The context

akistan is currently facing an economic meltdown, a political turmoil, a natural calamity and a tough IMF programme. Feel free to add another challenge to the list, the trust deficit between national stakeholders and global partners including multilateral institutions, international markets and bilateral partners.

Let us, for the time being, focus on the economic front. We are having a great stagflation. The GDP growth rate in FY23 is expected to hover around 1 percent, plus/ minus. To absorb new entrants in the labour market, Pakistan needs to have a growth rate of 7-10 percent. Averaging 25.46 percent during July-January FY23, headline inflation in January 2023 clocked at 27.55 percent. It is the highest since 1975.

Over the last two to three weeks, the value of the country’s currency has dropped to an all-time low. Trading at 230 to a dollar on January 23, the rupee dropped to 272 to a dollar on February 9. On January 29, the petrol prices were raised by Rs 35 per litre reaching Rs 249 per litre.

Another episode of reform measures can push inflation to around 40 percent. To complete the Ninth Review, the IMF has asked Pakistan to implement some highly inflationary measures. These include a GST hike from 17 to 18 percent, removal of energy subsidies and substantial raises in the prices of diesel, electricity and gas. After the recent Rs 22.20 hike, the price of petrol has jumped to Rs 272 per litre. Prices of diesel and electricity have also risen. A word of caution: while these measures will result in more hardship, the cost of not agreeing to IMF’s conditions will be much higher.

There are four sides to the current inflation. One, the rise in global energy prices, particularly since Ukraine war. Two, the IMF requirement to cut subsidies. Three, profiteering, smuggling and hoarding, particularly for basic food items. Four, consistent high inflation expectation in the market.

SBP and the monetary policy

While dealing with the first three factors is the government’s job, the last is the responsibility of the State Bank of Pakistan. The SBP has been forced to face and make some tough choices in monetary policy. Take a recent example: the Monetary Policy Committee meeting on January 23 had to make a choice between going all out to control inflation or consider a slowdown in economy. The former would have required a 150 to 200 base points hike in policy rate. But the MPC decided to balance the trade off and chose a rate hike of 100 bps. This was less than the market expectation and signaled that the SBP was not going all out to control inflation. This raised the inflation expectations to the higher side, compromising the credibility of the SBP and monetary policy effectiveness to curb inflation.

Going forward, the SBP faces even tougher and more complicated choices. The IMF is expecting an urgent 200-300 base points increase in the policy rate in anticipation of a steep rise in inflation. While it is a much-needed raise, this will compress the economic growth further taking it below 1 percent. This, virtually means closing businesses as the cost of production will be rising exponentially. This can spur more unemployment and poverty. But the cost of not doing it may be even higher.

What should the SBP do?

The SBP must make a key acknowledgment: there are several ministries and departments to deliver growth, but there is only one to curb inflation — the SBP itself. It must, therefore, prepare to deliver on inflation. As BIS in its recent annual report noted “The priority for central banks is to restore low and stable inflation.”

The SBP might feel that this comes at a high cost. It should not. As BIS general manager Agustín Carstens once wrote: “The key for central banks is to act quickly and decisively before inflation becomes entrenched. If it does, the costs of bringing it back under control will be higher. The longer-term benefits of preserving stability for households and businesses outweigh any short-term costs.”

However, a fundamental shift is needed. The SBP has to work on two sides to deliver on inflation, the policy rate hike and use of other policy instruments and communication to market. It will take a balance between the two to influence inflation, market and economy.

The SBP must not be shy to increase policy rate when required. The MPC must take decisions with greater focus on inflation. The SBP must carefully assess the inflationary pressures of resent measures and adjust policy rate hike, even if that suppresses the growth for the time being. It is essential to arrest medium-to-long term inflation expectations.

Exchange rate policy in Pakistan is the burning point for the SBP, the government and the market. Love for a strong rupee is deep rooted. So is the influence of the Ministry of Finance on exchange rate policy. The time has come for the SBP to take a lead on exchange rate policy. Adherence to old fashioned policies — aligned to treasury’s purview – has done great harm not only to the economy but also to the SBP. A recent exhibition of the harm was the arrest of dollar demand by withholding LCs that created a black market for dollar, a decline in remittances through official channels and panic in the market. Let’s not forget the steep fall of the rupee when floated free under the IMF pressure. The supply of necessary inputs and further inflationary pressures were a corollary. The SBP, therefore, must make it clear, mainly through its action, that no policies to accumulate depreciation — ad hoc overvaluation — will be adopted.

The most difficult part is the communication with market. Communication in crisis tests the communication capacity to the core. A rising trend in inflation expectations and inflation itself, and changing positions on inflation outlook suggest that the SBP has been struggling to communicate effectively. The SBP must be careful and consistent in providing forward guidance on inflation outlook and interest rate path.

Reversals and deviations reduce the trust between the market and the central banks. Stagflation coupled with the IMF programme will complicate the paradox of “forward guidance” further. Transparent and consistent communication that the SBP is committed to deliver on inflation can help it overcome, or at least reduce, monetary policy challenges. Close coordination and continued communication between monetary and fiscal policies will be critical.

The writer is the deputy executive director at the Sustainable Development Policy Institute. He tweets @sajidaminjaved. The views in the article do not necessarily represent the SDPI position