Outlook for inflation

Inflation has been at a historic low during the last three years. The annual rate of increase in the Consumer Price Index (CPI) has averaged only 3.7% from 2015-16 to 2017-18. This is in sharp contrast to the average rate of inflation of almost 7% in the previous three years.
The year, 2017-18, has closed with the inflation rate at just below 4%. The good news is that the rise in food prices has been even below 2%. This has largely insulated low-income households from the ravages of inflation.
How did Pakistan enter a period of such low inflation? Was this due more to domestic policies or external factors? In particular, why did food prices remain relatively stable? What is the outlook for inflation in 2018-19?
There is no doubt that like other countries Pakistan benefited greatly from the big slump in commodity prices. The overall Primary Commodity Price Index of the IMF was at its peak at 192.6 (with 2005=100), in 2011. Since then it has fallen by over 40%, reaching a low value of 100 in 2016. It is remarkable that on the average commodity prices in 2016 fell to the level of 11 years ago. During 2017-18, there has been some modest recovery in these prices.
The movement in international oil prices is of particular importance to oil-importing countries like Pakistan. From 2014-15 to 2016-17 the import prices in rupees of petroleum fell by as much as 54%. Consequently, domestic prices were also brought down. However, the decrease was less at 31% on average. The difference was taken up especially through enhancement in sales tax rates. During 2017-18, up to January, the import prices in rupees of POL products have gone up by 22%. The recent move by the caretaker Government to bring down the sales tax rates on these products to limit the increase in domestic prices is appreciated.
The fall in POL prices has had the impact of restraining costs of transport. These account for 12% to 15% of the price of goods in the domestic market. Also, import prices in rupees of manufactured goods have declined by 12% since 2014-15. Therefore, the substantial moderation in inflation during the last three years is essentially the consequence of a fall in the landed price of a wide range of imports.
The last four months have, however, witnessed a steady rise in the rate of inflation, according to the CPI. The year-to-year inflation rate was 3.2% in March; 3.7% in April; 4.2% in May and 5.2% in June. There is an impending 'low base effect' in July and it is likely that the inflation rate will exceed 6% this month.
Both the food and the non-food price indices are showing a similar pattern of monthly increase. The 'core' inflation rate which was 5.5% in June 17 has risen to over 7% in June 18. There is need for even more concern about the appreciable rise in the monthly rate of inflation in the Wholesale Price Index (WPI). It has already reached almost 8% in June 18. The CPI generally lags behind the WPI. Therefore, this is yet another reason why the latter price index is likely to rise faster in coming months.
The food price inflation has been low to date for a number of reasons. First, the retail prices of wheat flour (atta) and sugar have either been largely unchanged or fallen because of the high level of domestic stocks of these commodities and much lower international prices. Second, the import prices of pulses have fallen sharply. Third, there has been only moderate inflation in livestock products, especially milk. The exception is the price of chicken which has gone up by an unprecedented 26%, for unknown reasons.
What is the outlook for the coming months of 2018-19? First, this will depend on the extent to which the international oil price will continue to rise. There are already some projections that it could approach $80 per barrel in coming months, especially in the face of a big decline in oil exports from Iran because of the US sanctions.
Second, there is the uncertainty about the likely movement of the exchange rate. Already, the difference between the open market rate and the inter-bank rate has approached Rs 4 per dollar. This will begin to put pressure on the latter rate. There is the likelihood that if Pakistan goes to the IMF then one of the prior conditions could be a fairly large devaluation. Therefore, the domestic price level is likely to be very vulnerable to movements in the exchange rate. A rough and ready formula is that a 10% depreciation in the value of the rupee leads eventually to a rise in the CPI by about 2.5%.
Third, the effective price of electricity is also rising. After a long time there is a positive fuel adjustment charge of Rs 1.22 per kwh levied by NEPRA for the month of May 2018. This is the result of rising imported fuel costs and will be reflected in the billing month of July 18. Also, domestic gas prices are on the increase.
Fourth, there are rising demand-pull pressures on the economy. The fiscal deficit has jumped up to almost 7% of the GDP as compared to the budget target of 4.1% of the GDP in 2017-18. The bulk of financing, almost Rs 1500 billion, has come essentially from printing of money by the SBP. This will hit prices with a time lag of three to six months.
Therefore, there is a fundamental change in inflationary expectations. Both demand-pull and cost-push factors are coming into operation simultaneously, with a major impact on the rate of inflation.
The likelihood is that by the end of the first quarter of 2018-19 the rise in the CPI could approach 7% to 8%. Beyond this, if the currency continues to depreciate we could be back to double-digit inflation by December 2018. It is interesting that the official projection by the Ministry of Finance of inflation is only 6%.
Clearly, among the manifold challenges that the incoming government will face, a not so recognized one is of inflation beginning to get out of control.
(The writer is Professor Emeritus at BNU and former Federal Minister)