Pakistan's central bank has decided to raise its key policy rate by 50 basis points to 13%, as concerns about the persistence of inflation and the weak fiscal position outweighed improvement in the recovery process.

The State Bank of Pakistan, in its monetary policy council meeting on Friday, unexpectedly hiked the rate after keeping it unchanged for three consecutive rate-setting sessions. The central bank was widely expected to keep the interest rate unchanged.

"Concerns of persistence in inflation and fiscal weaknesses are overshadowing the improvement in the external current account deficit and economic recovery," the SBP said.

The bank expects risks to inflationary pressures to persist in financial year 2011. In the last financial year, inflation was 11.7%, 2.7 percentage points above the target.

A increase in electricity prices, general sales tax and revisions in government employees' wages are putting upward pressure on inflation, the SBP said. The bank expects average consumer price inflation to be between 11% to 12% in 2011, higher than the 9.5% target.

The bank observed that the decline in investments has narrowed the gap between national savings and investment. At the same time, aggregate domestic demand, led by public sector consumption expenditures, is picking up while the prospects for aggregate supply remain weak due to energy shortages and dismal law and order conditions.

These conditions, combined with rising debt continue to threaten the macro-economic stability of the country and call for renewed efforts to maintain the economic growth momentum, the bank noted.

Both the fiscal deficit and government borrowing missed their respective targets in the financial year 2010, putting upward pressure on interest rates. SBP forecast a deficit above 5% in 2011.

"Measures to increase the tax to GDP ratio and eliminate the revenue deficit of fiscal accounts are urgently required to provide a firm foundation for sustainable economic growth," the bank observed.

Meanwhile, the government has set an inflation target of 9.5% for 2010-11 fiscal year, down from an estimated 12% in 2009-10. Real GDP growth is forecast to be 4.1% in the current fiscal and may move to 4.5% in the next fiscal year and gradually go up to 5% in 2011-12 and to 5.5% in 2012-13.

Pakistan is trying to bring its budget deficit down to 4% of the country's gross domestic product in the 2010-11 fiscal year from 5% estimated for 2009-10, Finance Minister Abdul Hafeez Shaikh said in his budget speech on June 7.

The government also aims to lower total public debt to 51.5% of GDP from 54.8% estimated for the current financial year. In 2010, the GDP grew 4.1%, mostly due to an increase in total consumption expenditures.