Pakistan’s central bank cut its key interest rate by 150 basis points on Monday in a widely-expected move, its first rate reduction in nearly four years as it strives to boost growth amid a sharp decline in retail inflation.

The decision to cut the key rate to 20.5% comes two days ahead of Pakistan’s annual budget and a week after data showed inflation slowed to a 30-month low of 11.8% in May.

“The significant decline in inflation since February was broadly in line with expectations, (but) the May outturn was better than anticipated earlier,” the State Bank of Pakistan (SBP) said in a statement.

The SBP last changed rates in an emergency meeting in late June last year, when it raised them by 100 basis points to a record high of 22% to stabilise the economy and curb inflation that hit a record high of 38% last year and had stayed above 20% since May 2022.

Between September 2021 and June 2023, the SBP raised rates by 1,500 basis points to rein in inflation and secure a short-term $3 billion bailout from the International Monetary Fund (IMF) to stave off an imminent default.

Economic activity in Pakistan has slowed over the last two years, and high rates have kept the government’s borrowing costs elevated. With the new government looking to tighten its purse strings, lower rates will be critical in helping it reduce domestic borrowing costs.

“As anticipated, SBP has taken a step towards narrowing the real interest rate gap to stimulate the economy and reduce its debt servicing burden,” said Muhammad Ali, market analyst at AKD Securities.

GDP growth in the current financial year to June 30 is expected to be between 2% and 3% after a 0.17% deceleration in the 2022-23 fiscal year. The government is now targeting 3.6% growth in the year starting July amid an uptick in economic activity.

However, the SBP sees upside risks to the near-term inflation outlook associated with upcoming budgetary measures and uncertainty regarding future energy price adjustments.

The IMF is prescribing measures for the Pakistani government, including increasing revenue through widening the tax base and power tariff hikes, for a longer-term bailout of around $6 billion to $8 billion.

The SBP said there has been limited progress in addressing structural weaknesses to broaden the tax base and initiating energy sector reforms, and so it expects budgetary measures to be largely based on tax and levy increases.

It emphasised that broadening the tax base and reforming loss-making public sector enterprises would help achieve fiscal sustainability on a more durable basis, adding that this was imperative to keep inflation on a downward trajectory and contain balance of payments pressures.

The statement also flagged a risk of inflation rising significantly in July before trending down gradually during the next financial year.

Pakistan Business Council said, “With headline inflation decelerating by 550 bps from April to 11.8% in May, and the policy rate significantly positive, businesses generally expected a sharper cut.

“However, as the monetary policy committee points out, upward inflationary risks emanate from the FY 25 budget and future increases in energy tariffs. So the ball is in the government’s court to manage inflation.”

“Businesses should derive comfort from the narrowing current account deficit, a primary surplus on the fiscal account, deceleration in the growth of currency in circulation, declining food inflation, and stable FX reserves... All these factors augur well for further reduction in the policy rate.”

Musadaq Zulqarnain, Director of the Pakistan Textile Council and Chairman at Interloop, said, “I expect that, while the policy rate should come down by 300 basis points, out of abundant caution it was reduced by 150-200 basis points.

“It will surely help a bit, though the rates will still be in a higher than workable range. But this will set the direction. We will also have to wait for the budget to see what the overall impact (is).”

M Abdul Aleem, CEO AND Secretary General of Pakistan’s Overseas Investors Chamber of Commerce and Industry (OICCI), said, “At present our real policy rate stands at 10%. This leaves room for a higher cut, at least by 2%. However, the monetary policy committee decided to cut the rate by 150 bps.

“This decline in the policy rate will provide relief of around 600 billion rupees ($2.16 billion) in debt servicing to the government and also to businesses by lowering the cost of borrowing.

“Business confidence has already improved, as reflected in the latest OICCI Business Confidence Index.

“Post the June 12 budget, we expect a revival of economic activities and the creation of employment opportunities. Moreover, as inflation is declining, we expect more cuts in future.”