‘Unexpected’ decision: Why did SBP maintain the interest rate?

— Does central bank really expect inflation to decline significantly or has it accepted the rate hikes aren’t effective?

By Urooj Imran

ISLAMABAD: In a move that defied expectations, the State Bank of Pakistan’s (SBP) Monetary Policy Committee on Thursday decided to maintain the benchmark interest rate at 22 percent. 

This appeared to be quite unexpected; analysts polled by Profit as well as other publications prior to today’s meeting were majorly of the view that the SBP would hike the interest rate by 100-200 basis points (bps). After all, inflation still remains high despite declining from a record 38 percent in May. And global oil prices have been on the rise. 

However, the SBP appeared to be confident that inflation would continue to decline, especially in the second half of FY24. In the monetary policy statement released after the meeting, the central bank said the impact of high oil rates was being passed on through adjustment in administered energy prices, agricultural outlook had improved, and a recent crackdown on smuggling of essential food items and illegal foreign exchange trades had “begun to yield results”. 

“As such, real interest rates continue to remain in positive territory on a forward-looking basis,” it stated. [According to Investopedia’s definition, the real interest rate is the observed market interest rate adjusted for the effects of inflation].

What exactly does this mean? Let’s say the interest rate offered by a bank on your deposited savings is 20 percent. If you kept Rs 1 lakh in that account, at the end of the year, you would have Rs 1.2 lakh.

However, the annual inflation that year was 21 percent. This means that while the amount of money in your account increased, in real terms, you could buy less with that money because the cost would be Rs 121,000. This means the real interest rate was negative. If the real interest rate was positive — let’s say 23 percent — then you would have had Rs 123,000 at the end of the year.]

Positive real interest rates encourage people to keep their money in banks as it protects them from inflation. So, raising the benchmark interest rate to a point where the real interest rate is positive means less money is going towards purchases, which decreases demand — one of the primary tools a central bank uses to curb inflation. 

The SBP has raised the interest rate by 12.5 percentage points since April, mainly citing rising inflation. However, it decided to maintain the policy rate at the MPC’s last meeting in July and has stuck to its stance despite market expectations to the contrary. This means one of two things — either the SBP governor and the MPC truly believe that inflation will fall below 22 percent, or they (or whoever else influences the policy) believe there is little use in raising the policy rate as it will not control inflation. 

During the post-MPC analysts briefing, SBP officials asserted that inflation would decrease significantly in the second half of FY24, due in part to the high-base effect. 

In response to a question, Governor Jameel Ahmad also said the MPC had factored current global oil prices as well as projections while making a decision. “One particular factor taken into account was forward-looking inflation in the next 12 months and [we] tried to keep real interest rates positive.”

This shows the SBP’s confidence. It was a “very bold decision”, according to Yousuf Saeed, head of research at Darson Securities. “Today’s decision will boost market confidence. 

However, we need to keep an eye on energy prices (fuel, gas and electricity),” he commented. While inflation may continue its downward trajectory, will it fall below 22 percent and real interest rates become positive? 

“SBP believes that inflation will remain in check despite rising oil and power prices and real interest rate will be positive … We believe there is a high risk that inflation may remain higher than the SBP estimates due to rising global oil prices and adjustment in energy prices in Pakistan,” read a note by Topline Research. 

Topline also revised its estimate for average annual inflation in FY24 to 23 percent from 21 percent previously. This is slightly higher than the SBP’s estimate of 20-22 percent. 

Sajid Amin, deputy executive director at the Sustainable Development Policy Institute (SDPI), termed the SBP’s decision “risky”, saying the central bank may have taken it based on “ad hoc” measures such as the recent crackdown which led to the rupee’s appreciation and a reduction in the prices of food items including sugar. 

If inflation won’t come down, then why has the SBP not raised the interest rate? It may be because the governor and the Monetary Policy Committee believe that inflation cannot be controlled by simply hiking the interest rate. 

Fahad Rauf, head of research at Ismail Iqbal Securities, commented, “I think it is a fair decision, given that there are no signs of an overheating economy, and a rate hike would have yielded little benefit in terms of curbing cost-push inflation.”

In an economy like Pakistan’s that does not work on heavy borrowing, raising the interest rate would only lead to increasing the working capital of businesses, which would then pass on the effect to consumers. This is known as cost-push inflation. 

“Moreover, rate hikes would have further increased government fiscal deficit, and created a credit risk for the banking system,” Rauf added. 

Independent economic analyst AAH Soomro also said the marginal utility of further hikes was negligible at best. “The market seems disappointed though. It’s clearer now that despite higher oil prices and an increase in gas and electricity prices, SBP has given clear expectations of peaking interest rates. This should comfort the borrowers – the government the most. SBP must not ruin the opportunity by letting the rupee appreciate aggressively and should increase foreign exchange reserves,” he commented.

Another view is that since Pakistan is an import-dependent economy and the SBP’s interest rate hikes cannot possibly affect global prices of oil and food etc., such increases would have no effect on ‘imported inflation’. 

Of course, this is not something that the SBP governor can say out loud. 

And besides, other than analysing the reason behind the SBP’s decision, another important question remains: what will the International Monetary Fund (IMF) say?

Under the $3 billion Standby Agreement, the IMF has asked for an appropriately tight monetary policy that counters inflation. If the IMF is not satisfied, the government will have to raise the interest rate similar to how it did so in an emergency meeting in June. 

However, Governor Ahmed said during the briefing that the current monetary policy was tight and in line with the SBA.