A gamble with the economy

A better strategy might have been a staggered approach in reduction of interest rates, balancing inflation, growth.

Central bankers are typically the most risk averse amongst policymakers. So when they take a gamble as big as a 1.5 per cent cut in the benchmark interest rate in the country, it is worth paying attention to the reasons as to why they did so. On Saturday October 8, the State Bank of Pakistan (SBP) issued a press release stating that it had decided to reduce the discount rate — the interest rate at which it lends money to commercial banks — to 12 per cent from 13.5 per cent, citing lower inflation.

There is no question that the move has a potential upside: the cut by the SBP is likely to have a cascading effect across the financial system, reducing borrowing costs throughout the economy, thus making it easier for businesses to grow. No sane Pakistani would be opposed to lower rates if they help accelerate economic growth and we hope this measure by the SBP has its desired effect. But given the allegations that the move was politically motivated, it is worth questioning the wisdom of reducing interest rates by 150 basis points in one go.

For starters, it had emerged that the analysis within the central bank was not unanimous in supporting quite so dramatic a rate cut. Indeed, there is considerable debate amongst the economists at the SBP as to whether a cut in interest rates would hurt or help the economy. While economic growth should be the primary concern of any government, it is not the job of the central bank to allow the administration to take short-cuts, particularly at the expense of potentially fuelling inflation. This is precisely why central banks are given more independence than any other part of the government’s economic management team.

Some experts believe that a reduction in rates may well cause inflation to rise from its already high levels and cause an acceleration in the depreciation of the rupee. This is highly dangerous at any time, but particularly dangerous when the government is expecting to make large payments on its external debts over the next few months. A better strategy might have been a more staggered approach in reduction of interest rates, balancing the concerns between inflation and growth. The SBP has decided to take a gamble by doing it all at once. Let us hope for the sake of the Pakistani economy that it works.

Published in The Express Tribune, October 11^th, 2011.