Inflation downturn is here

The headline inflation clocked at 8.5 percent in April. The decline from the peak in Jan20 (at 14.6%) is sharp. Now the pace of the decline is likely to subside, inflation may hover around 7.5-8.5 percent in next two months to take the full year average between 10.5-11 percent. Thereafter (barring any exogenous shock) CPI may average between 5-7 percent in the 1HFY21.

Remember, the SBP was targeting 5-7 inflation level by having tight monetary policy stance. The expectations (prior to COVID in Nov-19) to achieve 5-7 percent inflation target to achieve in 24 months i.e. by Nov-21. In March, SBP wrote that this may be achieved earlier. The number are telling that this may be achieved in the 6-9 months. Seeing this, inflation is no more a concern, and tightening cycle is going to end earlier than expectations.  SBP may act accordingly and lower policy rate by 2-3 percent in the next few reviews. This is in addition to 425 bps cut in last 6 weeks.

SBP’s lowest discount rate is at 6.25 percent (policy rate :5.75%) in the past twenty years. It is not likely that interest rates will come down from its historic low. Monetary policy easing might end with policy rate at 6-7 percent by the end of this year. This may shift the focus towards growth earlier than expected. How quick would be the recovery is based upon the opening up of domestic and export markets; and the recovery in the world.

Having said that, SBP might have to be a little cautious in easing. The fiscal deficit stood at 3.9 percent in 9MFY20 and the full year projections are at 9.2 percent. This high deficit will unwind once the world returns to normalcy. Any demand driven growth has to be checked as this may balloon current account deficit again. The country does not have enough external buffers to sustain a growth momentum anytime soon. IMF 2^nd and 3^rd review will be resumed soon. Thus, more realistically speaking SBP may not go below 7 percent on policy rate.

It is a sign of relief for businesses in otherwise very testing times. CPI in April is down by 0.8 percent on monthly basis in April. The wholesale price index (WPI) is down to 5 percent in April from 15.4 percent in January. That is a big decline and is reflecting that prices will be down in retail market going forward. Sensitive Price Index which primarily measures the basket of poor is down to 9 percent in April from its peak of 20.2 percent in November. That is showing that supply side food shocks are over. However, there could be blips of supply disruptions later. The demand could pick up earlier than supply. But any such upward movement is not likely to last.

Earlier, when the headline inflation started coming down from its peak in January, core inflation did not respond and was up slightly in Feb. There were some emerging signs of second round of inflation through wage spiral effect. But the lockdown has killed that phenomenon. With large layoffs, wages are to remain downward sticky. The core inflation is down to 6.4 percent in April 20 (from 8% in Feb). The core inflation is the lowest since March 2018.

Petroleum prices are down by 15-25 percent in May. This will lower the inflation directly by 80-85 bps in May and will dilute any upward impact of food prices in the holy month. But it may not have impact on lowering goods and services prices. Diesel prices are down by 25 percent and it is the prime fuel for goods transportation. Not many companies will give benefit to the consumers, and are likely to use it for their own liquidity considerations. And prices can move up in the next 2-3 months with the world opening up.

Businesses are expected to operate on low capacity and demand will take time to normalize. Seeing this, lower inflation and low growth will be the case in this quarter. Some may term this deflation. But a better term is short term blip (or recession) in an otherwise recovering economy.