The potential benefits and risks of implementing low interest rates
In the heart of South Asia, Pakistan's economy is facing a critical juncture, with the State Bank of Pakistan (SBP) implementing one of the most aggressive interest rate cuts in its history. The policy rate, which stood at 22% in June 2024, has been reduced to 11% by May 2025.
However, this aggressive monetary easing carries several potential risks and challenges.
Firstly, the risk of economic overheating and inflation rebound looms large. Although inflation has eased to around 3.2-4% in mid-2025, this decline reflects mainly statistical base effects rather than a sustained drop in underlying price pressures. Aggressive rate reductions could overheat the economy that is still digesting previous cuts, potentially triggering a resurgence in inflation to 7-9% by year-end. Risks such as energy tariff adjustments, global commodity price volatility, and reduced remittance incentives add to inflation uncertainty.
Secondly, premature stimulus and recovery fragility could be a concern. The SBP has already cut the policy rate sharply, providing initial relief. However, monetary easing effects usually take 2-3 quarters to materialize fully. Further cuts without allowing time for prior measures to impact may destabilize recovery momentum and increase volatility in a fragile economy.
Thirdly, pressure on the financial sector and credit markets is a significant concern. While lower rates reduce borrowing costs and stimulate sectors like manufacturing, textiles, and SMEs, a too-rapid decline could stress financial institutions’ profitability and asset quality. Banks may face challenges balancing lower interest income with increased loan demand, raising the risk of credit misallocation or rising non-performing loans if growth fails to pick up sustainably.
Fourthly, political and market expectations vs. macroeconomic realities present a challenge. Stakeholders urge the SBP to reduce rates drastically to spur growth and investment. However, experts caution that such large cuts are premature given ongoing inflation risks and the need to balance growth with price stability. The government targets GDP growth rising to 4.2% in FY26, but aggressive monetary easing risks currency volatility and external balance pressures if growth does not meet expectations.
Despite these challenges, the external sector has shown temporary stabilization, with a current account surplus of USD 1.9 billion recorded during July-March FY25. Headline inflation plummeted to a mere 0.3 percent in April 2025, the lowest in over 30 years for Pakistan. However, wage increases, the hike in administrative prices, and the coming delivery of energy tariff increases could all help revive inflation in the second half of the year.
The transition to a low interest rate environment provides temporary relief but is not a solution to Pakistan's permanent economic problems. The country has to repay approximately USD 19 billion in external liabilities per year, and a delay in projected inflows from the IMF, bilateral creditors, or Eurobond issuance could strain its reserves.
Moreover, Pakistan's trade deficit surged to USD 3.4 billion in April, with import appetite rebounding as credit markets reopen and import restrictions ease. This situation, coupled with the distress in the rural economy due to unprecedented falls in prices of some agricultural commodities, which have hit rural incomes hard, adds to the economic woes.
As the country prepares for its next IMF review, scrutinising fiscal and monetary policy alignment, policymakers must maintain vigilance and avoid assuming that rotational improvements are equivalent to structural strength. Savers may be drawn to speculative investments due to bank deposit rates being below inflation-adjusted returns in alternative assets, potentially eroding official financial intermediation and leading to asset bubbles.
The author of this article, a Research Economist at Pakistan Institute of Development Economics (PIDE), can be reached at [email protected]. The article is copyrighted by Business Recorder, 2025.
- Pakistan's economy, currently in crisis, is experiencing one of the most aggressive interest rate cuts in history by the State Bank of Pakistan (SBP), with the policy rate dropping from 22% in June 2024 to 11% by May 2025.
- This aggressive monetary easing, although providing initial relief, presents several potential risks and challenges.
- The risk of economic overheating and inflation rebound is high, as aggressively lowered rates could trigger a resurgence in inflation to 7-9% by year-end, exacerbated by energy tariff adjustments, global commodity price volatility, and reduced remittance incentives.
- Premature stimulus and recovery fragility could jeopardize the economy, as further cuts without allowing time for prior measures to impact may destabilize recovery momentum and increase volatility.
- Pressure on the financial sector and credit markets is a significant concern, as lower rates could stress financial institutions' profitability and asset quality, potentially leading to credit misallocation or rising non-performing loans.
- Political and market expectations vs. macroeconomic realities pose a challenge, as stakeholders urge the SBP to reduce rates drastically to spur growth and investment, but experts caution against such large cuts due to ongoing inflation risks.
- The country has to repay approximately USD 19 billion in external liabilities per year, and a delay in projected inflows from the IMF, bilateral creditors, or Eurobond issuance could strain its reserves.
- Savers may be attracted to speculative investments due to bank deposit rates being below inflation-adjusted returns in alternative assets, potentially leading to asset bubbles and eroding official financial intermediation.
