Outlook for inflation

The rate of inflation has risen sharply in the last two months. It had come down to 5.7 percent in January 2021. Since then it has increased to 8.7 percent in February and the latest estimate is that on a year-to-year basis it reached 9.1 percent in March.

This varies from the projections made by the Planning Commission and the SBP. The former institution had asserted in the Annual Plan that the inflation rate would remain low at 6.5 percent in 2020-21 as compared to the double-digit rate of 10.7 percent in 2019-20. The SBP, in its recent Monetary Policy Statement, has stated that in the last quarter of 2020-21 the rate of inflation would continue to be in the range of 7 to 9 percent.

However, the average monthly rate of inflation in the first nine months has reached 8.4 percent, significantly above the projection by the Planning Commission. Further, at 9.1 percent in March it has exceeded the range given by the SBP.

There is need to take note of the latest projections by the World Bank as of the 31st of March 2021 in the periodic South Asia Economic Focus Report for 2020-21 and beyond. The World Bank expects the rate of inflation in Pakistan in 2020-21 to be 9 percent. This implies that since it averaged 8.4 percent in the first three quarters, the rate of inflation will be as high as 10.8 percent in the last quarter of 2020-21. As such, the World Bank anticipates a return to double-digit inflation in the short run in Pakistan. This is in sharp contrast to other South Asian countries where it is likely to be in the range of 4.5 percent to 6 percent.

The removal of the Finance Minister, Dr Hafeez Sheikh, has been rationalized on the grounds that he is responsible for the relatively high rate of inflation in Pakistan. It is essential, therefore, to identify the factors which are responsible for the rise in prices in the country.

A less emphasized factor has been the rate of expansion in money supply, as measured by M2. It was 17.4 percent as of March 19, 2021 compared to the same day last year. This is high by historical standards. It averaged 12.6 percent in the last five years. The various financing packages announced by the SBP to cushion the shock of Covid-19 have contributed to the big expansion. However, it must be recognized that the SBP has done a stellar job of sustaining economic activity. There has also been the higher level of domestic borrowing to finance a budget deficit larger than anticipated partly because of the shortfall in tax revenues after Covid-19.

The other contributory factor has been the negative supply shock of lower agricultural production of wheat, sugarcane, cotton, etc. Further, import prices have started rising sharply after the trough reached in the quarter of 2019-20. Perhaps the best example is that of the international price of oil which has doubled since April 2020.

Overall, the former Finance Minister cannot be held responsible for the inflation in the country. A lot of the inflation has been due to negative exogenous and external factors. His efforts at coordinating the response to Covid-19 must instead be recognized. Pakistan saw a loss in the GDP growth rate of less than 2.5 percent in 2019-20. It was much higher in other South Asian countries. For example, in India the growth rate plummeted from 4.1percent in 2018-19 to minus 7.1percent in 2019-20 and in Bangladesh from 8.4 percent to 2.6 percent.

What then is the outlook for inflation in coming months? As highlighted above the World Bank expects it to exceed 10 percent. This is the most likely scenario for many reasons. First, the high rate of monetary expansion is likely to persist as the peak level of domestic borrowing takes place in the fourth quarter of the financial year.

Second, the big increase announced in the electricity tariff of almost two rupees will have a continuing impact on the rate of inflation. Over half the jump in the inflation rate from 5.7 percent to 8.7 percent in February was due to the impact on electricity bills of domestic consumers. Now there will be a impact on the price level of goods due to rise in the cost of production.

Third, there could be a return to higher inflation in food prices. The increase has been substantially limited up to now by the fall in prices of vegetables and fruits. However, this situation could change. Further, there are concerns about the forthcoming price of wheat flour. For the right reasons, the procurement price has now been raised to Rs 1800 per 40 kgs in Punjab. Sindh had earlier offered Rs 2000 per 40 kgs. This implies an increase of 29 percent in Punjab and 43 percent in Sindh. Also imported wheat price is close to Rs 2000 per 40 kgs.

This ought to have been backed up by a sizeable increase in budgetary subsidies to PASSCO and USC to insulate especially the low-income households from the big hike in the procurement price. But, very surprisingly, these subsidies have been slashed drastically in the Federal Budget of 2021 from Rs 15 billion to Rs 7 billion in the case of PASSCO and from Rs 43 billion to only Rs 3 billion in the case of USC. Large additional subventions will be needed if a big jump in the price of wheat flour is to be avoided.

There is some optimism that the significant appreciation in the value of the rupee will reduce the component of imported inflation. However, this may be largely neutralized by the rise in the dollar prices of imported items. For example, the price of palm oil had fallen by 20 percent between March 20 and July 20 after Covid-19. It has since risen by 53 percent. A similar pattern is observed in imported pulses, spices, sugar, etc. Therefore, the base effect of lower import prices from April to July 2020 will imply a higher rate of inflation of imported consumer goods even after the impact of a stronger rupee.

Beyond the above-mentioned factors putting pressure on CPI there are some other unusual developments. The first is the big jump in the rate of inflation according to the Sensitive Price Index (SPI) and Wholesale Price Index (WPI). It is 14 percent in the case of the SPI and 15 percent in the WPI in March 2021. These rates of inflation are substantially higher than the 9 percent inflation in the CPI. Both the SPI and the CPI are leading indicators of the inflationary trend. Also, the third largest weight in the CPI is of clothing and footwear. The inflation rate in these items has reached double-digit. This reflects the shortage of cotton and yarn. Also, the prices of imported synthetic fiber and yarn have gone up sharply.

Finally, there is the likely impact of implementation of policies and actions agreed with the IMF following the resumption of the Programme. A commitment to raise additional revenues of Rs 700 billion in the forthcoming budget of 2021-22 will require withdrawal of exemptions and enhancement in tax rates even in indirect taxes as happened in the 2019-20 Budget. This will exert further pressure on the price level. Also, there is agreement to raise electricity tariffs by 35 percent in six months from April to October 2021. This will unleash another round of cost-push inflation.

Overall, the outlook for inflation is worrying. It is likely to rise to a double-digit rate in coming months. Unlike the projections of the World Bank and the IMF the high rate of inflation is likely to persist in 2021-22. Dr Hafeez Sheikh will be remembered for operating in an environment of only single-digit inflation at the time of his exit.

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

Copyright Business Recorder, 2021