Inflation – mainly food, is becoming a concern. This could have both political and economic repercussions, such as inviting hawks at SBP earlier than is anticipated. Political opponents’ circus is gaining people support due to rising inflation. However, the CPI data needs to be reviewed carefully. Rural inflation is a new entrant in the 2015-16 base, while the old base was merely urban. Moreover, weights of commodities and their impact on CPI also warrants attention.
Urban inflation (closest comparison to old base) is at 7.7 percent in Sep-20. On the other hand, rural inflation is at 11.1 percent. National CPI stood at 9 percent. If the old base is followed, inflation at 7.7 percent and forward-looking inflation at 5-7 percent (given that SBP CPI forecast for FY21 is of 7-9 percent), the policy rate at 7 percent looks comfortable.
The other way to look at risks to forward looking inflation is growth in Wholesale Price Index (WPI), which currently stands at 4 percent – while the gap between WPI and rural CPI is at whopping 7 percent. Either the rural and national CPI numbers must come down or WPI must move up. If the current CPI surge (mainly in food) has its second-round impact on wage inflation and other factors, it will lead to a surge in WPI soon enough.
The other element to note is the weights of key food products in CPI and food basket that may indicate which elements are critical. Milk is the key commodity that needs to be explored. Its weight in NCPI is 9.4 percent (Urban: 8.06 percent, & rural 11.45 percent) and in food its weight is 27.1 percent (urban 26.5 percent and rural 28.0 percent). This means 10 percent increase in milk prices would have an impact of 0.9 percent on overall CPI. That seems too high.
With surge in wheat prices, corn prices have moved up too. Both are used as raw material in milk production (feeding milking animals), because of which milk inflation is moving up too. Since April 20, milk prices in urban areas have increased by 12.8 percent and in rural by 10.9 percent. Interestingly, milk prices are increasing at higher rate in urban areas.
The second major element in food inflation is wheat. Its weight in food group is 14.2 percent (urban 12.2 percent, rural 17.2 percent) and 7.1 percent in national CPI (urban 3.7 percent, rural 7.0 percent). Since June-18, wheat prices in urban CPI are up by 64 percent (rural 61 percent). Milk prices increase since then is 22 percent for urban and 17 percent for rural. This implies that wheat price increase is taking place since the start of FY19 while milk price increase is a recent phenomenon. This partially explains why food inflation is too high in recent months.
That is the history of two key food items. Interestingly, wheat and milk combined weight in rural CPI is at 18.5 percent while in urban it is at 11.8 percent – NCPI at 14.4 percent. One may wonder when large part of rural population consumes on farm production of milk and wheat, how such high weights are justified in rural CPI.
This leads to two discoveries. First, that the recent surge in milk prices is one of the prime reasons for high food inflation. And second, high weights assigned to wheat and milk commodities in rural food economy appear unjustifiable. If the milk prices continue to rise, the food inflation may run in control. Whether that milk price increase should become (one of the) deciding factors in monetary policy decision making is a subject for another day.
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