SBP needs to adopt a new policy mix

The MPS is being announced later today and it should make for an interesting read. In the prevailing policy paralysis due to election considerations, the absence of a Finance Minister, delays in fiscal reform, the implications that the MPS has for economic stability are seismic. That is why in my view the SBP will have to be courageous and mitigate macroeconomic risks, which it has indicated it is ready to do. Part of being courageous will necessitate having to resist the urge to cut the policy rate in its bi-monthly policy decision due today and maintain the status-quo. While some people might find this prescription hard to stomach and will point to the muted inflation number this month, (6.57% YoY), they are forgetting that:

(1) Inflation is a lag indicator and reacting to the number after it is out or after the phenomenon has taken hold defeats the purpose of a proactive central bank. Even if we look at it from a mathematical point of view; taking the present inflation at 6.57%; if we assume increases are mean reverting and thus use a mean increase of 1% monthly, we will be looking at a year end inflation rate of 11% approx in December.

(2) In another more optimistic scenario in which Inflation only increases by 0.5% MoM, we will be looking at a year end inflation rate of 7% approx in December. Scenario two is what all of us would prefer but it would be brazen for anyone to jump the gun on what the actual scenario will be at the end of the year. Thus any cut in interest rates today will be rather impertinent on behalf of our economic managers. In an environment of policy paralysis and looming dangers the SBP needs to be a step ahead not a step behind of any dangers to our macroeconomic stability. The SBP has to adopt a wait and see policy. Only after the downward trend in inflationary pressures has been confirmed, inclusive of core Inflation (presently at 9%), should the SBP venture to cut rates. However, subjective evidence is suggesting that wider general price levels have continued to increase. A similar increase can also be witnessed in property and wage price pressures. Growing energy crises, that require tariff rationalisation in short term can easily increase CPI to double digits in coming months. Keeping all this in mind the ideal time to reconsider rate would be sometime in June.

If things do go further south in the coming months the SBP will have to further modify its existing framework of inflation-targeting by explicitly making financial stability one of its key objective functions. The SBP accordingly will need to adopt a new policy mix by using policy tools, such as reserve requirement ratios and its interest rate corridor, to supplement the short term interest rate. The objective of any SBP policy implementation should be to gradually lead Pakistan’s economy to robust growth without hampering the medium-term inflation outlook.

Accordingly, policies need to be pursued to prevent an excessive deviation of exchange rates from economic fundamentals, while necessary measures also need to be taken with the support of other institutions to ensure reasonable loan growth rates. It is impossible to achieve both goals simultaneously by only adjusting the policy rate; this is not the optimal response. In this context, the long delayed policy response of reducing the corridor and the eventual increasing of the OMO rate will help with the reduction in incentives for the interest rate carry trade. It is good to see that the OMO has shrunk from PkR 600 mil to PkR 500 mill but more has to be done to decrease this amount. The SBP should further decrease the corridor between overnight borrowing and lending rates so as to further decrease volatility in the short-term interest rates, limit maturity mismatches, all of which will eventually push funding costs up and reduce the expected risk/return ratios from (funding) carry trades. This in turn should discourage short-term speculative inflows into fixed income securities. This will also offer the banks an opportunity for an orderly exit from their respective OMO positions so that the banks can get back to their original mandates, which is loan growth and not speculative FI or equity trading.

In order to offset the expansionary impact that the previous SBP/Government policies have had on domestic absorption, the SBP will have to embark on a quantitative tightening strategy, basically aimed at directly controlling the amount of liquidity and moderating the rapid expansion in the OMO. The intermediate objective of any policy response has to be to stop the rate of investment in government securities and this will support both the financial and price stability objectives.

M2 expansion, which registered an average increase of 14% Y/Y in Fy12, has started to pick up, averaging at 15.8% Y/Y in current fiscal year. This monetary expansion is well above the expected nominal GDP growth in Fy13. Thus the SBP also has to start using reserve requirement ratios more effectively. The Central Bank needs to start hiking reserve requirement ratios significantly, with varying degrees across maturities, and broadening the coverage of liabilities subject to reserve requirements. These hikes in reserve requirement ratios will lead to a significant level of PkR liquidity withdrawal from the banking system. Along with the above the SBP will also have to revert to it’s tried and tested policy tool of increasing the discount rate to mitigate risks, but at a little later time. While this orderly draining of overhang will have adverse consequences for the PIB and T-Bill market, firstly the bank’s balance sheets are strong enough to take the hit and secondly the job of a bank is to be a financial intermediary and provider of credit not a speculator in fixed income as their primary source of income. So if banks are over reliant on FI income to boost their bottom line a forced realignment is in order. As a result of the implementation of the above strategy, the maturity of the liabilities of the banking system will decrease, supporting financial stability via reductions in the roll-over and interest rate risks of Pakistani banks and encouraging alternate sources of funding and meaningful economic reform. Although such a policy might be painful in the medium term it will reduce macro-financial risks by helping to lead the economy to a more balanced growth path.