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Monetary Tightening on the Loose

What is this behavior, State Bank?

The next SBP's Monetary Policy Committee (MPC) meeting will occur on July 07. The current policy rate stands at 13.75 percent, while the latest cut-off rate of 03-month MTBs is as high as 15.08 percent. It seems that the central bank is not catching up with the market. Finally, the headline inflation currently stands at 21.3 percent, thus making the current inflation rate the third-highest for the entire year, only behind 26.66 percent (1974) and 23.07 percent (1973). It implies that even a 125 bps hike to 15.25 percent will result in negative 'real' policy rates. In short, depositors and savers save less and spend more in the face of undervalued, rapidly depreciating PKR, thus making it even worse. It is most likely that the central bank will perform further tightening in the next monetary policy issue by jacking up the policy rate, but what good will it do?

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A policy rate hike would be rendered ineffective at this point. But why? A central bank possesses several tools to tame money supply and inflation, of which three are primary: policy rate, OMOs, and cash reserve ratio (CRR). Pakistan's banking watchdog, as far as OMOs are concerned, frequently uses this monetary policy instrument but to little to no effect. The latest financial injection is worth PKR 1.37 trillion.

Now, get back to the instrument in question, i.e., the policy rate. The previous monetary policy witnessed a 150 bps (1.5 percent) hike in the policy rate. The justification SBP provided for this move was "should help moderate demand to a more sustainable pace." The author believes the central bank cannot grasp that it possesses little to no control over the inflation Pakistan is currently facing. As far as inflation is concerned, at least three kinds of inflation exist. They are demand-pull inflation, cost-push inflation, and monetary inflation.

Pakistan is majorly stricken with cost-push or supply-side inflation due to the sky-rocketing global commodity prices, causing fuel and food inflation, mainly due to the Russia-Ukraine conflict. Only a recession can bring down the international oil prices, impacting food inflation. As the recession fears loom in for the US and eventually the world (spillover effect at play), oil prices recently observed a sharp slash. Citi Group predicts the oil price to be as low as $65 per barrel.

Cognitive Dissonance

If you're reading this sentence, the author must assume that you must have known by now the following:

  • The central bank has a tight monetary policy stance.
  • The central bank frequently injects money.
Now, notice the above two points. Don't they sound contrary to one another? They are. What is this behavior, State Bank? It is incomprehensible how the central bank, whose monetary policy aims to deprive the market of liquidity, offers liquidity through the very tool of the monetary policy - OMOs. Also, the issue department of the central bank gets the most money. This contradictory behavior raises questions about economic decision-making at the nation's central bank and the underlying thought process.

Originally published at https://rafeyirahman.substack.com. If you liked this or learned something new, please consider subscribing to Finesse for more financial literacy posts.

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