Economic stabilisation and disinflation

The economy has been in a stabilisation phase since April 2022. This is one of the largest stabilisation phases in the history of Pakistan. The average inflation rate has dropped to 5.25% in the first nine months of FY2025. The import bill has remained around $43 billion in the said period, which was lower by around 30% from the peak observed in FY2022.

The foreign exchange reserves held by the State Bank of Pakistan (SBP) are hovering around $11 billion, which may cover around 2.5 months of merchandise imports. A large part of these reserves is built through the buying of dollars by the SBP from the domestic foreign exchange market. Even the rollover of international debt servicing payments has also helped in bolstering these reserves.

The main instrument used by the authorities to improve these statistics is the policy rate. The policy rate was jacked up to 22% in a short period. The policy rate affects aggregate demand and aggregate supply simultaneously. However, the impact on aggregate supply is faster than the aggregate demand.

A higher policy rate makes it difficult for business firms to finance their inventories. Normally, the business firms borrow from banks to maintain a level of inventories. When demand is high, these firms draw down on inventories, which maintain prices of their products. If the level of inventories is low, this will increase the prices. Hence, the high policy rate creates shortages of industrial products in the economy.

The higher policy rate also affects the level of fixed investment in the economy. This fixed investment increases the productive potential of the economy. Hence, the high policy rate affects inventories and fixed investment, which in turn reduces aggregate supply.

In the context of developing economies, the impact of high policy rate on aggregate demand is relatively low as there is inertia in consumption. This implies that the high policy rate affects the aggregate supply faster than the aggregate demand.

Analysts, a few economists and some media commentators are hinting at disinflation in the economy owing to a quick deceleration in prices. Although this disinflation is considered good in a small circle, yet this does not bode well for the broader economy.

Specifically, this deceleration in prices is not good for industrial capitalists as they reduce the level of output. When the industrial capitalists expect lower profitability, they reduce their level of output and even put their expansion plans on hold.

The SBP has gradually brought down the policy rate to 12% while core inflation is even lower, which makes the real interest rate positive. In simple words, the real interest rate is equivalent to the nominal interest rate adjusted for inflation.

The positive real interest rate is not preferred by industrial capitalists. Hence, disinflation and the positive real interest rate stunt the growth of the industrial sector. The large-scale manufacturing sector has shown a contraction of around 2% in the first eight months of FY2025, as depicted by the Quantum Index of Manufacturing (QIM), tabulated by the Pakistan Bureau of Statistics (PBS).

In a nutshell, macroeconomic stabilisation is implemented to control excess demand where aggregate demand exceeds aggregate supply. This is mainly done through a high policy rate and partly through austerity measures.

The high policy rate affects the aggregate supply more than the aggregate demand, which will aggravate the cost structure of business firms. In other words, this will fuel cost-push inflation as stabilisation measures are relaxed in due course of time. Hence, this situation is not good for the broader economy, specifically for industrial capitalists.

The writer is an independent economist, who worked at SDSB, Lahore University of Management Sciences (LUMS)