ISLAMABAD - Following the steep decline in inflation rate, the State Bank of Pakistan (SBP) on Saturday reduced the interest rate by one percent to seven percent, the lowest in 42 years.

The SBP Board of Directors reduced the policy rate by 100 basis points given the macroeconomic conditions. The new interest rate for the next two months (May-June 2015) would be effective from May 25 2015.

“The cut in interest rate will help in generating business activity and attract more investment in the country,” said SBP Governor Ashraf Mahmood Wathra while declaring the monetary policy here. The cut in energy and fuel prices coupled with decline in interest rate will also promote economic activity, he added.

The inflation based on consumer price index had recorded at a 12-year low of 2.1 percent in April 2015, as the fall in CPI was largely because of a decrease in global oil and commodities prices. Therefore, the Central Bank reduced the interest rate to 7 from 8 percent, which is fourth consecutive cut in policy rate this fiscal year.

The State Bank of Pakistan has also introduced ‘SBP Target Rate’ in order to enhance the effectiveness of monetary policy and manage liquidity in the inter-bank market in an efficient and meaningful manner. SBP target rate will be in addition to ceiling rate and floor rate of the corridor.

The SBP has kept the target rate at 6.5 percent. Meanwhile, the ceiling rate has reduced to 7 from 8 percent and floor rate to 5 from 5.50 percent while the width of the interest rate corridor is reduced by 50 basis points from 250 to 200 basis points.

“Macroeconomic conditions towards the end of FY15 have further improved compared to the beginning of the fiscal year. Current account deficit has narrowed down; average annual inflation is significantly below the target; there is a marginal uptick in real GDP growth; and foreign exchange reserve buildup continues,” stated the monetary policy of the SBP issued here.

It said all these developments were reflected in the recent upgrades in outlook by international rating agencies that have further improved investor confidence. The current macroeconomic stability achieved through domestic policies and favorable external developments provide an opportunity to focus on reforms that will put the economy on sustainable growth path.

With contraction in imports, led by sharp decline in oil prices, and strong growth in remittances, the external current account deficit at $1.4 billion during Jul-Apr FY15 is around half of the deficit recorded in the corresponding period of last year. The improvement has overshadowed lower surplus in capital and financial account, especially weak foreign private investment.

Meanwhile, the country’s foreign exchange reserves increased to $12.5 billion as of 15th May from $9.1 billion of 30th June 2014. The reserves are expected to further increase due to subdued outlook of international oil prices, successful continuation of IMF program, and realisation of expected official foreign inflows.

The inflation continues with its downward trajectory in this fiscal year. The year-on-year CPI inflation has declined to 2.1 percent in April 2015 from 8.2 percent in June 2014. Soft international commodity prices, stability in exchange rate, contained government borrowings from SBP, moderate aggregate demand, and SBP’s earlier conservative monetary policy stance have remained the key factors in controlling inflation this year. However, uncertainty about international oil prices and possible adjustment in domestic energy prices are the main risks to this inflation outlook.

Credit growth during July-March FY15 has remained well diversified in terms of coverage and type of finance. All three sectors of the economy - agriculture, manufacturing and services - availed credit both for working capital and for fixed investment purposes. The highlight remains the loans to private sector businesses in fixed investment category that increased to Rs84.4 billion in Jul-Mar FY15 from Rs50.3 billion in the same period of last year. However, owing largely to decrease in commodity prices, loans in the working capital category dropped to Rs90.3 billion in Jul-Mar FY15 from Rs223.8 billion in the same period of FY14.

Broad money (M2) has expanded by 7.3 percent during July 1-May 8, FY15 against 7 percent during the same period last year. After remaining tight during most of the current fiscal year, liquidity conditions at the back of overall improvement in balance of payments have relatively eased towards the end of FY15. The money market overnight repo rate, on average, remained 49 basis points below the SBP’s policy rate in the post March 2015 monetary policy decision compared to 33 basis points in the post January 2015 decision.

These developments bode well for the smooth transmission of policy rate changes to other market interest rates in addition to the implementation of the revised interest rate corridor framework. In line with monetary policy stance, market interest rates have fallen since January 2015. With current trends in key macroeconomic variables, money market liquidity is expected to remain at ease in the coming months.

Real GDP is provisionally estimated to have grown by 4.2 percent in FY15, slightly higher than 4.0 percent in FY14. Overcoming energy shortages and improving law and order conditions is expected to provide further impetus in reviving investment and higher production. Gradual realisation of planned investment in energy and infrastructure projects will provide additional boost to growth. Consequently, growth is expected to be revived at a relatively faster pace going forward.