Inflation as a fiscal problem

Inflation as a fiscal difficulty.

Key points

• Khanzaib AhmadAbdul Moeez Mirza Published September 7, 2026 Updated September 7, 2026 07: 39am.
• The correlation between debt servicing and headline inflation in the period 2006-16 was negligible and became moderate to solid post the 2022-23 spiral.
• Khanzaib Ahmad is a co-developer of the Monetary Policy Uncertainty Index for Pakistan and an analyst at Chase Securities.
• The conventional economic theory believes cost spirals are the result of excess aggregate demand that the State Bank of Pakistan can tame by raising interest rates.
• Floating rate instruments constitute approximately 70 per cent of all domestic sovereign debt.

Khanzaib AhmadAbdul Moeez Mirza Published September 7, 2026 Updated September 7, 2026 07: 39am. Join our Whatsapp Channel. Add Dawn as a trusted source.

Against the backdrop of the post-Covid 19 massive inflationary spiral, the fiscally suffocated administration, with limited days of foreign exchange reserves, became dependent on the domestic debt market to finance its massive deficits against the backdrop of rising inflation. Therefore, it had to matter a massive amount of floating-rate, long-tenor debt instruments to manage extreme rollover risk.

For reference, the total cumulative issuance of semi-annual floating Pakistan Investment Bonds rose from less than Rs1 trillion in 2020 to more than Rs14tr in 2024, and is at present more than Rs22tr. Floating rate instruments constitute approximately 70 per cent of all domestic sovereign debt. While Average Time to Refix (ATR) stands just above one year, the debt portfolio's Average Time to Maturity (ATM) is near 3.9 years. This leads to a vicious cycle of repricing: cost increases immediately upset fiscal accounts.

Notably, the conventional economic theory believes cost spirals are the result of excess aggregate demand that the State Bank of Pakistan can tame by raising interest rates. Nevertheless, Pakistan has high cost-push, structural, and import-driven inflation. The recurring cost spirals are mainly on the supply side and are the result of sudden currency devaluation, global commodity shocks, frequent revisions of administered energy tariffs to offset energy sector circular debt and domestic food supply bottlenecks.

In this structural context, the monetary policy measures taken by the State Bank of Pakistan are certainly needed. In the absence of a hawkish monetary policy against the backdrop of an inflationary wave, inflationary expectations swiftly obtain out of hand, second-round wage-price spirals set in, and exchange rate pressures build up, potentially leading to an uncontained macroeconomic spiral. But the central bank's tightening directly affects the most significant channel that links inflation to an overwhelming fiscal burden: the domestic cost of debt.

Notably, the administration should continue to work on structural reprofiling to address the sovereign portfolio's repricing sensitivity.

Notably, the correlation between debt servicing and headline inflation in the period 2006-16 was negligible and became moderate to solid post the 2022-23 spiral. The central bank's rate hike to tackle cost shocks reprices the government's enormous domestic floating debt stock. This means that the policy rate hikes obtain swiftly and vigorously passed on through the sovereign debt portfolio to fiscal expenditures. This transmission is a delayed pass-through, with the sensitivity of debt servicing being highest after two to three quarters as floating instruments reprice at successive auctions.

Meanwhile, the costs of servicing the debt take up a sizeable share of the federal budget. Despite three consecutive years of contractionary fiscal policy delivering consistent primary surpluses, debt servicing consumes 40 per cent of the federal budget. The administration had no choice but to cut development spending and investment in productive capital.

Notably, an anti-price policy, applied to control costs, ends up increasing fiscal pressure, deteriorating the composition of public finances, and consuming public investments that can no longer be applied for long-term structural productivity spending.

This structural difficulty would need to be significantly addressed by improving sovereign debt indicators. The Debt Management Office has achieved good results previously few years, with its efforts to reprofile domestic maturities, growth fixed-rate debt issuances, and extend the average maturity of the public debt stock. Nevertheless, the sovereign portfolio is still quite sensitive to repricing risk.

Continued to these fiscal weaknesses are the severe climate and geopolitical vulnerabilities facing Pakistan. It is still one of the most climate-sensitive countries in the world and continues to suffer from devastating floods, heatwaves, and yield losses that displace millions of individuals, destroy infrastructure, trigger food inflation, and erode fiscal buffers.

In practice, the current adaptation and mitigation actions are not adequate in view of the magnitude of the challenge. There is an urgent need to build dedicated infrastructure for climate change adaptation, modernise water management, improve storage logistics, and create agriculture climate-smart in Pakistan to reduce vulnerability to frequent environmental shocks.

Meanwhile, Pakistan has to accord with its extreme geoeconomic vulnerabilities in a fracturing global order. The domestic economy is highly vulnerable to cross-border commodity cost fluctuations, given its high reliance on imported fuel. The geopolitical and climate vulnerabilities have resulted in stagflationary pressures, leading to severe episodes of macroeconomic instability.

As recurring cost spirals are not the result of runaway domestic demand but of rate disruptions from outside the economy, the need to protect the economy requires proactive fiscal measures to overcome acute climate and geopolitical vulnerabilities.

State agencies need to invest in climate-smart agricultural infrastructure, streamline storage logistics, and limit dependence on imported energy to shield the real economy from probable and unpredictable supply-side shocks. The Debt Management Office, by contrast, should continue working on structural reprofiling. It involves increasing the proportion of fixed-rate debt and lengthening debt maturities, to address the sovereign portfolio's repricing sensitivity.

For context, the administration has to address these structural and debt-market fault lines, so that conventional monetary interventions will no longer exacerbate the sovereign's fiscal difficulties.

Khanzaib Ahmad is a co-developer of the Monetary Policy Uncertainty Index for Pakistan and an analyst at Chase Securities. Abdul Moeez Mirza is a research assistant at IBA School of Business Studies. Published in Dawn, The Business and Finance Weekly, September 7th, 2026.

In short, inflation as a fiscal problem is the central thread here, and readers can expect follow-up reporting as the picture becomes clearer.