Zafar Iqbal
Recent data points and trends suggest a promising outlook, with inflation likely to decrease at a faster pace than expected. This is a significant shift from last year’s inflation hike, indicating a positive turn in the economic landscape. The decline in inflation, particularly in food prices such as wheat, which dominates Pakistan’s inflation, is a welcome development. This downward trend in food prices not only helps anchor inflation expectations at lower levels but also aligns with the State Bank of Pakistan’s (SBP) goal of maintaining positive real rates.
The SBP was behind the curve in hiking rates in 2022-23 and remains so in slashing rates in 2024-25. Perhaps this is a strategy to anchor lower inflationary expectations and maintain higher real rates to ensure external account stability, which may be the driving force behind Pakistan’s monetary policy. While falling wheat inflation is real and is likely to cascade to other food items, leading to lower overall inflationary expectations, it does not necessarily mean that the SBP should aggressively cut interest rates.
Managing inflation expectations is a critical aspect of maintaining price stability. The past two years have seen a significant increase in inflation, with retailers, distributors, importers, and manufacturers raising prices in anticipation of future hikes. However, this trend is now reversing, with business inflation expectations showing a decline. This shift is evident in the auto market, where some manufacturers have already reduced prices, partly due to changes in government taxation policies.
Lower wheat prices may impact rural wages, which are often linked. Lower wages would reduce rural core inflation, which has been higher than urban inflation, as wage increases in rural areas were higher.
While the SBP should exercise caution and keep real rates substantially positive, a token interest rate cut in the next monetary policy committee (MPC) meeting is very likely. Even if inflation may touch single digits in 2025 and the decline may be sharper than anticipated, the reduction in interest rates may not be as steep. The focus should be on building reserves, for which higher real rates can act as catalysts.
While the forecast is for lower inflation, it’s important to be mindful of potential challenges. The upcoming budget and the new IMF programme could introduce inflationary consequences. The continuation of a tight fiscal policy and the absence of new taxes on petroleum products are positive indicators. However, the potential increase in power tariffs may pose a challenge. Overall, a cautious approach is advised, assuming energy price revisions and new taxes.
The behaviour of the currency is crucial. The latest Real Effective Exchange Rate (REER) reading is at 104. While the Pakistani Rupee (PKR) has remained largely unchanged against the USD, it has depreciated against the currencies of other trading partners. Thus, a slight currency depreciation is very likely to occur at the start of the next programme to ensure that consumers’ inflation expectations remain in check. Given the turbulence of the past two years, some rationale exists for the SBP’s tight policy.
