Pakistan's Monetary Policy Tradeoff After the 2023 Inflation Shock

1. Introduction

Pakistan's monetary-policy problem over the past two years was not whether the State Bank of Pakistan should care about inflation, but how quickly it should normalize policy rates after the 2023 inflation peak. Inflation had reached levels not seen since the early 1970s, driven by a combination of domestic fiscal imbalances, a sharp exchange-rate depreciation, and the aftereffects of the 2022 floods on food supply chains. At its peak in May 2023, CPI inflation stood at 37.97 percent year-on-year. The policy rate, raised to 22 percent in June 2023, was held at that level for more than a year.

This essay argues, using four frameworks from monetary economics, that the SBP was right to keep policy restrictive while inflation expectations were fragile, and also right to move only gradually toward easing as headline inflation fell. Further rate cuts should remain conditional on three criteria: inflation remaining within the 5-to-7 percent target range, exchange-rate pressure staying contained, and fiscal policy preserving credibility. The four analytical frameworks are the New Keynesian IS curve, the expectations-augmented Phillips curve, a monetary-policy reaction function, and the Romer fluctuation model.

2. Background: Disinflation After the Pandemic Shock

Pakistan entered the post-pandemic period with deep structural vulnerabilities: a weak fiscal position, a large current-account deficit, and a currency that had been kept artificially stable at the cost of mounting external liabilities. The convergence of these vulnerabilities with global commodity price shocks and the catastrophic 2022 floods produced an inflation episode that peaked at 37.97 percent in May 2023. The main drivers were energy-price adjustment through the removal of fuel subsidies agreed with the IMF, a large exchange-rate depreciation as foreign reserves fell to critical levels, and supply disruptions from the floods. Monetary transmission in this environment was complicated: the output gap turned sharply negative as real GDP contracted by 0.41 percent in FY2023, but inflation remained elevated because of the supply-side component and because inflation expectations had become de-anchored from the target range.

As the IMF's Extended Fund Facility restored fiscal discipline and exchange-rate stability, and as the SBP's restrictive posture began to anchor expectations, inflation fell sharply: from the May 2023 peak to single digits by early 2025 and to 3.5 percent by June 2025. The output gap, having turned deeply negative during the period of tightest policy, began to narrow as domestic demand recovered and supply disruptions faded. The crucial observation is that the output gap was already deeply negative when inflation peaked, meaning that the demand component of inflation had already been constrained; the persistence came from the supply side and from inflation expectations that had become de-anchored.

3. Models and Evidence

IS Curve and the Credit Channel

In the New Keynesian IS curve, current output relative to potential depends negatively on the real interest rate and positively on expected future output. When the SBP raised the policy rate to 22 percent, it raised the cost of borrowing in real terms and compressed investment demand and durable-goods consumption. Evidence for this transmission can be seen in the behavior of private-sector credit: its share of GDP declined from a peak of 17.6 percent in FY2018 to 13.8 percent in FY2024, the period of tightest monetary conditions. This decline reflects both the direct effect of higher borrowing costs and the indirect effect of government crowding out of domestic financial resources.

Pakistan's credit channel has a structural complication. The government's large and growing fiscal deficit was financed predominantly through the banking system, absorbing deposits that might otherwise have funded private investment. Government borrowing from commercial banks rose steadily from 23.0 percent of GDP in FY2014 to 40.5 percent in FY2025. When the government borrows heavily from the banking system, it crowds out private borrowers and weakens the monetary transmission mechanism: the central bank raises the policy rate to cool demand, but a large portion of bank lending is insensitive to that rate because the government cannot substitute out of domestic bank borrowing in the short run. Even when households and firms do not respond strongly to the policy rate itself, tighter monetary policy can still affect the economy through bank lending conditions, credit availability, collateral values, and exchange-rate expectations. In Pakistan, these channels are important because firms rely heavily on bank credit, government borrowing absorbs domestic financial resources, and exchange-rate movements feed quickly into import prices.

Expectations-Augmented Phillips Curve

The expectations-augmented Phillips curve relates current inflation to expected inflation, the output gap, and supply shocks: π = π^e + κ(y − y*) + ε. Pakistan's inflation persistence reflected a combination of elevated inflation expectations and a large positive supply-shock component. Even when the output gap turned deeply negative, inflation remained elevated because the supply-side term was large and because expectations had become de-anchored from the 5-to-7 percent target range. The SBP's decision to maintain a restrictive policy stance, even as real activity weakened, can be understood as an effort to rebuild the credibility needed to pull expectations back toward target. A central bank that eases prematurely, before expectations are re-anchored, risks validating higher inflation expectations and making subsequent disinflation more costly in output terms.

Monetary-Policy Reaction Function

A standard Taylor-type rule suggests that the appropriate policy rate depends positively on the deviation of inflation from target and the output gap. For most of 2023 and 2024, both signals pointed toward tight policy: inflation was far above target, and while the output gap was negative, the supply shock meant that this gap alone was not sufficient to bring inflation down quickly. The SBP's departure from a mechanical rule in the tightening phase reflects the judgment that supply-shock episodes require a more patient response. The central bank must hold policy tight long enough for expectations to come down, even if this prolongs the period of below-potential output.

4. Romer Model and Policy Recommendation

The Romer Fluctuation Model

The Romer fluctuation model helps clarify why Pakistan's policy tradeoff is difficult. In the model, the short-run equilibrium is described by the IS curve relating output to the real interest rate, the monetary-policy rule relating the real interest rate to inflation and output, and the Phillips curve relating inflation to expected inflation and the output gap. Supply shocks shift the Phillips curve upward, changing the combination of output and inflation that the economy reaches in equilibrium. The key insight is that a central bank facing a supply shock must choose between stabilizing inflation at the cost of a larger negative output gap, and stabilizing output at the cost of higher inflation.

Fiscal Constraint on Monetary Policy

A key constraint on the SBP's room to maneuver is fiscal dominance. Pakistan's public debt, including guaranteed obligations, stood at approximately 73.8 percent of GDP in FY2025, and interest payments consumed roughly 57 percent of government revenue. These figures do not by themselves put monetary policy on an unsustainable path, but they limit the central bank's room to hold the policy rate high for an extended period, because high rates increase the cost of rolling over domestic public debt. Pakistan's debt burden is not unusually high by international standards, but weak revenue capacity, rollover risk, and high interest costs relative to revenue make fiscal dominance a serious constraint on monetary credibility.

Policy Recommendation

The SBP has moved in the right direction. The policy rate was gradually reduced from 22 percent to 12 percent by mid-2025, reflecting the fall in headline inflation and the progressive re-anchoring of expectations. The recommendation here is to continue this gradual approach, conditional on three criteria. First, headline CPI inflation should remain within the 5-to-7 percent target range. Second, the exchange rate should not come under significant depreciation pressure. In Pakistan's import-intensive structure, a sharp depreciation would quickly reignite inflation through import prices and fuel costs, undoing the disinflation gains. Third, the fiscal path should remain credible. As long as the government continues to borrow heavily from the banking system, the monetary transmission mechanism is partially impaired, and the central bank cannot afford to ease further than the inflation and exchange-rate signals warrant.

5. Conclusion

Pakistan's monetary-policy experience from 2022 to 2025 is a case study in how a central bank should respond to a large supply shock in a structurally vulnerable economy. The SBP was right to raise the policy rate to 22 percent and to hold it there for over a year. It was right to ease gradually once headline inflation and inflation expectations began to come down. The disinflation from the May 2023 peak to 3.5 percent by June 2025 was achieved without a financial crisis or a banking-system failure, which is a significant outcome given the depth of the initial shock.

The Romer model and the expectations-augmented Phillips curve explain why patience in disinflation is valuable. Once expectations become de-anchored, re-anchoring them requires a period of restrictive policy that is costly in terms of output. Premature easing would simply prolong the problem, requiring a larger adjustment later. The conditions for further rate cuts are clear from the evidence: inflation within the target range, the exchange rate stable, and fiscal credibility preserved. If those conditions are met, additional easing is warranted. If any of them breaks down, the SBP should hold or reverse course.

References

• International Monetary Fund (2025a). Pakistan: Extended Arrangement Under the Extended Fund Facility—First Review. Press Release No. 25/150. May 9.
• International Monetary Fund (2025b). Pakistan: Second Review Under the Extended Fund Facility. December 8.
• Romer, D. (2024). Short-Run Fluctuations. ECON 251 Lecture Notes.
• State Bank of Pakistan (2025). Monetary Policy Statement. September 15.
• World Bank (2025). Pakistan Economic Monitor. June.