CITING a better-than-anticipated decline in May’s inflation figures, the State Bank ceded to rate cut demands on Monday, by slashing its policy rate by 150bps to 20.5pc, after having held it steady at a record 22pc for nearly a year.

The bank also mentioned the uptick in economic activity, and improvements in the external sector outlook and international reserves, resulting from a lower current account deficit, as factors leading to its decision. The bank had been resisting mounting pressure to start reversing monetary tightening ever since inflation began slowing in January.

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Critics of the bank’s restrictive policy stance insisted that higher rates could not go on forever without damaging the economy. Even the finance minister repeatedly expressed hopes for rate cuts in “line with inflation”. The big drop in May’s inflation to 11.8pc, however, was widely seen as evidence justifying the bank’s shift to a slightly less restrictive stance, amid the growing clamour for respite from crushingly high lending rates.

Recent market expectations regarding the size of the rate cut have swung between 100bps and 200bps, but the majority of market polls showed that most analysts did not anticipate a reduction of more than 100bps.

That the SBP decision comes just ahead of the announcement of the budget, and in the midst of negotiations between the government and the IMF for another bailout package, it underscores the bank’s confidence that economic stability is gaining traction and that concluding a new agreement with the Fund is just a matter of time. The monetary policy decision is based on the bank’s understanding that inflation out-turns last month were better than expected, and that underlying inflation pressures are receding amid appropriate fiscal and monetary policies.

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However, the bank also mentioned that the upcoming budget and uncertainty regarding future energy price adjustments pose an upside risk to the near-term inflation outlook. But it is hopeful that the impact of the earlier monetary tightening will keep new inflationary pressures in check. Regarding the outlook, the bank is clear that room for further interest rate cuts will depend on budget assessments and IMF measures.

For now, the bank is said to have modelled the budget and IMF measures according to known factors. However, the actual measures may cause a deviation in the inflation outlook.

Although the rate cut signifies the taming of inflation for the moment, it is mostly symbolic since borrowing costs are likely to remain high as the SBP chases its medium-term target of 5-7pc inflation by September 2025. The rate cut will substantially accrue debt payment savings to the government, bring down financial costs of businesses and perhaps provide a boost to the stock market and real estate. However, it is unlikely to unlock investments in the real sectors.

Published in Dawn, June 11th, 2024