Introduction: Monetary Policy Decision Looms Large
KARACHI – As Pakistan’s economy continues its fragile journey toward stability, the State Bank of Pakistan (SBP) is preparing to announce its monetary policy decision on July 30, 2025. With economic stakeholders, financial analysts, and business leaders keenly awaiting the central bank’s move, a crucial question dominates the economic landscape: Will the SBP continue to cut interest rates, or will it pause to reassess the broader macroeconomic picture?
The current debate revolves around the effectiveness of recent interest rate cuts and the potential impact of further reductions on inflation, the exchange rate, and the current account deficit. In the context of global economic uncertainty and domestic fiscal pressures, the decision holds significant importance for Pakistan’s economic trajectory.
Recent Interest Rate Cuts: A Shift in Policy Stance
Over the past year, the SBP has embarked on a dramatic policy shift, reducing the benchmark interest rate from a record-high 22% to 11% by May 2025. This unprecedented reduction aimed to stimulate economic activity, ease borrowing costs for businesses, and revive investment sentiment that had stagnated due to high inflation and interest rates.
While these cuts have provided welcome relief to the private sector—particularly SMEs (Small and Medium Enterprises) and the housing and construction industries—the full impact of these changes has yet to materialize. Monetary policy, by its nature, works with a time lag, often requiring six months to a year to fully reflect in consumer spending, investment patterns, and inflationary trends.
Economist Perspective: Why Holding Rates May Be the Wiser Choice
As an economist closely monitoring both domestic and global financial indicators, my assessment is that maintaining interest rate stability is essential at this juncture.
While lower interest rates are typically associated with economic stimulation, further cuts at this stage could undermine recent gains in macroeconomic stability. There are several reasons why a more cautious and measured approach may be warranted:
1. Inflationary Pressures Persist Despite Recent Decline
The headline inflation has shown a notable year-on-year decrease, but this improvement is largely driven by the “base effect”—a statistical phenomenon where current inflation looks low simply because of very high prices in the same period the previous year.
Base Effect Explained: If inflation was 25% last year and is now 10%, it appears like a significant improvement. However, the actual price level remains high, and any external shock (such as an increase in global oil prices or a supply-side bottleneck) could reignite inflationary trends.
In addition, structural factors such as:
- Possible hikes in electricity and gas tariffs
- Volatility in global oil and commodity prices
- Uncertainty in food supply chains
- Reduced remittance incentives
can potentially push inflation back up to the 7-9% range in the coming months.
Thus, prematurely reducing interest rates may compromise the central bank’s inflation control objective.
2. Real Interest Rate and Its Importance for Currency and Trade Balance
The real interest rate—calculated by subtracting inflation from the nominal interest rate—is a critical factor in determining a country’s monetary policy stance. The SBP’s long-term inflation target is 5-7%, which requires a positive real interest rate of around 3-5% to maintain balance in:
- Import control
- Exchange rate stability
- Current account deficit management
Why Positive Real Interest Rates Matter:
- They discourage excessive imports by making credit more expensive.
- They help attract foreign capital and prevent capital flight.
- They support the Pakistani Rupee by maintaining a favorable interest rate differential compared to global markets.
A negative or neutral real interest rate environment—especially when inflation begins to rise again—can quickly erode investor confidence, cause rupee depreciation, and reintroduce external sector vulnerabilities.
3. External Sector Fragility and the Current Account
While Pakistan’s current account deficit (CAD) has narrowed in recent months, this improvement is not yet robust or sustainable. It has been largely driven by:
- Reduced imports due to administrative restrictions
- Favorable base effects in trade balances
- A one-off increase in remittances earlier this year
However, any resurgence in import demand—particularly due to cheaper credit—or fluctuations in global oil prices could widen the CAD again. In such a scenario, a stable interest rate helps:
- Maintain cautious consumer behavior
- Reinforce macroeconomic discipline
- Prevent unsustainable foreign exchange outflows
4. Exchange Rate Considerations
Another major reason to maintain the current interest rate is the fragile exchange rate stability. The Pakistani Rupee has shown signs of recovery after months of volatility, but this trend remains highly sensitive to external shocks, especially in a dollarized global financial environment.
Lower interest rates often lead to:
- Capital flight to countries with higher yields
- Currency devaluation due to lower demand for the domestic currency
- Imported inflation as foreign goods become costlier
Therefore, keeping interest rates stable reinforces the confidence of foreign investors and bondholders, helping to stabilize both the exchange rate and foreign reserves.
5. Global Environment Remains Volatile
On the international front, geopolitical tensions, such as instability in the Middle East, ongoing conflicts in Ukraine, and rising protectionism, continue to disrupt supply chains and inflate global commodity prices.
Additionally, major central banks such as the US Federal Reserve and the European Central Bank have maintained relatively high interest rates due to persistent inflation in developed economies. If Pakistan were to reduce rates aggressively, the interest rate differential could lead to an outflow of portfolio investments.
Recommendations for Policymakers and the SBP
Monetary Policy Direction
- Maintain the current interest rate until the inflation outlook improves based on core economic factors, not just statistical effects.
- Observe the effects of previous rate cuts before initiating more.
Fiscal-Monetary Coordination
- The government should complement the SBP’s cautious stance by ensuring fiscal discipline, reducing non-development expenditures, and improving tax compliance.
Strengthening Remittance Flows
- Reinstate or increase incentives for overseas Pakistanis to use formal channels for sending remittances.
- Support banking reforms to enhance digital transfers and financial inclusion.
Energy Price Stabilization
- Work with energy regulators to smoothen energy price adjustments, avoiding sudden spikes that fuel inflation.
Conclusion: A Time for Patience, Not Aggression
While the temptation to further reduce interest rates exists—particularly to stimulate credit growth, employment, and industrial activity—Pakistan’s current economic context demands monetary prudence and strategic patience.
The State Bank of Pakistan’s upcoming decision on July 30 will serve as a litmus test for its commitment to sustainable macroeconomic management. By maintaining the current interest rate, the SBP can safeguard hard-won gains in currency stabilization, inflation control, and external account balance.
In conclusion, interest rate stability is not just a monetary tool—it is a strategic anchor that underpins confidence in the economy. For a country like Pakistan, navigating through both domestic and global uncertainties, maintaining this anchor is crucial to long-term prosperity.
