KARACHI: The State Bank of Pakistan (SBP) on Monday increased the policy rate by 25 basis points to 7.25 per cent after keeping it at 7 per cent since June 2020 citing the pace of the economic recovery has exceeded expectations.

The central bank reduced the key lending rate by a cumulative 625bps from 13.25pc to 7pc in a short span of time from mid-March to June 2020 to offset the impact of Covid-related slowdown on the economy.

The Monetary Policy Committee (MPC) in its statement observes that while year-on-year inflation has declined since June this year, rising demand pressures together with higher imported inflation could begin to manifest in inflation readings later in the fiscal year.

“This robust recovery in domestic demand, coupled with higher international commodity prices, is leading to a strong pick-up in imports and a rise in the current account deficit,” said the SBP.

The committee said the economic recovery now appears less vulnerable to pandemic-related uncertainty. “As a result, at this more mature stage of the recovery, a greater emphasis is needed on ensuring the appropriate policy mix to protect the longevity of growth, keep inflation expectations anchored, and slow the growth in the current account deficit,” it added.

The SBP believes that this rebalancing would be best achieved by gradually tapering the significant monetary stimulus provided over the last 18 months.

“The MPC noted that over the last few months the burden of adjusting to the rising current account deficit had fallen primarily on the exchange rate and it was appropriate for other adjustment tools, including interest rates, to also play their due role,” said the SBP.

It said the stance of monetary policy is still appropriately supportive of growth, with real interest rates remaining negative on a forward-looking basis.

“In the absence of unforeseen circumstances, the MPC expects monetary policy to remain accommodative in the near term, with possible further gradual tapering of stimulus to achieve mildly positive real interest rates over time,” said the SBP.

With a supportive FY22 budget and accommodative monetary policy, most high-frequency domestic demand indicators such as sales of automobiles, POL (petroleum, oil and lubricants) sales, cement and electricity generation continue to depict robust growth. This growth is mirrored in the strength of imports and tax collections, it added.

The large-scale manufacturing registered strong growth in June (18.5pc) before moderating in August to 2.2pc, in line with typical seasonal patterns, said the SBP.

The services sector is also rebounding strongly; latest Google Community Mobility Reports show that activity across grocery stores, restaurants, and shopping centers during July and August rose above pre-Covid levels.

In agriculture, the decline in the area under cultivation of cotton is expected to be compensated by an increase in area for rice, maize, and sugarcane.

“Based on these trends, growth in FY22 is now expected toward the upper end of the forecast range of 4-5pc, notwithstanding some greater uncertainty with respect to spillovers from the evolving situation in Afghanistan,” said the SBP.

The current account deficit rose to $0.8bn in July and $1.5bn in August, reflecting both vigorous domestic demand and high global commodity prices. While remittances remained strong, growing by 10.4pc during July-August FY22 and exports also performed reasonably well (averaging $2.3bn per month), they were outstripped by imports.

“In response, the rupee depreciated by 4.1pc since the last MPC meeting,” said the SBP.

Under the flexible market-based exchange rate regime, the SBP does not suppress an underlying trend in the exchange rate and any interventions are limited to address disorderly market conditions.

Since its flotation, the rupee has moved in an orderly manner in both directions and has depreciated by only 4.8pc to date, much less than many other emerging market currencies over the same period.

“Since the rupee was floated, SBP’s gross foreign exchange reserves have nearly tripled to a record $20bn, while net international reserves have risen by nearly $16bn between end-June 2019 and end-August 2021,” said the SBP.

“Any unforeseen slippages in the fiscal stance would further bolster domestic demand, imports and inflation,” said the SBP.

The MPC felt that some macro prudential tightening of consumer finance may also be appropriate to moderate demand growth as part of the move toward gradually normalising monetary conditions.

“Looking ahead, the inflation outlook largely depends on the path of domestic demand and administered prices, notably fuel and electricity, as well as global commodity prices,” said the SBP.

Published in Dawn, September 21st, 2021