Inflation in check; currency needs a check

Surprisingly, food prices went down by 0.2 percent month-on-month in Ramadan which is both counterintuitive and against anecdotal evidence. Unsurprisingly, alcoholic beverages and tobacco sub index was down by 15.3 percent in June. Whether there was a special Ramadan discount as indulgers refrained from consumption or not, we will never know. Rooh-Afza will probably be replaced by Johnnie Walker to undo the dip in prices.

Jokes apart, FY17 full year inflation stood at an average of 4.2 percent, well within the target of 6 percent. Low food inflation is the prime reason - the non-perishable and perishable food items on average increased by 3.3 percent and 2.6 percent respectively in FY17. The second biggest component of CPI is housing and utility index, which is up by 4.9 percent while the increase is partially offset by 0.8 percent decline in transport index. The year was not good for social sectors as health and education have become dearer with double digit inflation in both indices.

Core inflation is persistently above 5 percent which is showing that demand driven pressure. Overall trend is of rising inflation as the CPI is on upward journey, having bottomed out at 2.85 percent in FY16. The question is that where would inflation be in FY18 and beyond? Would it remain within the target of 6 percent? What are the inflationary expectations? And what variables have high correlation with the CPI?

A quick analysis of past fifteen years data, suggest that the CPI has high correlation with WPI and currency devaluation. The impact of former comes with a lag on headline inflation. And WPI data suggest that there will be a spike in CPI soon.

Wholesale price index is based on prices in the factor market and its affect on consumer price index comes with a lag of a quarter or so. The WPI remained in negative 0.3 and 1.1 percent respectively in FY15 and FY16 and this partially explains why CPI came down from 8.3 percent in FY14 to 4.5 percent (FY15) and 2.9 percent in FY16. The WPI stood at 4.0 percent in FY17; and at an average of 5.0 percent in the last two quarters to suggest that CPI would inch up in coming quarters.

Last 15 years correlation of WPI and CPI is at 0.85. However, both are indictors of inflation and have dependency upon the other macroeconomic variables and move in tandem accordingly. What other indicators are more important in an economy where financial penetration is low, documentation is scarce and reliance on imports is high?

It is certainly not money growth (M2 ) whose correlation to CPI is negative 0.5 for the past fifteen years. Thus, the impact of monetary easing is not really impacting inflation. The single most important indicator is the currency devaluation; and it builds inflation expectation which in turn is a self fulfilling prophecy. That is why the currency is being managed by economic managers, be it be Shaukhat Aziz (FY04-08) or Ishaq Dar(FY14-17); and as soon as currency starts devaluing, inflation moves up.

The relationship stands other way round too i.e. if the inflation starts moving up; the expectation of currency devaluation would build and the demand supply mechanism may actually depreciate the currency. And once the currency is depreciated, imported inflation comes into play and that cascades to every sector.

The correlation between CPI and USD devaluation stands at 0.76 for the past fifteen years. FY18 is crucial and any meaningful spike in inflation could spur currency devaluation. And then the ripple effect takes place. Let’s imagine the future from what was happened around 2008 crisis.

The demand driven inflation started picking up much before currency depreciation in the previous decade, as CPI averaged 9.2 percent in FY06-08 but the currency was kept artificially up with an average yearly devaluation of 1.8 percent. The bubble burst in FY09 as currency fell by 25.7 percent. It did not only have an adverse impact on inflation for that very year (CPI:20.8%); but the double digit inflation continued for next three years, and currency kept falling too.

The momentum was halted in FY15; as till FY14 inflation and rupee parity both were heading south - CPI stood at 8.6 percent and rupee fell by 6.4 percent in FY14. Dar took control of currency since Mar14 and an on average yearly currency depreciation is at 0.6 percent in FY15-17. The CPI averaged at 3.8 percent in the same period.

Now seeing WPI, CPI may be a little higher in FY18; but knowing Dar’s obsession with rupee dollar parity, the currency may not fall in tandem. That said, rupee depreciation seems inevitable in FY19. However, the good news is that quantum of depreciation might not be similar to what happened in FY09, if inflation is a suggestive indicator to depreciation. The fall in currency would be anywhere between 5-10 percent; and this would be followed by higher inflation and further depreciation in FY20-22. It could all happen sooner, should the JIT findings go against Nawaz Sharif and Dar.