SBP Policy Rate Likely to Fall to 19% by End of FY24: Report

Headline inflation in the country is expected to decline to 17 percent by May 2024 which will provide the central bank room to cut the policy rate to 19 percent by the end of the current fiscal year (FY24), according to a report by Arif Habib Limited (AHL).

The FY24 began with high year-on-year (YoY) headline inflation averaging 27.8 percent in Jul-Aug and, spiking in September 2023 to 31.4 percent mainly due to low base effect and rising fuel costs. Moreover, the second quarter will continue to see high headline inflation due to an increase in gas tariff, high international oil prices and moderate PKR depreciation, according to the report.

Inflation will start to moderate during the third quarter, with both YoY and MoM rates showing a receding trend. YoY CPI will gradually decline from 26.4 percent to 19.4 percent, indicating a slowing down of price increases compared to the same period in the previous year mainly due to high base effect.

“Given the anticipated decrease in inflation to 19 percent by March 24, there appears to be ample room for the SBP to contemplate the initiation of a policy easing move. This could potentially involve announcing a reduction of 100bps in March 2024. This would mark the first rate cut since June 2020, representing a gap of over 3.5 years,” added the report.

The report expects a prominent drop in the fourth quarter in both YoY and MoM inflation rates. YoY rates are expected to decline further to 17 percent in May providing further room for SBP to cut policy rates, as the real interest rates turn positive. It expects the central bank to cut the rates by 200bps in this quarter, closing FY24 around 19 percent level.

Given further deceleration in inflationary pressures in 1HFY25, the report foresees a further 500bps reduction in policy rate in 1HFY25 (14 percent in December 2024) which will result in a cumulative reduction of 800bps in CY24.

The report also highlighted certain factors that Monetary Policy Committee (MPC) might consider for opting for a gradual loosening of monetary policy.

If timely external commitments, including both inflows and rollovers, materialize, the Current Account Deficit is expected to remain consistently below $500 million per month. This, coupled with the SBP’s Foreign Exchange (FX) Reserves, which are anticipated to provide nearly three months’ worth of import cover, paints a positive picture for the country’s external financial stability.

The inflation projections, with expectations of average inflation ranging between 22-23 percent over the next nine months followed by a significant decline to 17.7 percent by June 2024 and a further drop to an average of 13.6 percent during 1HFY25. These projections indicate a favorable environment for the MPC to consider a gradual easing of the monetary policy stance.

The economic outlook appears challenging, with a notable contraction already observed in Large Scale Manufacturing during 1MFY24, down by 1.1 percent YoY (FY23: -10.3 percent YoY). The severity of this economic downturn will be particularly pronounced in cyclical sectors, including construction and other areas heavily reliant on domestic demand. In this context, a rate cut would likely play a crucial role in stimulating overall economic activity, the report added.

Areas of concern

While some downward adjustments have recently been observed in domestic petrol prices, the situation remains sensitive to international oil price movements, and any increases on that front could have further implications for domestic petroleum prices and, subsequently, inflation.

Since first-round effects of inflation are initially reflected by a surge in commodity prices, which may take time to feed into the economy and be reflected in the CPI. Looking ahead, it is crucial to keep in mind that substantial spike in oil and other commodity prices are a notable concern for our projections. These fluctuations may potentially lead to variances from CPI estimates in the foreseeable future, it added.

Another area of concern revolves around the potential for a substantial depreciation of the PKR versus the USD. Such a development would have a notable impact on inflation estimates as well. It is estimated that every one percent change in the average exchange rate leads to a 17bps change in CPI, over a period of 18 months.

The report further stated that, “Additionally, on the monetary policy front, the IMF, through its Country Report as part of the ongoing SBA program, has strongly emphasized the necessity of implementing a tight monetary policy. This measure is considered crucial in addressing the persistent inflationary pressures and steering inflation back within the targeted range of 5-7 percent by the conclusion of FY25.”

However, given the challenging external account situation, we believe it is imperative for Pakistan to maintain its engagement with the IMF in the long term.

The report anticipates that Pakistan will complete the current SBA program and subsequently enter into another program post the General Elections in the 1Q/2Q24. This is seen as essential to address both long-term structural issues and external financing needs. To secure the IMF’s support, there is a possibility that the SBP might delay the initial interest rate cut beyond March 2024.

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