Pakistan’s recent inflationary episode is mainly driven by higher fuel prices, freight shipping costs, and insurance charges, caused by oil price (supply) shocks resulting from the closure of the Strait of Hormuz due to the Iran–US war. The higher fuel costs may have a devastating impact on Pakistan's economy, as oil is the single most important energy source that drives the wheels of the economy. These inflationary pressures have progressed rapidly, as transportation and logistics costs, food and non-food prices, and the costs of raw materials for farming, industry, and trade have increased drastically in just a half-month period.
Further, if these inflationary pressures are prolonged and become permanent, the economy will experience the second-round effect in terms of wage and price-setting behaviours. In this trajectory, controlling the rising inflation is the foremost policy concern for most central banks, and foreseeing this, the State Bank of Pakistan has increased the policy rate by 100 basis points in its April Monetary Policy Committee meeting.
But the question arises here: “Is the recent State Bank of Pakistan action, i.e., monetary tightening stance, the right response to energy price-driven inflation in Pakistan”, when the economy is in its early recovery stage after a long period of economic recession. Empirical evidence suggests that tightening monetary policy will have a deeper recessionary impact on the economy in terms of significant welfare losses for households, businesses, and credit markets. In this op-ed, the author discusses the State Bank of Pakistan's recent rise in the policy rate and its implications on the Pakistan economy, as detailed below.
Pakistan Bureau of Statistics statistics reveal that consumers are confronted with sudden inflationary pressures, particularly in energy bills (11.5%) and transport costs (12.5%) due to energy supply shocks in February 2026, while persistent inflation in education (9.3%), health (9%), and miscellaneous items (21.61%). Raising the interest rate addresses inflation if it comes through the demand channel.
While the current inflation in energy bills and transport costs is purely a supply-side, i.e., a cost-push phenomenon. Further, the inflationary pressures in education and health are a signal of structural inefficiencies in the education and health services, not the kind that should be tackled by squeezing aggregate demand. It should be resolved with some other administered measures.
Raising the interest rate will keep the banking sector further away from the private sector and will have a crowding-out impact on the economy
In contrast, raising the interest rate here will translate into increased borrowing costs for producers, reduce production and output, create unemployment, reduce the earnings of consumers, and thus create a welfare loss for household consumers.
The Monthly Quantum Index of Manufacturing Industries (QMI) is estimated to be 131.50 in February 2026, in comparison to 144.46 in January 2025, showing a decline of about 8.97 per cent on a month-to-month basis. It shows 6.45 per cent growth on a year-to-year basis in March 2026, compared to 10.54 per cent growth in January 2026.
Pakistan Institute of Development Economics policy view indicates that the QIM index reveals a volatile, stop-start pattern, with a sharp early-year slowdown, partial mid-year recovery, strong uptick in January 2026, and renewed contraction in February 2026, indicating that momentum is externally driven and fragile. As such, the economy is not booming but in a recovery phase rather than in distress.
The recent surge in fuel costs resulting from oil price shocks has increased production, raw material, energy, and logistics costs significantly, and will lower production activities in the upcoming months. In this situation, the economy can no longer sustain the burden of tight monetary policy.
The State Bank of Pakistan's raised policy rate will increase borrowing costs for working capital and fixed investments and reduce the net present value of business projects. Further interest rate hikes would reduce industrial output, create unemployment, and may weaken export competitiveness and slow the recently gained economic recovery. Empirics show that with an increase in the State Bank of Pakistan policy rate by 100 basis points, investment declines by 0.40 per cent on a yearly basis.
The high cost of borrowing crowds out the private sector while simultaneously making government securities more attractive. Consequently, the banking sector is increasingly channelling funds into government securities rather than private-sector lending, as reflected in a constant, wide gap between the Advances-to-Deposits Ratio and the Investment-to-Deposits Ratio.
Raising the interest rate will keep the banking sector further away from the private sector and will have a crowding-out impact on the economy. Further, the increase in the policy rate will amplify fiscal debt and interest payments and have severe implications on the fiscal front.
Another important element for businesses is economic policy uncertainty and business sentiment. Business sentiment is directly linked to the State Bank of Pakistan policy rate. Statistics show that there is an inverse relationship between the State Bank of Pakistan policy rate and business sentiment.
At present, Pakistan is confronting high economic policy uncertainty as the EPI index has reached 350.23, showing a 77.2 per cent growth in March 2026 in comparison to the previous month, February 2026. Literature indicates that economic policy uncertainty curbs business sentiment and pushes back the economy for decades. In this way, the current increase in the policy rate will wash away newly grown business sentiment as well.
Knowing that current inflation is a supply-side phenomenon and active monetary policy will deepen the economic recession, most central banks, like the United States Federal Reserve, the Bank of England, the European Central Bank, and the Bank of Japan, also hold the policy rate unchanged.
Pakistan Institute of Development Economics policy view calls this a status quo action. Raising interest rates in response to energy inflation is akin to treating the wrong ailment. It imposes real economic costs without addressing the root cause of inflation.