Energy Shocks and Inflation

The forces beyond the direct control of the domestic money policy, which are now significantly contributing to Pakistan’s inflation issue, are worsening the problem. Renewed pressure is being felt on domestic prices from international energy prices, geopolitical tensions and imported production costs. But the traditional policy tactic is well known: increase interest rates. Whether to use monetary measures to control inflation when its major source is not the domestic economy is the question.
The recent inflation forecast for Pakistan demonstrates this situation. The October 2026 Monthly Economic Update and Outlook report by the Finance Division had headline inflation at 10.3 per cent in September, up from 5.8 per cent a year before, while expected inflation for October was 9.5–10.5 per cent. September’s average price for Brent crude was $116.8 per barrel, up 28.4 per cent from August.
The cost of fuel is not the only pressure. Greater global energy prices raise transportation, electricity generation and industrial production costs and ultimately contribute to rising food prices as well as costs of key commodities. This structural reliance on imported energy makes Pakistan more vulnerable. The Annual Report 2024-25 of the State Bank of Pakistan (SBP) states the vulnerability of the economy to global price fluctuations in energy products.
In this backdrop, the State Bank of Pakistan (SBP) increased the policy rate by 50 basis points to 12 per cent in October 2026 to bring down the inflationary expectations and slow the second round effects. The move comes in response to a valid worry, but it also poses a basic issue on the efficiency and expense of the policy of monetary restraint during a time when the inflation process is largely supply-led.
In my opinion, three inter-related hurdles make monetary transmission mechanism in Pakistan more complex.
First, importing inflation is exacerbated by external vulnerability. Rising international energy prices raise the import bill, foreign exchange demand and pressures on exchange rates. The additional depreciation of the currency will lead to the further increase of the costs of imported fuel, machinery and intermediate goods. This pass-through effect is an amplification of the original shock, especially in a country with poor external buffers.
Secondly, the effects of monetary transmission are limited. The major impact of higher interest rates is on domestic borrowing, consumption, investment and aggregate demand. They have no control over international oil prices or over disruption to the oil supply. Furthermore, monetary tightening can have negative effects on the investment of industries and economic recovery even in the absence of the disinflationary impact of monetary tightening. Exchange-rate pass-through and expectations of inflation are key in emerging-market monetary frameworks, says the Bank for International Settlements.
Third, institutional coordination is also not sufficient. More integrated policies are needed in response to external shocks in monetary, fiscal and energy policies. Domestic price formation is complicated by inefficient subsidies, circular debt, distribution losses and energy-sector reforms yet to be implemented. These structural weaknesses can’t be corrected by adjusting interest rates.
Pakistan is thus in need of a more nuanced policy mix which will differentiate between temporary imported inflation and permanent domestic inflation.
It is first important to improve the diagnosis of inflation. The SBP should carefully isolate first-round energy-price impacts from second-round inflation, by core inflation, inflation expectations, wage developments and sectoral price indicators. The persistence and extent of inflation should be taken into account when determining interest rates, not when the headline CPI moves up or down. The goal should be to avoid temporary supply shock inflation being fixed in domestic prices, while not dampening the economy in needless ways.
Second, there needs to be more coordination between monetary and fiscal authorities. There should be a coordinated mechanism to monitor imported inflation, exchange rate pressures, and domestic price adjustments within the ambit of the Ministry of Finance, SBP and the regulators of the energy sector. Fiscal assistance should be temporary, transparent and targeted, and not be based on broad energy subsidy. The experience of Indonesia, reported in the OECD Economic Survey, illustrates how a mix of energy-subsidy reform and targeted support for vulnerable households can work.
Third, dependence on foreign energy resources should be minimized and structural changes should be a priority in the economy. MOE and the relevant regulators should speed up the renewable energy sector development, enhance transmission infrastructure and foster energy efficiency in industry. The goal should be to lessen the economy’s reliance on external energy-price fluctuations, not to continually deal with the effects of such movements by resorting to monetary contraction.
Last but not least, safeguarding productive investments and industrial competitiveness is of paramount importance. The output costs of disinflation can be better minimised through predictable monetary communications, more effective credit allocation, and more productive interventions, especially in export-oriented manufacturing and small businesses. This is not to be interpreted as sacrificing price stability but rather as not to be price stability at the expense of the productive capacity.
In the end, however, monetary policy will not create energy, or eliminate geopolitical disruption or the international commodity price rise. It is tasked with ensuring that external shocks do not become part of the framework of inflationary expectations and price-setting in the domestic economy. The Pakistan economy is in need of a shift from an interest rate-driven approach to a coordinated policy which incorporates monetary credibility with fiscal discipline and structural energy reforms. The only way for an economy to come to a long-term price equilibrium is to cut demand only after fixing the structural drivers of imported inflation.