Inflation expectations: normalcy in sight?

The recent data points and trends suggest that inflation is likely to come down at a faster pace than expected. This is in stark contrast to last year when the inflation hike exceeded expectations.

The State Bank of Pakistan (SBP) was behind the curve in hiking rates in 2022-23 and seems to remain so in slashing rates in 2024-25. Perhaps this is a strategy to anchor lower inflationary expectations and maintain higher real rates to ensure external account stability, which may be the driving force behind Pakistan’s monetary policy.

Inflation was expected to decrease due to the base effect, and this is indeed happening. Additionally, the month-on-month (MoM) decline is quite encouraging. The average MoM inflation over the last three months stands at 0.4 percent compared to 2.1 percent in the preceding 24 months.

In April, it was minus 0.4 percent, and judging by the trend in weekly inflation, May 2024 is likely to be negative as well. This would mark the first time since 2014 that two consecutive MoM readings have been negative.

The decline is particularly sharp in food inflation, especially in wheat, as inflation in Pakistan is largely food-dominated. This downward trend in food prices would help anchor inflation expectations at lower levels, which the SBP aims to achieve by maintaining positive real rates.

The latest survey conducted by the SBP in April 2024 suggests that consumers’ inflation expectations are still elevated, although slowly tapering off for businesses. Given the recent history of the past two years, it is crucial to manage these expectations to keep inflation low.

Last year, when the average MoM increase was 2.2 percent, retailers, distributors, importers, and manufacturers raised prices in anticipation of future increases. They believed that if they couldn’t sell products immediately, they could offload them in the future, as they expected inflation to remain high. However, this trend is reversing, as evidenced by the decline in business inflation expectations.

This phenomenon is observable in the autos market, where some manufacturers have already lowered prices, partly due to changes in government taxation policies. Others may follow suit. Assemblers are negotiating discounts on Completely Knocked Down (CKD) kits with principals to stimulate demand, and suppliers may do the same due to low global demand.

Many other industries may also follow suit, as capacity utilization remains a challenge for many. The decline in prices of non-perishable food items indicates a narrative of falling inflation. Food prices have doubled since the beginning of 2021, but this upward trend is now slowing down, with food prices decreasing by 2.3 percent last month, and a similar decline expected in May 2024.

This decline began with wheat imports in the current fiscal year, followed by a bumper crop this year, resulting in a supply glut and low international prices. Lower wheat prices may impact rural wages, which are often linked. Lower wages would reduce rural core inflation, which has been higher than urban inflation, as wage increases in rural areas were higher.

While falling wheat inflation is real and is likely to cascade to other food items, leading to lower overall inflationary expectations, it does not necessarily mean that the SBP should aggressively cut interest rates. The SBP should exercise caution and keep real rates substantially positive. However, with May inflation expected at 14-15 percent, a token interest rate cut in the next MPC (monetary policy committee) meeting is very likely.

Even if inflation may touch single digits in 2025 and the decline may be sharper than anticipated, the reduction in interest rates may not be as steep. The key consideration for the SBP is to manage external accounts, as aggressive cuts could widen the current account deficit, which currently barely covers two months of imports. The focus should be on building reserves, for which higher real rates can act as catalysts.

The upcoming budget and the new IMF programme could have inflationary consequences. It is expected that tight fiscal policy will continue, and there may be no new taxes on petroleum products, although the increase in power tariffs may remain a challenge. Overall, the forecast is lower inflation, assuming energy price revisions and new taxes.

The behaviour of the currency is crucial. The latest Real Effective Exchange Rate (REER) reading is at 104. While the Pakistani Rupee (PKR) has remained largely unchanged against the USD, it has depreciated against the currencies of other trading partners. Thus, a slight currency depreciation is very likely with the start of the next programme to ensure that consumers’ inflation expectations remain in check. Given the turbulence of the past two years, some rationale exists for the SBP’s tight policy.

The good news is that inflation is likely to decrease, and the SBP should ensure that it remains low. To ensure external account stability, real rates are likely to remain significantly positive.

Copyright Business Recorder, 2024