SBP's Policy Rate Linkage to Inflation

State Bank of Pakistan Policy Rate Linkage To Inflation Rate.

“The primary purpose of contraction monetary policy is to make it harder for companies and consumers to borrow and spend money and, in turn, halt inflation.” (Business Insider)

In each country, the central bank has the essential obligation to regulate price stability by controlling inflation, which generally is carried through by the policy rate tool. Every country manages its policy rate in step with its own condition's circumstances. In Pakistan, since September 2021, the State Bank of Pakistan (SBP) has been changing policy rates at around 675 basis points, which was 7.5 per cent till July 2022, and now it has increased to 15 percent in September 2022. Pakistan has not been the only country that has drastically raised interest rates: Worldwide, we have all been seeing a hike, specifically after COVID-19.

It could be one of the reasons for the SBP raising interest rates, as it is ensuing throughout the world (Global Impact). But, the recent growth in the consumer price index (an increase in the prices of goods) due to domestic and international supply-side factors has matured a surge in inflation. Unfortunately, before the thorough aftermath of the deadly floods in Pakistan, inflation hit a 47-year high at 27.26 percent in September 2022. The upshot, the inflationary surge has become the worst enemy of economic growth.

The question is, why is inflation affecting Pakistan so severely? The reason is that we all have been entering a commodity super cycle, where global commodity demand has escalated, and the shortage of supplies in the world markets has resulted in supply chain commotion. Furthermore, meeting and managing consumer demands has become more complicated than before on the ground of world petroleum prices, global inflation, populations, shipment route restrictions, and transportation cost maintenance issues. Similarly, the industrialized and other emergent nations have also been encountering indistinguishable challenges and intricacies. Supply-side issues after the post-COVID-19 situation have become a phenomenon all over the world. Thus, Pakistan is experiencing one and the other demand-pull and cost-push inflation. The State Bank of Pakistan is trying to curb these effects by raising interest rates.

Now you're probably curious about the correlation linking interest rates and surging inflation and how SBP can curb inflation by raising interest rates that would be conducive to the financial system/State.

The mechanism of tightening monetary policy layout is that when the SBP elevates interest rates, it influences the retail rates of lending and the deposit rates of the banking sector. Raising policy rates (short-term interest rates) alters the commercial banks borrowing costs and the rates they charge on loans.

Contractionary monetary policy also exerts influence on consumer and business psychology. The effects are immediate on the stock market, higher interest rates cause stock investors' earnings to fall and stock prices to drop, and they become further circumspect to bidding on stock prices. The other side effect comes from increased saving rates as bond valuation during this time becomes attractive. Venture capitalists or individuals consider depositing their income or assets in banks to earn a profit, eventually causing downward pressure on rupees and prices. Additionally, it gives rise to exchange rate because higher interest rates entice foreign capital, which drives down the cost of local goods and boosts exports while lowering imports. As investors decide in the spirit of anticipation to handle the increased cost of doing business, the transitory rise in inflation is the first lag in the transmission mechanism of money supply, which allows misapprehension among the consumer and investors.

Moreover, this makes the financial sector's lending rate more expensive, and purchasing goods and services also becomes higher priced for consumers and investors. When this happens, consumers and investors spend less, which results in a slowdown of the economy. Comprehension about interest rates and the economy leads investors to figure out the big picture and construct sound investment decisions. Besides, the corollary goes down on the fiscal budget as Pakistan's fiscal budget deficit has emerged wide-ranging on account of extensive borrowing by the government. They would reconsider their consumption by either rationalizing their expenditures or increasing revenues through taxes, which reduces the supply of money in circulation or credit availability. Consequently, government spending would shrink and drive the situation arduous to borrow.

Hence, the hierarchy advances towards the stock market's quick effects, then the financial sector, and finally to the target audience to change their expenditure pattern to reduce the economy's overall demand for commodities and services.

To control the wide-ranging fiscal debt, output gap, supply-side shock, and the behaviour of individuals (expectation), both consumption and demand are suppressed by this procedure. It usually takes at least 12 months or 18 months in developing countries for a change in the interest rate to have a widespread economic impact. But subsequently, the causal nexus comes to an end.

The State Bank of Pakistan's (SBP) efforts to combat inflation is a grand interest rate experiment. Like it or not, we all are part of it.

Interest rate & Inflation rate worldwide, September 2022, bar graph representation.