The average inflation for the fiscal year 2023-24 may very well be off target, but the taper has most certainly begun. According to PBS, the monthly inflation for Feb 2024 clocked in at 23 percent, lowest in 20 months since July 2022. In fact, the month-on-month rate has pretty much plateaued, clocking in at just 0.03 percent over Jan 2024. But is it sufficient?
Even if monthly CPI freezes at current levels from here to June end, 12-month average inflation would clock in at least 24 percent, three percentage points above GoP’s target of 21 percent, and two percentage points above SBP’s inflation forecast for the fiscal year 2023-24. Analysts would be quick to point out that on 12-month forward looking basis, inflation is all set to climb down aggressively and conclusively, citing the base effect. That may very well be, but where is the evidence?
At the risk of oversimplification, the recent climb down in inflation rate is broadly attributable to CPI’s food basket, whose share in monthly inflation has dropped from over 55 percent at its peak, to just 31 percent based on the latest reading. In terms of percentage points contribution, Food CPI has fallen from 18 percentage points in May 2023 – when N-CPI rose up to 38 percent, to just 7 percent as of Feb 2024, when the N-CPI reading has clocked in at 23 percent. Therefore, of the 15-percentage points reduction in N-CPI from its peak, 11 percentage points – or 73 percent – stems from the high-weighted food basket alone.
Meanwhile, non-Food CPI has remained stubbornly high at 28.2 percent as of Feb-23, contributing 16 percentage points to the N-CPI reading of 23 percent. Non-Food CPI’s percentage point contribution to general reading has remained over 15 percent for at least 12 months now. And with a fresh round of energy tariff revisions waiting to be unleashed just round the corner – as newly elected federal government begins negotiations for the next IMF program – there is really no certainty that non-Food CPI would ease substantially in the coming months.
Nevertheless, shouldn’t the base effect be sufficient cause to forecast substantial slowdown in inflation, and with it – justify a reduction in the discount rate? First, for the advocates of cost push inflation, if monetary policy had nothing to do with the historic food inflation over the past two years, then a slowdown in food inflation shouldn’t be bandied about as sufficient cause to justify a rate cut. Two, core inflation hasn’t exactly been trending downward for long enough to serve as damning proof that demand side inflationary pressures have conclusively subsided.
If there is any demonstrable evidence of why food inflation reached levels that it did – 48.5 percent at its peak just 10 months ago – and has now been conclusively brought under control – at 18 percent as of Feb 24 – it is the relative stability in the exchange rate beginning October 2023. Which brings us to the million-dollar question.
If the currency is overvalued – or all set to face another round of pressures as the same analyst community would have us believe based on forward market premiums – then lowering interest rates today based on forward looking forecasts would only prepone those pressures on the exchange rate. And as it has been witnessed time and again, every fresh round of currency depreciation unleashes pressure on food commodity prices as the cross-border arbitrage makes speculation in tradable commodities particularly lucrative.
Even if the exchange rate is currently overvalued, maintaining the discounting rate at current levels as inflation gradually tapers will only expand the delta, ensuring positive real rates and mitigating the downward pressure on currency. A rush to reduce interest rates would serve no purpose except prematurely signal the beginning of next growth cycle, even as the fiscal side shows no sign of changing its habits, reduce expenditure, while kicking the can of structural reforms – especially in the energy sector – down the road.
If there is one thing that sets apart monetary policy guidance in developed markets against Pakistan is the resolute commitment to the central bank’s inflationary target. Even as inflation has been trending lower for 18 months in the US, the Federal Reserve refuses to rush rate cuts until the inflation rate is resolutely within the target range. Meanwhile, the SBP has probably missed its inflation target for at least past six years (if not longer). If the contraction ends prematurely once again (just as it did in 2019-20), SBP’s medium target will probably never be met. But then, in the ’long run we are all dead“, and the MPC knows that better than anyone else.