THE State Bank of Pakistan (SBP) recently raised the policy rate to 13.75pc with the primary objective of anchoring inflation. The raised interest rate is expected to attract more savings owing to higher returns, which, in turn, will decrease money holding, total spending and aggregate demand.

Historically, SBP’s monetary policy has remained ineffective in targeting inflation through interest rate adjustments because the inflation rate has shown a positive relationship with the policy rate in Pakistan rather than a negative correlation.

As is evident, inflation was 11.1pc on a year-on-year (YoY) basis in April 2021, while the policy rate was 7pc at the time. However, the inflation rate in May 2022 increased to 13.8pc on a YoY basis and the policy rate was 13.75pc. Up to April 2022, Pakistan’s economy overheated due to a ballooning import bill of $60 billion relative to export receipts of $26.9bn. Consequently, the trade deficit rose and the current account deficit went up to $13.8bn.

This recurrent issue of high current account deficit reflects the over-dependence of Pakistan on imported goods and services. It is one of the structural problems leading to lower production potential and supply to meet the domestic demand. Hence, the policy rate hike would neither control inflation nor would it compress aggregate demand. The SBP needs to revisit its inflation-targeting mechanism. Supply-side constraints resulting from high borrowing costs for the small and medium businesses due to high policy rates will limit the production capacity of domestic businesses. The policy rate should be kept on the lower side for supporting domestic enterprises.

Abdul Basit Bhatti
Sukkur

Published in Dawn, June 16th, 2022