THE interest rate cutting cycle is well and truly under way. After the slashing of the policy rate by three percentage points since August last year, financial markets are expecting the State Bank of Pakistan (SBP) to trim the discount rate by another 1.5 to two percentage points later today, bringing it down from 10.5 per cent to somewhere around nine per cent.
Should this occur, the move will be premised on, among other data points, official measures of inflation showing a large decline in price pressure in the economy over the past two to three months. Year-on-year headline consumer price inflation has declined to 8.8 per cent for September — a level last seen three years ago.
The moderation in inflation has come on the back of a sharp slowdown in food inflation which has dropped from 11.3 per cent in May this year to 7.6 per cent in September. Inflation in the non-food items of the consumption basket has also moderated, from 13 per cent to 9.7 per cent in the same period. Price inflation in the non-food, non-energy items used by an ‘average’ consumer (referred to as ‘core’ inflation) has declined less convincingly, from 11.2 per cent in May to 10.5 per cent in September. Among the major items of consumption whose prices have declined over the past few months compared to year-ago levels are consumer price index (CPI) heavyweights such as sugar (down 28 per cent), gas (down between seven and 42 per cent for various categories) and varieties of pulses. On the other hand, important food items in the consumption basket such as wheat, vegetable oil, gram, milk and onions have recorded fairly steep increases.
The other factor that will reinforce SBP’s hand in lowering interest rates further is the easing up of the pressure on the balance of payments, with August recording a large current account surplus. Even though this can be explained by the lumpy windfall inflow under Coalition Support Funds (CSF), the underlying trend is more benign than what many (including myself) had expected. Non-oil imports have declined despite the massive fiscal injection provided by the government’s budgetary transgressions for the third year running — prima facie a sign that aggregate demand pressures are on the wane.
The SBP can take justifiable credit for apparently anticipating correctly the inflation path and the balance of payments — though the central bank’s own rationale detailed in the last monetary policy statement all appeared to favour an increase in interest rates rather than an easing of monetary policy.
How will inflation play out in the coming months? In the short run, the outlook for inflation is contingent heavily on international oil prices. The recent unexpected fall in global oil prices has largely been due to a short-term spike in petroleum stockpiles in the US; fears of an imminent release from the US Strategic Petroleum Reserve (SPR); continued glum economic data from the Euro-zone, China and India; and, the earlier-than-expected reopening of the Gulf of Mexico’s oil platforms following hurricane Isaac.
Geopolitics involving Iran and the other hotspots in the Middle East could still provide a price-supportive backdrop to oil for now, as will the recent launch of the new round of quantitative easing (‘QE3’) by the US Federal Reserve. On the other hand, a continuation of the sharp reversal in international oil prices will provide important support to not only the balance of payments but also to the extent of the pass-through to domestic prices, to the inflation path.
Global prices of food and agricultural commodities are also presenting a mixed picture. Sugar prices have declined sharply, as have the prices of palm oil and, more recently, tea. On the other hand, world prices of many grains and cereals are responding to unfavourable weather conditions in many important producing regions. Overall, the United Nations’ Food and Agricultural Organisation’s Food Price Index is up six per cent since June.
A potential party-spoiler is the extent of rupee weakness that may or may not occur over the coming months. If the balance of payments situation starts to deteriorate once again — with a potential catalyst being capital flight ahead of national elections or ahead of the lumpy debt repayments to the IMF — the rupee could come under substantial pressure. At the margin, this will feed into domestic inflation.
It is important to note here that the element many of us who have been dubbed ‘inflation hawks’ are most worried about — fiscal and monetary excesses — plays out over a longer time frame than changes in the price of oil, for example. Hence, while there has been respite in inflationary pressure in the past few months, on paper at least, uncertainty regarding the longer term inflation outlook remains in the presence of policy excesses.
A fundamental issue that should not get lost in the debate is whether inflation is being recorded ‘accurately’. Some long-standing concerns about the inflation methodology have been reinforced, rightly or wrongly, by the most recent change of base. Two of these issues are: first, the significant reduction in the weight of food items in the consumption basket, contrary to the findings from the official household survey (Household Integrated Economic Survey); and second, the use of ‘life-line’ energy tariffs for the calculation of consumer inflation. Both of these constructions tend to understate inflation in a period of rising commodity prices.
The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.