Outlook for inflation

ARTICLE: The year 2019-20 saw a return for some months to double-digit inflation for the first time after 2011-12. Starting in August 2019, the CPI increased by 10.5 percent, reaching a peak of 14.6 percent in January 20. Thereafter, there has been a declining rate falling to 8.2 percent in May 20. The month of June has witnessed a minor upsurge in the rate of inflation to 8.6 percent.

The falling trend in the rate of inflation has led to some optimism about the outlook for inflation in 2020-21. The Monetary Policy Committee of the SBP in its recent meeting has expressed the view that the average inflation rate in 2020-21 could fall below the previously announced range of 7 percent to 9 percent, due particularly to the absence of demand-side pressures. This motivated the MPC to reduce the policy rate by 100 basis points to 7 percent.

The Annual Plan for 2020-21 prepared by the Planning Commission shows even greater optimism with inflation expected to remain at 6.5 percent due to decline in international oil and commodity prices and low demand. The IMF in its report on Pakistan for access to the Rapid Financing Facility in April projected the rate of inflation at 8 percent in 2020-21.

There is a need to understand why the rate of inflation fell by 6 percentage points from January to June 2020. In the former month, there was extraordinarily high inflation in the prices of perishable food items of over 78 percent. In particular, we witnessed the 'tomato price effect' with the price of this vegetable jumping up by 211 percent. Since then the inflation rate combined of vegetables and fruits has come down sharply to 7 percent. This explains almost 60 percent of the drop in the rate of inflation from January to June.

The second favorable development has been the fall in the price of motor fuel. This price had risen in the first half of 2019-20 due to the depreciation in the value of the rupee in the presence of high international price of oil ranging from $60 to almost $70 per barrel. In January 2020, the rise in the price of motor fuel was as high as 25.7 percent. From March onwards, this price has plummeted reaching a low of just over $20 per barrel in May 2020. Consequently, the price of motor fuel fell by over 28 percent in June 20. This transition from rise to fall in the price inflation in motor fuel explains 26 percent of the six-percentage point drop in the rate of inflation from January to June 2020.

Therefore, the peak rate of inflation in January 20 was primarily attributable to the abnormal increases in the prices of perishable food items and motor fuel. Recent months have witnessed a change in the sources of inflation. While the inflation rate has moderated substantially in the case of perishable food items it has risen significantly in the case of non-perishable food items to almost 16 percent. These items have a considerably higher weight of almost 30 percent in the CPI as compared to the weight of 5 percent of perishable food items.

Supply factors have probably played a greater role in the rise in inflation in non-perishable food items. The big jump in wheat flour price of 24.5 percent is attributable to supply bottlenecks in the lockdown due to Covid-19 and also due probably to hoarding by flour mills and wholesalers. This is also likely to be the case with almost 15 percent rise in the price of sugar, which is no longer being exported. The production of sugar has fallen by 7 percent in 2019-20.

High double-digit rates of inflation are being observed in imported food items like pulses, vegetable ghee and spices. Overall, the contribution to inflation in June 2020 of the rise in prices of non-perishable food items is over 52 percent. This pressure on the CPI is likely to persist in coming months.

There have also been some recent portents of a rising tendency in the rate of inflation. The rate of inflation in the rural CPI reached the double-digit rate of 10 percent for the first time in June 2020 after March 2020. Similarly, the weekly Sensitive Price Index registered a rise above 10 percent in the fourth week of June 2020. Fortunately, in the first week of the new financial year it fell to just below 10 percent.

The extremely worrying aspect of the current inflation in the country is that since it is concentrated in food prices it is having a disproportionate impact on the cost of living of the poorer households. According to the PBS, the latest estimate of the rate of inflation in the SPI for the lowest quintile of the population is as high as 13 percent as compared to 8 percent for the top quintile.

The expectations about the future rate of inflation have been heightened by the unprecedented hike in the prices of petroleum products 10 days ago. The price of petrol (super) has been increased by almost 34 percent and that of HSD oil by over 26 percent. This will not only impact on the price level directly but also indirectly on the prices of food and other non-food items via the rise in transport costs following the resulting increase in freight transport charges. A first estimate of the impact of the rise in prices of petroleum products on the CPI is almost two percentage points. Consequently, it will not be surprising if we see the rate of inflation rising to a double-digit rate in July.

The question then is what will the outlook be for the rate of inflation in 2020-21? Demand factors are, no doubt, operative. The rise in unemployment and poverty due to Covid-19 will reduce demand for basic consumer goods and services. However, there are a number of factors which will continue to exert pressure on the price level.

First, there is considerable monetary overhang. M2, the money supply, has increased by almost 14 percent in 2019-20, at almost twice the rate of expansion observed in 2018-19. This will put pressure on the rate of inflation with a time lag. Second, as the world economy recovers gradually after Covid-19, there is the likelihood of an increase in oil prices, especially in the second half of 2020-21. Third, there is the likelihood of a significant jump in power tariffs in an effort to manage the circular debt problem. Fourth, the exchange rate may come under pressure if there continues to be a big drop in exports and remittances. Fifth, there has been an abject failure in regulation of markets. Cartels and resort to hoarding have raised prices artificially. Also, the consequences of the locust attacks on food security need to be factored in. For example, the price of the staple, wheat flour, may be subject to upward pressure due to supply shortages.

Overall, the expectation of the Annual Plan of inflation in 2020-21 at 6.5 percent appears to be very optimistic. Similarly, the other forecasts are generally of a low single-digit rate. However, given the above factors there is a real risk that the rate of inflation could hover around 9 to 11 percent in 2020-21. The Government will have to make sustained and wide-ranging efforts to control the rate of inflation.

(The writer is Professor Emeritus at BNU and former Federal Minister)

Copyright Business Recorder, 2020