Currency equilibrium – almost there

The pricing adjustment has started unfolding and the picture is not as gloomy as presented by a few corners. The REER came down to 102.3 in Dec18 - these levels were last seen in FY12. This implies that the impact of Dar's policies is largely undone in past 13 months.
On inflation, energy prices and currency adjustments have not taken prices too high - CPI clocked at 7.2 percent in Jan19 and the Jul-JanFY19 average stood at 6.2 percent. One may argue that two third of required electricity prices are yet to be passed on and there is still room in interest rates hike and currency adjustment, but the government does not have the resolve to do so anytime soon.

The punch line is that the tightening steps are yielding results with currency almost at its theoretical equilibrium and real interest rates are well in positive - 2-2.5 percent based on CY19 expected inflation, the need is to consolidate and focus on economic recovery through structural adjustments.

The REER adjustment was little too sharp in December as the ratio came down by 3.8 percent, this is higher than NEER adjustment of 3.6 percent. This implies that nominal exchange rate adjustment transmission on inflation is low to dilute adjustments.
Inflation in Pakistan was bound to be not go out of bounds due to currency adjustment. The reason is simple - food and other commodity prices in Pakistan, prior to the currency adjustment, were higher than the world - and after over 30 percent currency correction, the gap has thinned. Agriculture commodities are competitive in Pakistan with less or no subsidy required on exports and there is room for value addition.

Now with REER close to equilibrium, there is no urgent need of any further currency adjustments purely based on economic fundamentals. The IMF’s push is still there for currency depreciation but the government (MoF and SBP) is required to negotiate.

On CPI, Jan19 was always supposed to be a tough month - there is an impact of electricity prices adjustment and quarterly house rent index as well - housing and utility sub index (29.4% CPI weight) increased by 3.1 percent on monthly basis and 11.6 percent year-on-year. Electricity prices increased by 8.5 percent in January over December, this contributed 0.38 percent out of 1 percent increase in monthly CPI. The house rent index hike is recorded at 2.4 percent - contributing 0.52 percent increase in monthly CPI. Barring these two elements, the CPI increased by 0.11 percent in Jan19.

There will be no such adjustment in Feb and Mar, hence monthly CPI will remain subdued, but high base effect will contribute to spike in the yearly CPI number - likely to hover around 7.5-9 percent for the rest of fiscal year. The core inflation stood at 8.7 percent in Jan19 which is close to its peak - average core inflation for 2019 is expected to be around 8.5 percent

Seeing this, having real interest of 200 basis points on full year core inflation, with exchange rate approaching its equilibrium, is uncalled for. Interest rates may change direction in fourth quarter, and signs of economic recovery may start appearing.