Has the State Bank (SBP) gotten it wrong once again? That’s the question being asked by many as the bank last week decided to keep its benchmark policy rate steady at 15 per cent for a second consecutive meeting to support an economy struggling to contend with an unprecedented liquidity crisis worsened by the recent deadly floods.

The reasons are obvious: the central bank’s recent track record during the pre and post-Covid periods doesn’t inspire much confidence when cutting or raising the borrowing costs to boost or tame growth. On both occasions, the bank appeared to have been overtaken by the events others had warned about much in advance.

It was slow to start the monetary easing cycle to cut the rate to 7pc from 13.25pc to fight off the likely impact of the pandemic on the economy after resisting calls for proactively reducing the borrowing costs as the pandemic’s impact on the global economy was already becoming evident.

Likewise, the SBP had ignored the demands for monetary tightening last year even when it had become clear that the previous government’s push for rapid growth to please voters ahead of the 2023 election was proving stressful for the external sector, as reflected by the growing current account imbalance.

The central bank’s recent track record during the pre and post-Covid periods doesn’t inspire much confidence

It started to increase the rate only when it had become impossible for the government to avoid the International Monetary Fund (IMF) and get its bailout package restored in January after weeks of negotiations and much tougher conditions. So the concerns that the central bank should have consolidated the rate further, given the rapid and persistent increase in inflation instead of keeping it steady, have valid reasons.

The decision “strikes an appropriate balance between managing inflation and maintaining economic growth in the wake of the floods,” the SBP contended in its monetary policy statement. The bank has lowered its estimates for growth to around 2pc from the previously projected pre-flood range of 3-4pc on enormous flood losses and said the headline inflation would be higher than its forecast range of 18-20pc and linger longer than expected.

The government had in the budget for this year predicted inflation to stay around 11.5pc and was targeting to achieve a 4.8pc growth rate. In an SBP podcast following the announcement of the monetary policy division, Dr Ali Chaudhry, research advisor at the SBP, said inflation would, however, drop fairly fast to 5-7pc during the next fiscal year, and GDP will expand by an additional 2pc on economic activity anticipated to be generated by post-flood reconstruction.

The bank had based its decision on the “continued deceleration in economic activity as well as the decline in headline inflation and the current account deficit” since the August monetary policy meeting when it had “paused” further tightening on the back of expectations of the revival of the stalled IMF programme a week later.

At that time, it was unclear if the floods would be so devastating for the flagging economy. The latest policy statement noted that the “recent floods have altered the macroeconomic outlook and a fuller assessment of their impact is underway.

On the one hand, inflation could be higher and more persistent due to the supply shock to food prices. It is important to ensure that this additional impetus does not spill over into broader prices in the economy. On the other, growth prospects have weakened, reducing demand-side pressures and suppressing underlying inflation. In light of these offsetting considerations, the Monetary Policy Committee (MPC) considered it prudent to leave monetary policy settings unchanged at this stage.“

The statement defends the decision to keep the rate unchanged. Since the August MPC meeting, aggregate demand has declined, signalling that the tightening measures implemented over the last year are gaining traction. With growth likely to slow further in the aftermath of the floods, the monetary tightening needs to be carefully calibrated going forward.

Then, after peaking in August as expected, headline inflation fell last month due to an administrative cut in electricity prices. However, core inflation continued to drift upwards in rural and urban areas. Moreover, the current account and trade deficits narrowed significantly in August and September, respectively, and the rupee has recouped some of its losses following the recent depreciation. Last but not least, the IMF programme is back on track.

The statement also underlines that the SBP is of the view that the demand destruction through earlier policy and administrative interventions — like boosting the borrowing cost by 800 basis points between September 2021 and July this year and restrictions on imports — and the floods that have caused economic losses of $30bn or almost 10pc of GDP. Together this provides enough space to keep the pressure off the current account to close at the targeted level of 3pc of GDP this fiscal year.

The central bank expects the current account imbalance to not breach the projected level for the entire year despite the likely pressures on imports due to the huge destruction of the cotton crop and the potential delay in wheat sowing in parts of Sindh. It thinks that the impact of the potential increase in cotton, wheat and other food imports will be offset by the fall in international commodity prices.

This is despite the spike in the global oil prices seen in recent days in the wake of the Organisation of the Petroleum Exporting Countries Plus cut in production. Besides, the impact on the current account could be further cushioned by international assistance in the form of current transfers. Given secured external financing and additional commitments in the wake of the floods, the reserves should improve throughout the year.

The current account deficit shrank for the second consecutive month in August to only $0.7 billion, almost half the level in July. During the first quarter, imports have declined by 12.7pc to $16.3bn while exports have grown by 1.8pc to $7bn.

Dr Ali Chaudhry thinks it is not clear whether the recent spike in oil prices is sustainable, considering the economic recession staring the face of developed economies. Still, he points out, the $5 per barrel means savings of $1bn for Pakistan. Thus, he believes that the surge in imports of food and industrial raw materials due to the biblical floods will be compensated by the drop in the oil prices as the overall imports will likely be squeezed with a favourable impact on the current account.

Thus, a slowing economy, declining demand and imports, lower current account deficit and expectation of foreign flood assistance have given the SBP comfort to run real negative rates. “The interest rate is not changed because it already is high, and that inflation is projected to drop next year except administered prices,” says the SBP research advisor.

Yet the view that the SBP is taking a major risk by not consolidating further shouldn’t be ignored, given the fact that the symptoms might have improved, but the fundamentals of the economy remain unchanged. The possibility of fiscal slippages in the wake of the floods in an election year must not be discounted. So far, the government has restrained itself from indulging. But how long can it avoid the temptation?

Published in Dawn, The Business and Finance Weekly, October 17th, 2022