Saghir Mushtaq
In its recent meeting, the Monetary Policy Committee (MPC) of the State Bank of Pakistan (SBP) has decided to reduce the policy rate by 50 bps to 10.5%, effective from 16th December 2025. Two and a half years back, in a reaction to a record high inflation rate of 29.2%, the MPC had resorted to an all-time high policy rate of 22%, effective from 27th June 2023. After the usual monetary policy-specific time lags, the inflationary tempo started experiencing a gradual deceleration, and consequently, after a year’s interval, the restrictive stance of monetary policy has been periodically relaxed. Our holistic assessment, to be elaborated hereafter, of key developments in the macroeconomic scene over the last two and a half years is that, despite many periodic reductions in the policy rate over the last one and a half years, the policy rate is still restrictive. Once its objective has been achieved, its continuation is not compatible with the situation when the recovery in the economy is fragile and the government has initiated a process of implementing a wide agenda of reforms. This analytical brief will discern some insights from Pakistan’s short-run experience of using inflation-targeting monetary policy to control inflation in a recession.
The monetary policy is basically a demand management policy and cures only the ills originating from excess demand. The spike in inflation had spurted mainly due to cost-push factors, supply shocks, and inflation expectations. These forces were partly fuelled by non-economic factors like political uncertainty, law and order, and the geopolitical environment. Demand management policy was a misfit prescription. Such an inflationary spurt is a one-off phenomenon and disappears in the short run. Since maintaining price stability is the function of the State Bank of Pakistan (SBP), this naturally alerted the SBP to jump into the arena to face the challenge. The monetary policy stance has undergone a U-turn shift.
Luckily, the Bank has succeeded in achieving its goal of price stability and, very wisely, it has availed the opportunity to simultaneously achieve exchange rate stability. The SBP is following an “inflation targeting” framework for steering monetary policy. Under this, the policy rate, that is, the interest rate the SBP charges on loans given to member banks, is targeted to contain inflation within a certain range. Price stability is a favourable condition for facilitating economic growth and generating employment opportunities. In fact, monetary policy can cause numerous ripple effects through various transmission channels in the economy and is used alone or in combination with other policies to promote private investment, exchange rate stability, and financial stability, etc.
In the short run, over the last two and a half years, the economy has experienced encouraging improvements in a number of areas. Inflation trending at two digits has been tamed. A comfortable buffer stock of foreign exchange reserves has been raised. The Bank’s prudent interventions in the foreign exchange market, coupled with the government’s stern warning to speculators, have resulted in stalling worrisome continued exchange rate depreciation, which was also fuelling inflation. The IMF’s programme is on board and the country’s credit rating in the international financial market has encouragingly improved. Government revenues have increased and the fiscal deficit, both overall and primary, has been reduced. These are encouraging signs of improved performance of the economy in the short run. In the beginning of the period, the economy was in a stagnation. In 2022–23, GDP growth had plummeted to -0.2%, the worst in history, and inflation reached an all-time high of 29.2%. The rupee was fast depreciating and foreign exchange reserves had declined to a worrisome level. The country’s rating in the international market was downgraded. The overall fiscal deficit had reached an alarming level of 7.8% of GDP in 2022–23, and so was the picture of the external account.
The flip side of this scenario is that, despite gradual reduction, the current nominal interest rate is still considerably high, and money illusion makes it further worrisome. The real policy rate, nominal rate adjusted for inflation, stands at 4.5% (10–6). We have adjusted the whole series of policy rates over the decade during which the Bank has started using inflation-targeting monetary policy. This is the record highest rate. On average, our inflationary situation is very much similar to that in the South East Asian countries, but none of the countries such as Malaysia, Indonesia, India, and Bangladesh has as high a real interest rate as in Pakistan, let alone developed countries such as the USA and the UK, which have around a 1% rate. The important point is that the policy stance is still excessively restrictive.
At the time of initiation of this tight stance, the economy was beset with high inflation and recession, that is, stagflation. The reform measures agreed under the IMF programme prompted contractionary fiscal policy, resulting in higher taxes, withdrawal of subsidies, and reduced public expenditure. Utility tariffs have increased. The cost of production has increased and output has contracted. In a nutshell, the economy came under multiple stresses, both from the demand and supply sides, mainly due to tight monetary policy coupled with supply-restraining measures. GDP has revived from a dip in 2022–23 to a mild recovery, but the growth in the subsequent period is no significant improvement over population increase.
Basically, three factors cause inflation: inflationary expectations, expansionary fiscal and monetary policies, and supply shocks and cost-push factors. The economy is operating at much less than its potential level, in technical terms experiencing a deflationary gap. Much of our inflationary syndrome owes to the last two factors. Expectations of entrepreneurs and consumers are affected by economic policies and by how strong the government’s regulatory mechanism is in offsetting market imperfections. The contractionary macroeconomic policies are completely misfit to address the inflationary tendency caused by supply shocks and cost-push forces. This reduces liquidity in the system, impacting adversely both output and demand.
A reduction of 0.50 percentage points in the policy rate is not a significant reduction to give an impetus to the economy. Exchange rate stability achieved in this short run is credible, but we must not miss the fact that its trade-off is a high cost of distortion, resulting from the SBP’s interventions in the foreign exchange market. The government is prioritising high technology and, hopefully, this initiative would give an impetus to real sector productivity, which would cushion this distortion over time. Low output growth, in contrast to its potential level of 6–7%, export stagnation at around 8% of GDP, low investment levels hovering around 15–16% of GDP for decades, high unemployment, and a poor technology base are formidable challenges on the supply side. The solution seems to lie in the application of Say’s Law, that supply creates its own demand.
The writer is an economist associated with the Pakistan Institute of Development Economics.
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