EAG supports SBP’s cautious approach towards decreasing the policy rate
In the recent MPC meeting, the SBP decided to reduce the policy rate from 12% to 11%. This decision is motivated by a sharp decline in inflation, including a steady decline in core inflation. The Economic Advisory Group (EAG) agrees with the decision taken by the SBP to decrease the policy rate while continuing to maintain the real interest rate at a significantly higher level.
The EAG notes that inflation expectations have reduced to close to the SBP inflation target range. Professional forecasters expect inflation to equal 7.1% over the next year and 7.6% over the next two years. This is also reflected in expectations around the exchange rate. Market expects the exchange rate to depreciate by 4.2% over the next twelve months. This has come down from more than 8% a few months back.
In addition to falling expectations, the poor performance when it comes to real economic activity also suggests that there are no demand side pressures. The large-scale manufacturing activity for the first eight months of the ongoing fiscal year has contracted by 1.9%. The year-on-year decline for February 2025 was even higher at 3.51%. Construction, which employs a large fraction of the labour force, contracted by 9.3% during the first half of this fiscal year.
These trends point to the absence of inflationary pressures and, therefore, justify a more accommodating monetary policy.
However, EAG also points to key vulnerabilities which have started to show and risk another round of volatility. Figure 1 shows data on SBP interventions in the market since 2003. After several quarters of accumulating reserves in FY23 and FY24, the SBP spent more than a billion dollars in reserves in the third quarter of this fiscal year. While the SBP expects reserves to increase by June 2025, spending reserves may leave the country vulnerable if the foreign inflows fail to materialise. Pakistan’s external liabilities continue to remain high and the EAG warns against depleting foreign exchange reserves in anticipation of foreign inflows.
To emphasise this point, Figure 2 plots data on foreign inflows due to government borrowing from international markets since 2003. The figure shows that the government has failed to raise new debt from international markets in recent years beyond what is required to pay existing debt. This is also the reason for why SBP foreign currency reserves have increased by less than what the IMF was expecting before the crisis started. In its February 2022 staff report, the IMF was expecting reserves to increase to $20.9bn by the end of the ongoing fiscal year. However, SBP reserves stood at only $10.2bn by the end of April 2025 which equals only 1.7 months of import cover.
Two additional data points also call for caution. First, the growth rate of broad money supply continues to remain high at 13%. This suggests that inflation over the medium term may increase above the SBP target range once again. Second, the yields on the long term government bonds also remain close to 12%. This again suggests that the market does not expect inflation to permanently fall within the SBP target rate over the medium to long run. The SBP must continue to signal that it is willing to pay the cost to keep inflation within its target range over the long run.
The EAG’s overall assessment is that the SBP is still concerned about a potential rebound in inflation with inflation increasing above its target range of 5-7% over the medium term. However, it also wants to provide an impetus for economic growth by opting to lower the interest rate. Between two extremes, involving an exceptionally larger cut to ease business conditions and environment and to keep the interest rate at the 12% level and avoid exchange rate pressures, SBP is considering a more cautious approach given it is accommodating to the demand side pressures but not conceding to the pressures to drastically reduce the discount rate to lower levels given the decreasing trend in inflation.
For further information, contact EAG Chair, Dr Aadil Nakhoda at anakhoda@iba.edu.pk
The Economic Advisory Group is an independent platform of individuals drawn from economics, policy and the private sector. It was formed in January 2021, under the auspices of PRIME Institute, an independent think tank, which serves as its secretariat.
Chair: Aadil Nakhoda, IBA Karachi
Members:
Ahmed Jamal Pirzada, Bristol University
Ali Salman, PRIME Institute
Mueen Batlay, Think Build Scale Pvt Ltd
Muhammad Adil Mansoor, Business Recorder
Muhammad Ashraf Khan, Retired Federal Secretary
Najma Pirzada, The Life Sciences Division
Sajid Amin Javed, SDPI
Samir Ahmed, LUMS
Vaqar Ahmed, SDPI