Disinflationary trends

Since 1990s, with technological advancement and development of global value chains, global inflation is on a decline. So are interest rates. In the aftermath of 2008 crisis, and now under COVID, the global debt has gone up to the levels that reserve currencies’ economies cannot afford to come out of this low interest rates cycle – just like Japan is stuck for decades now.

There is a clear trend of inflation on a downward track since 1990s in Pakistan. The old relationship of strong correlation of currency depreciation and inflation is breaking in Pakistan. This space wrote in 2017 that currency devaluation will not bring inflation home unlike 2008 (read “Impact of currency depreciation”, published on 21st December 2017). Between Dec 2017 and July 2020, the currency devalued by 60 percent; but the CPI index is up by a mere 20 percent. The traditional relationship does not exist anymore.

Back in 1990s, the global interest rates used to be very high. Thereafter, the rise of China, wide use of internet and advancement in computing technologies have changed the world production landscape. The technology helped in enhancing productivity while the production is moved to places where labour is cheap. The emerging economies supported export-oriented industries to keep the final products price hike in check. With these exporting economies moving up the ladder, the production is moving towards economies where labour is still cheap.

This is a good news for Pakistan. Inflation would remain relatively low on sustainable basis, and the interest rates may remain subdued too. Gone are the days when interest rates and inflation used to sustain in double digits. There might be one off spike due to commodity-based supply shock – such as 20 percent increase in milk prices can increase the CPI by 2 percent.

Historic trends are showing this tale. In 1990s, annual increase in CPI stood at 9.7 percent which moved down to 8.3 percent in 2000s and 7.4 percent in 2010s. The numbers of currency devaluation were similar. Now the inflation may stand between 5-7 percent in the medium term, if not lower. The SBP is targeting this as well. This would imply that interest rates may hover around 6-9 percent keeping in view 1-2 percent real interest rates.

The overall cost of servicing debt will be low and capital formation might be a bit easier. The long-term debt cost would likely fall and government should work on developing long term yield curve where expectations of inflation and interest rates are to be aligned with changing global realities.