Morning Call about Economy

Karachi: SBP short-sightedness internalises the reactive policy bias

In the recent monetary policy statement the State Bank of Pakistan (SBP) slashed the policy rate by 150bps, bringing it to 12%.

According to Arif Habib Limited, the objective was motivated primarily to rejuvenate the economic growth, given the descending headline inflation which for the period 3MFY12 clocked in at 11.5% YoY, compared to 13.4% YoY 3MFY10. In Arif Habib Limited’s view excess liquidity flow following the rates cuts, will help revive the investments but is likely to reignite inflationary expectations in long run, which appoints SBP to reconsider its easing campaign, beyond FY12. In Arif Habib Limited’s opinion recent cuts in policy rate points towards SBP short-sightedness, this internalises the policy over reaction.

Monetary easing can do little to reverse the real growth trend
With the fall in inflation the SBP can now focus to formulate a more growth centric approach by reducing the benchmark interest rate. Although there has been evidence of slowdown in the economic growth (in particular that of large scale manufacturing registering +0.68% YoY, Jul’11) owing to high interest rate environment. However in Arif Habib Limited’s opinion lackluster performance of manufacturing sector, is more of capacity constraint factor rather a product of high interest rate. And considering that, monetary easing can do little to reverse the trend.

Inflationary expectations are likely to reignite following rate cuts
However one thing is for sure that a fall in discount rate appoints money supply growth, combine this with fiscal and trade imbalances over hang, the monetary policy runs the risk of reversing the downward trending inflation. Hence the question is whether a drastic rate cut by SBP is justified in terms of spurring the economic growth and allowing just that, the SBP might be reigniting the inflationary expectations.

SBP short-sightedness internalises the reactive bias
Arif Habib Limited thinks in order to effectively manage monetary policy and to have minimum externality effect on the economy; the SBP needs to shift its focus on long-term price pressure that exists in the economy. For central banks to have a proactive monetary approach appoints better predictor of future price directions and the symptoms that lurks within. By not doing just that, the SBP runs the risk of internalising the reactive bias which hints towards short-sightedness. Arif Habib Limited sees the problem partially stemming from core reliance on Consumer Price Index (CPI) inflation, which only reflects consumer price movement at a given point in time. The actual causative factors of price pressure in an economy are left unnoticed, which renders a question of effective monetary management.

Bottom line
In short increase in the money supply will likely fuel in inflationary expectations in the economy and given the near and medium risks to inflation. In present context Arif Habib Limited thinks it would be counterproductive to allow the rates to easing that soon, allowing money supply to increase and feed into sustained higher core inflation. In terms of subdued growth the real factors still remain unaddressed such that energy and power, and a resolution in the near to medium term seems bleak.