SBP flags inflation spike and external risks amid middle east conflict

The State Bank of Pakistan (SBP) said the war in the Middle East poses significant risks to the economic outlook. It added that rising energy prices, supply chain disruptions, and higher freight and insurance costs could significantly weigh on the country’s macroeconomic stability.

According to its Half Year Report, State of the Economy, the surge in international energy prices was immediately transmitted to domestic inflation despite the government’s decision to initially absorb a major portion of the increase.

However, the report said the impact on overall economic activity is not expected to be significant in FY26.

It noted that high-frequency indicators, including the Purchasing Managers’ Index (PMI), suggest industrial output—particularly large-scale manufacturing (LSM) and construction—has maintained the momentum observed in the first two quarters through February 2026.

The war, however, is expected to weigh on output toward the end of FY26.

On agriculture, the report said wheat output points to a better harvest than last year, though slightly below the FY26 target. Combined with a lower-than-expected impact of floods on major kharif crops such as sugarcane and rice, agriculture is expected to perform relatively better in FY26.

The stronger performance of agriculture and industry is expected to have positive spillover effects on the services sector. As a result, real GDP growth is projected to remain close to the lower bound of the 3.75% to 4.75% forecast range.

Food inflation is expected to moderate due to higher production and limited export opportunities amid regional conflicts, though this may be partially offset by higher transportation costs in the second half of FY26.

Energy inflation is expected to rise after the government passed on higher global oil prices following the outbreak of war. Oil price shocks also pose upside risks to core inflation through cost pressures, second-round effects, and rising inflation expectations.

These developments suggest that headline CPI inflation is likely to remain above the upper bound of the medium-term target range of 5% to 7% in the remaining months of FY26 and into FY27.

The spike in energy prices, along with higher insurance and freight costs, is also expected to increase Pakistan’s import bill and freight service payments. However, the government’s decision to pass on higher fuel costs to consumers, along with energy conservation measures, is expected to help contain demand and reduce energy imports.

A decline in LNG imports may further ease the energy import bill. However, exports are expected to remain weak due to slower global growth, multi-year low rice prices, closure of Pakistan’s western border, and global trade realignments caused by tariff adjustments.

Workers’ remittances may also come under pressure in the fourth quarter of FY26, as remittances from Gulf Cooperation Council (GCC) countries account for around 55% of total inflows between FY21 and FY25. However, on a full-year basis, remittances are expected to remain strong in FY26, partially offsetting the widening trade deficit.

As a result, the current account deficit is projected to remain close to the lower bound of the 0% to 1% of GDP range in FY26.

On the fiscal side, higher energy prices and the war are expected to affect tax and non-tax revenues as well as discretionary spending. The rise in domestic fuel prices is likely to increase energy subsidies, while petroleum levy collections may decline due to lower fuel consumption and conservation measures.

However, cuts in development spending are expected to partially cushion the fiscal impact. Overall, the SBP projects the fiscal deficit to remain within 3.5% to 4.5% of GDP.

While the near-term outlook remains broadly stable, prolonged effects of the war on supply chains and global demand could pose medium-term risks to macroeconomic stability. These include weaker remittances, disruptions in imports of raw materials and machinery, and potential impacts on industrial production and exports. Fertilizer shortages may also affect agricultural yields.

Slower growth could also reduce revenue generation, while higher discretionary spending needs may require additional revenue measures with inflationary implications. Inflation expectations, though currently anchored, could also rise.

The SBP said it will continue to take appropriate measures to preserve macroeconomic stability, particularly to keep inflation under control and maintain external buffers.