the policy rate by 150 basis points to 13.75 per cent. This action, together with the much-needed fiscal consolidation, should help moderate the demand to a more sustainable pace, while keeping inflation expectations anchored and containing risks to external stability.

Since the last MPC meeting, provisional estimates suggest that the growth in FY22 has been much stronger than expected. Meanwhile, external pressures remain elevated and the inflation outlook has deteriorated due to both homegrown and international factors.

Domestically, an expansionary fiscal stance this year, exacerbated by the recent energy subsidy package, has fuelled the demand and lingering policy uncertainty has compounded the pressures on the exchange rate.

Globally, inflation has intensified due to the Russia-Ukraine conflict and renewed supply disruptions caused by the new Covid wave in China. As a result, almost all the central banks across the world are suddenly confronting a multiyear high inflation and a challenging outlook.

After contracting 0.9 per cent in FY20 in the wake of the Covid pandemic, the economy has rebounded much more strongly than anticipated, growing 5.7 per cent last year and accelerating to 5.97 per cent this year, as per the provisional estimates.

At 13.4 per cent (YoY), headline inflation unexpectedly rose to a two-year high in April and has now been in double digits for the six consecutive months. The inflation momentum was also elevated at 1.6 per cent (MoM) and the core inflation rose further to 10.9 and 9.1 per cent in rural and urban areas, respectively.

On the external front, notwithstanding some encouraging moderation in the current account deficit during April, the rupee depreciated further due to both domestic uncertainty, as well as the recent strengthening of the US dollar in the international markets; following a tightening by the Federal Reserve.

The MPC’s baseline outlook assumes continued engagement with the International Monetary Fund (IMF), as well as reversal of fuel and electricity subsidies together with the normalisation of the petroleum development levy (PDL) and the general sales tax (GST) on fuel during FY23.

Under these assumptions, the headline inflation is likely to increase temporarily and may remain elevated throughout the next fiscal year. Thereafter, it is expected to fall to the 5 to 7 per cent target range by the end of FY24, driven by fiscal consolidation, moderating growth, normalisation of the global commodity prices and beneficial base effects.

Considering the balance of risks around this baseline, the Monetary Policy Committee felt it was important to take effective action to anchor the inflation expectations and maintain external stability.

In addition to today’s policy rate increase, the interest rates on the Exports Finance Scheme (EFS) and the Long-Term Financing Facility (LTFF) loans are also being raised.

Going forward, to strengthen the monetary policy transmission, these rates will be linked with the policy rate and will adjust automatically, while continuing to remain below the policy rate to incentivise exports.

At the same time, the MPC emphasised the urgency of strong and equitable fiscal consolidation to complement the monetary tightening actions. This would help alleviate the pressures on inflation, market rates and the external account.

Unlike most emerging markets, Pakistan experienced a relatively mild contraction after the Covid shock in 2020; followed by a sustained and vigorous rebound. As a result, the output is now above its pre-pandemic level, such that tightening of macroeconomic policies that is necessitated by the presently elevated pressures on inflation and the current account is also warranted from the perspective of the demand management.

Most demand indicators have remained strong since the last MPC, including sales of POL and automobiles, electricity generation and the sales tax on services, and growth in large-scale manufacturing (LSM) accelerated in March.

Both consumer and business confidence have also ticked up. With the output gap now positive, the economy would benefit from some cooling. On the back of the monetary tightening and assumed fiscal consolidation, the growth is expected to remain moderate at 3.5 to 4.5 per cent in FY23.

The current account deficit continues to stay moderate. In April, it fell to $623 million, less than half the average for the current fiscal year, on the back of lower imports and record remittances.

Based on the Pakistan Bureau of Statistics (PBS) data, the trade deficit shrank 24 per cent relative to its peak last November. These developments are in line with the SBP’s projected current account deficit of around 4 per cent of GDP this year. Next year, the current account deficit is projected to narrow to around 3 per cent of GDP, as imports growth continues to slow with moderating demand and the recent measures taken by the government to curtail non-essential imports, while exports and remittances remain resilient.

This narrowing of the current account deficit together with the continued IMF support will ensure that Pakistan’s external financing needs during FY23 are more than fully met, with an almost equal share coming from the rollovers by bilateral official creditors, new lending from the multilateral creditors and a combination of bond issuances, foreign direct investment (FDI) and portfolio inflows. As a result, excessive pressure on the rupee should attenuate and the SBP’s forex reserves should resume their previous upward trajectory during the course of the next fiscal year.

Instead of the budgeted consolidation, the fiscal stance in FY22 is now expected to be expansionary. At 0.7 per cent of GDP, the primary deficit during the first three quarters of the year compares unfavourably with the primary surplus of 0.8 per cent of GDP during the same period of the last year.

This slippage was driven by a sharp rise in the non-interest expenditures, led by higher subsidies, grants and provincial development expenditures. The resulting demand pressures have coincided with the sharp rise in costs from the surge in the global commodity prices, exacerbating inflationary pressures and the import bill.

Timely action is needed to restore fiscal prudence, while providing adequate and targeted social protection to the most vulnerable. Such prudence enabled Pakistan’s public debt to decline from 75 per cent of GDP in FY19 to 71 per cent in 2021, despite the Covid shock, in a sharp contrast to the average increase of around 10 per cent of GDP across the emerging markets over the same period.

In nominal terms, the private sector credit growth remained robust through April, reflecting strong economic activity and higher input prices, which have enhanced the working capital requirements of the firms. Since the last MPC meeting, the secondary market yields, benchmark rates and cutoff rates in the government’s auctions have risen, particularly at the short-end.

The MPC noted that the market rates should be aligned with the policy rate and in case of any misalignment after today’s policy decision, the SBP would take appropriate action.

The headline inflation rose to 13.4 per cent in April from 12.7 per cent (YoY) in March, driven by perishable food items and the core inflation. The rise in the core inflation reflects strong domestic demand and second-round effects of supply shocks.

At the same time, the measures of long-term inflation expectations have also ticked up. As electricity and fuel subsidies are reversed, inflation is likely to rise temporarily and may remain elevated through FY23 before declining sharply during FY24.

This baseline outlook is subject to risks from the path of global commodity prices and the domestic fiscal policy stance.

The MPC will continue to carefully monitor the developments affecting the medium-term prospects for inflation, financial stability and growth.