Pakistan registered economic recovery despite Covid-19 related lockdowns.
The State Bank of Pakistan (SBP) has raised the interest rate by 25 basis points to 7.25%. The central bank, in the monetary policy issued on Monday, said that Pakistan has registered economic recovery despite Covid-19 related lockdowns.
The SBP has changed the interest rate after a relatively long period, keeping it at 7% for one year.
The State Bank is now trying to tackle inflation instead of propping up economic growth.
“Since its last meeting in July, the monetary policy committee noted that the pace of the economic recovery has exceeded expectations,” the monetary policy statement said.
“With growing signs that the latest Covid wave in Pakistan remains contained, continued progress in vaccination, and overall deft management of the pandemic by the Government, the economic recovery now appears less vulnerable to pandemic-related uncertainty,” it said.
“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,” it added.
The State Bank added that the year-on-year inflation has declined since June. It was increasing demand pressures together with higher imported inflation. It may increase inflation later in the fiscal year.
Senior Research Analyst Raza Jafri said that the State Bank wants to make the economic growth sustainable and therefore it has raised the interest rates.
“There’s economic growth but the State Bank wants to make it sustainable by slowing it down,” Jafri said.
Jafri explained that in the past, Pakistan had registered growth for a few years but it was not sustainable. Current account deficit would reach to unsustainable levels and subsequently foreign exchange reserves would also fall. Different governments had to pull brakes after two to three years of economic growth.
“You don’t go very fast that you meet an accident. I think the State Bank has taken prudent line,” he said.
The State Bank said it would continue to monitor inflation.
According to the SBP document, domestic inflation decreased from 9.7% in June to 8.4% in July and August.
This dip indicated a decleration in administered prices of energy on the back of reduced petroleum development levy (PDL) and sales tax on petroleum products.
In August 2021, the core inflation declined in both urban and rural areas. However, the SBP acknowledged that “the momentum of prices remains relatively elevated, with month-on-month increase of 1.3% in July and 0.6% in August”.
The SBP stated that inflation expectations of households as well as businesses drifted up while wage growth accelerated on the back of strengthened recovery.
The direction of inflation mainly depended on domestic demand, administered prices (mainly fuel and electricity) and global commodity prices.
“The MPC will continue to carefully monitor developments affecting medium-term prospects for inflation, financial stability and growth and stands ready to respond appropriately,” the SBP Monetary Policy statement concluded.
According to the Monetary Policy Committee, domestic fiscal conditions propped up growth recovery since the start of the current fiscal year (FY21).
Private sector credit, spurred by historic cuts in the policy rate and Covid-related support packages, grew by over 11% this fiscal year. This growth was mainly seen in consumer loans (especially auto finance and personal loans) followed by expansion in credit for fixed investment and working capital loans.
The slight tightening of consumer finance was deemed appropriate to ease up demand growth to normalize prevailing monetary conditions.
However, with an increase of 25 basis points in the interest rate, loans have become more expensive for the users of any credit facility. However, an interest rate of 7.25% is much lower than the 13% interest rate announced in July 2019. When the PMLN government left in July 2018, the policy rate stood at 7.50%.
The rate, revised every two months, affects every interest rate in the market. In other words, a higher policy rate means commercial banks will charge more, making borrowing more expensive for individuals, businesses and the government.
Higher interest rates make loans expensive. Businesses, which rely on bank financing, stop new projects, the government cuts spending on development projects, and consumers stop using auto finance, home loans and even reduce credit card use. In a nutshell, a higher interest rate shrinks economic activity and slows down job creation.
On the other hand, a lower interest rate encourages people and businesses to borrow more, which in turn increases consumption on the national scale. Since the overall demand is high, it makes the prices of goods rise, thus inflation increases.
The role of the central bank is to maintain the interest rate at a level that keeps inflation in check while also not reducing economic activity.