The new inflation number has surprised all economic analysts. Against an inflation of 9.1% in May (YoY), and on the face of significant increase in petroleum price and depreciation of rupee during June, the consensus forecast for June inflation was 9.5%. The actual has come out at 8.9%, a surprising slow-down in inflation. What would this development mean for the economy as we advance into the next fiscal year?
Although many people would be interested in comparing the inflation with last year, in our view, the more relevant and interesting comparison is of the more recent behavior of inflation. This would help us formulate a view as to where it is headed as we enter the first year of IMF program.
There are a number of interesting aspects that have led to this slow-down in inflation. First, the month-on-month (MoM) inflation increased by merely 0.4% compared to 1.3% and 0.8% in the previous two months. Clearly, a slow-down in inflation was building up in the last three months or so. Second, it is the food (40% of the basket) inflation that is dominating the final outcome of overall inflation. The food inflation, YoY, has shown a declining trend for the fourth consecutive month. In January and February, it had risen sharply by 2.4% and 5% from a very low inflation mostly from the previous three years. This rising trend continued till May and reached 8.7%. For the first time after six months, this trend has been reversed in June when the food inflation was down to 8.2%. On the other hand, the non-food inflation is sticky and has exerted pressure on overall inflation. It had reached double digit (10.5%) in January 2018 but has only slightly decelerated to 9.3% in June.
Third, the core inflation, excluding food and energy, is also giving the necessary support to keep the overall inflation within the single digit territory. Curiously, despite its rising trend even during the period when inflation was massively down, core inflation has now shed its stubbornness and is following a downward trajectory. After peaking at 8.8% in February, the core inflation has been on the decline and clocked at 7.2% in June 2019, with an average of around the same level.
Evidently, it is the food inflation that is holding the fort. Alternatively, supplies of food items are what have restrained an otherwise menacing trend in inflation during the year compared to the previous three years. Equally importantly, the petroleum prices have not shown a rising trend with the result that overall inflation has remained contained.
We now discuss the future outlook of inflation in the FY20. The most important challenge to inflation would come from the taxation measures announced in the budget. Even though the government has avoided taking such indiscriminatory measures like the increase in the GST rate, which would have badly affected inflation, there are still a number of tax measures that would affect prices of key consumer items such as sugar, cement, cigarettes, gas, electricity and others. This would be a one-off impact and would not signal a continuing fueling of inflation as rising petroleum prices. On the other hand, we should not be seeing the tumultuous adjustment in exchange rate and interest rate as much of it has supposedly been done before the Fund program was done. This should be a countervailing force on budgetary measures and therefore limiting the overall impact.
Notwithstanding the impact of the taxation measures, the key to price stability would be the continuing supplies of items in the food basket, particularly vegetables and fruits, besides the grains and lentils. If the international oil prices remain within the broad-trend it had set during 2018 and 2019, one would not be worried of any serious threat from this source. Based on the price trend in FY19, which eventually turned out to be moderate, compared to many predictions that indicated a run-away inflation, there is a strong basis to forecast a moderate outlook, not very different than the one in FY19. In particular, we believe that inflation would remain in the single digit territory.
Let us now discuss the policy implications of this emerging trend. The average inflation was recorded at 7.34% compared to 3.92% last year. The Government forecast was 8% and the SBP had also forecast it in the range of 6.5-7.5%.The target for next year is 8%. In its last monetary policy statement, the SBP has not made a forecast except saying that "[inflation] is anticipated to be considerably higher in FY20".The IMF has projected it to be 13%, which is way too high. For an average inflation to be at 13% in a fiscal year, the marginal rate (YoY) at end-June has to rise up to 18-20%. This looks a distant possibility based on the analysis we have given above.
The most significant policy implication is for the policy rate determined by the monetary policy committee (MPC) of the SBP. We would argue that considerable adjustment has already been made in the policy rate which was last set at 12.25% in May after an increase of 1.75% and further increase would have no justification. To see this point, consider first the definition of the real interest which really is the target rate. Simply put, it is the nominal interest minus inflation. But as we discussed above, a variety of measures are available for inflation even when we would agree to consider the policy rate as the nominal interest of choice.
So our first problem is to fix the inflation index, average headline or core inflation. Second, is it the average inflation we would look at or the year on year inflation?. That would be the second choice. Suppose we consider the headline inflation and rather than the average, we consider the Y-o-Y for the latest month. In the present scenario, this number is 8.9%. With a policy rate of 12.25%, the real interest rate works out to 3.35%, which is a very high rate of interest compared to world interest rates. On the other hand, if we consider the average headline inflation - which uses more information as it covers a longer series - which was 7.34%. Based on this inflation rate, the real interest rate would be 4.91% or close to 5%. Which is absurdly high.
To conclude, we see a moderate outlook for inflation, unless of course some disruptive changes occur, and hence we see considerable room to reduce interest rates. It may be highlighted that at such massive interest rate, given an exceptionally high and inflexible government demand for credit, the spending on interest payments have ballooned to nearly 6% of GDP. With the focus on primary deficit, there is an open license to incur any amount of debt servicing as it would not be counted toward fiscal adjustment. Under the circumstances, high interest rates would cause considerable increase in income inequality and must be corrected as early as possible.
(The writer is former finance secretary) [email protected]
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