In July consumer price index is at 31 months low and is in single digit for the first time in this calendar year. With inflation arguably the paramount factor in fixing the policy rate; a cut of 50-100 bps in Fridays monetary policy announcement is echoing the market.
BR Research conducted a survey of 27 research houses on their expectations regarding the MPS. Prior to the release of the latest inflation data, 22 of the respondents had expected the central bank to hold the policy rate unchanged.
However, after the said data was released and respondents were revisited, 23 out of 27 respondents stated that a cut in the discount rate should be forthcoming on Friday.
These responses shed ample light on market participants perception that inflation is the paramount concern in the monetary policy decision.
In fact, State Bank of Pakistan is primarily concerned with soothing inflationary expectations while guarding private sector credit appetite so that a balance may ensure a smooth transition towards higher growth.
Over the past two years, inflationary expectations have become anchored due to government borrowing from the banking system. This burden will only be lifted if and when the fiscal house is brought to order.
The other factor which is driving inflation and swaying currency is the volatility in the international commodity prices, especially oil and food. These two virtually constituted half of the CPI weight and their price hike is the chief reason for persistent double digit inflation since FY09.
And in theory monetary policy cannot do much to control either of these as they are driven by supply side factors; unlike core inflation (non food non energy) driven by demand that can be controlled by interest rate movements.
Lately, there is some respite on the supply push factors and that is why CPI is in single digits as oil prices were quite low. But government borrowing from the central bank - Rs505 billion in FY12 versus virtually nothing in the previous year - resulted in the gradual upsurge in core inflation.
NFNE inflation averaged 10.9 percent in the past seven months as compared to 10.2 percent in the preceding six months. This factor may slash the quantum of the rate cut in the upcoming review.
Demand for credit will also not be spurred significantly as long as expectations of a high fiscal deficit and its monetisation remain high. No wonder investment in the economy is at its lowest ebb since the creation of Pakistan.
The balance of payment vulnerability is also keeping SBP; although the resumption of the Nato supplies on the back of improved Pak-US relations has marginally improved prospects for foreign inflows.
The countrys restored relation with the US has economic effects - the reimbursement of $1.18 billion in the form of Coalition Support Fund has eased the falling central bank reserves for the time being. This augments the argument of a sharp rate cut.
But this is not sustainable and may just delay the inevitability that Pakistan will soon be back at the window of the IMF.
Mind you, the latest IMF Article 4 Review was vocal about the monetary policy tighteninzg to attain the macroeconomic stability. Hence, an aggressive rate cut may not bode well with the lender of the last resort.
In a nutshell, fiscal imbalances, BOP vulnerabilities, surge in core inflation and 18 percent hike in oil prices from the recent low will limit the central banks ability to lower the discount rate to a modest 50 bps.
The objective as repeatedly said by SBP Governor, shall remain maintaining real interest rates - the difference between expected inflation and the discount rate - close to zero.