KARACHI - The State Bank of Pakistan on Wednesday decided to increase its monetary policy rate by 50 basis points to 13.5 percent for the period of October-November 2010. Resurging inflation led by supply constraints and heavy government borrowings on account of massive current outlays with an aim to finance flood-related spending caused the SBP to further tighten its monetary stance for the next couple of months. The SBP announced monetary policy decision after its Central Board of Directors meeting held under the Chairmanship of Governor Shahid H Kardar at the Banks building here. The monetary policy stance is formed by the consideration that the effect of continued inflation is substantial and felt by the entire economy. A tightening of the stance is thus called for in full recognition that the difficulty to contain fiscal deficit has resulted in the private sector bearing the full brunt of such an adjustment, the State Bank explained the rationale behind the increase in policy rate in its monetary policy decision. It said that the next quarter would be crucial in forming an assessment of the effectiveness of governments efforts to contain the fiscal deficit and its inflationary borrowings from the SBP and the banking system. It may be recalled here that tightening cycle was initiated in the previous monetary policy where the discount rate was raised by 50bps in the wake of upside risk of inflation and fiscal weakness. According to the SBP momentary policy document, the recent catastrophic floods have serious implications for macroeconomic stability and growth prospects. However, even before the floods, the macroeconomic conditions and outlook were looking fragile. By the end of FY10, inflation was high and the fiscal deficit had risen to 6.3 percent of GDP. Early assessments indicated that these pressures are unlikely to abate in FY11. Post-flood projections raise legitimate concerns about the worsening of the macroeconomic balances since the initiatives required addressing the underlying cause for the primary stimulus to aggregate demand, coming from the fiscal side, having yet to be launched with vigour and coherence. They show that inflation will increase further accompanied by a drop in economic growth, both the trade balance and fiscal accounts will be under stress, and the banking system may witness pressure on account of rise in NPLs of the private sector and borrowings of the government, unless a comprehensive and coordinated response is developed to meet these challenges, the SBP said. The SBP further said that the clarity on the nature and scale of such a package would depend on the complete assessment of losses to the economy expected to be completed next month. Nevertheless, the components of the economic strategy that would need to continue to be in focus despite uncertainty would include implementation of tax reforms to enhance much needed revenues, resolution of the energy sector subsidies and circular debt to restore economic growth, relief measures for those affected by the floods, and containment of government borrowing from SBP to restrict inflation. A committed and credible progress on these fronts will be critical for reviving confidence and stability and stimulating economic growth, otherwise the burden of any adjustment will continue to fall on the engine of growth, the private sector, the SBP pointed out. The central bank added that losses in agriculture and infrastructure due to floods were more direct and visible while the impact on industry and opportunities for the workforce was going to be indirect. It also estimated that the economic growth for FY11 could come down to 2.5 percent from an earlier target of 4.5 percent. While aggregate private consumption may decelerate as a result those of the government will most likely to increase to meet the urgent needs of the flood victims and their rehabilitation, leading to a sharper deterioration of the fiscal accounts. The central bank warned that in the aftermath of the floods, bringing inflation down to single digit would require a supportive and sustained financial and fiscal effort over the next couple of years. Better management of financial resources including more transparency and timely availability of fiscal figures, broadening of the tax base, controlling discretionary current expenditures and reprioritising development expenditures would be imperative for fiscal consolidation. The SBP clarified that these steps would remove any ambiguity arising out of the pre-flood budget for FY11, which initially announced a deficit of 4 percent that shot up to 5.2 percent of GDP after the combined provincial budgets were unveiled. How the fiscal policy response to the floods is incorporated in the revised budget remains to be seen, but it is clear that even attaining the deficit of 5.2 percent of GDP will require considerable adjustment in the key fiscal parameters. The year-on-year growth of 7.5 percent in the Federal Board of Revenues (FBR) tax revenues during the first two months of FY11 compared to the budget target of 25.6 percent for the full year does not instil much confidence, it concerned. The SBP found that the disruption in the supply chain of food items caused the month-on-month (MoM) food inflation to jump to 5.1 percent in August 2010, pushing the M-o-M CPI inflation to 2.5 percent. In SBPs assessment this temporary spike in prices is largely due to floods, as it is over and above the average M-o-M growth in food inflation (1.6 percent) and CPI inflation (1.1 percent) during Ramazan in the previous five years. It may take two to three months for food inflation to return to normal levels. Slowdown in private demand later in the year will at best have a moderating effect on CPI inflation as it is likely to be neutralised by an expected increase in governments spending in general and on reconstruction in the flood-affected areas in particular. It is estimated that average CPI inflation for FY11 may fall between 13.5 and 14.5 percent. Further, likely increases in electricity prices, induction of the RGST and continued reliance of the government on borrowings from the SBP only add to the uncertainty surrounding inflation expectations, it added.