The State Bank of Pakistan on Saturday warned that if the government continues to subsidise domestic oil and electricity bills, it will have adverse implications for its fiscal position as well as for inflation. The State Bank in its Monetary Policy Statement (MPS) has said that passing the increase in international oil prices and cost of electricity generation to consumers is required under current economic environment though it results in a temporary increase in inflation.
According to MPS, the impact of flood was not limited to disruption in economic activity but it also caused a spike in inflation, particularly during September 2010 to December 2010. In that period, the year-on-year CPI inflation averaged at 15.5 percent. There has been a modest decline in inflation since then as the impact of floods is dissipating. However, a comparable six-month pre-floods average indicates that persistence of inflation is not due to floods alone.
Overall, the average CPI inflation in FY11 was 13.9 percent, which is slightly lower than SBP's earlier projections but higher than the target of 9.5 percent for the year. Importantly, this inflation is not limited to food items only as feared earlier due to floods. Prices of perishable food items, which were more severely affected after the floods, have declined considerably.
On the other hand, prices of non-perishable items have increased, leaving the overall food inflation largely at the same level observed before the floods. Thus, it is the behaviour of non-food inflation that needs to be assessed more closely to understand the persistence of inflation, it added. The non-food inflation has been more than 10 percent on year-on-year basis during the last two months after remaining in a single digit during the previous four months.
Furthermore, increase in electricity tariffs and adjustments in domestic oil prices did contribute to inflation both directly and indirectly. The current assessment suggests that CPI inflation is likely to persist in double digits in FY12, though it is expected that it will be lower than the outcome of FY11. It is important to remember that a cumulative increase of 150 basis points in SBP's policy rate during H1-FY11 greatly helped in making this incremental gain.
The persistence of inflation essentially indicates that the gap between aggregate demand and supply is still significant and that high inflation expectations are prevalent. Efforts to contain demand through monetary policy have been diluted by an expansionary fiscal policy, while aggregate supply has been affected by falling productivity due to severe energy shortages and deteriorating law and order conditions.
Consistent with real GDP growth target of 4.2 percent, outlook of the fiscal and external accounts, and expected money growth of 15 to 16 percent, inflation is projected to fall in the range of 11 to 12 percent, according to MPS. The announced target of average CPI inflation for FY12 is 12 percent. The government has also announced in the MTBF a desired path of inflation of 9.5 and 8 percent for the subsequent two years.
Adherence to the broad fiscal parameters of MTBF would facilitate a reduction in aggregate demand and help achieve the inflation target. An improvement in the fiscal position is also expected to reduce government borrowings from the banking system and create space for the private sector. The resulting expected increase in investment would enhance the productive capacity of the economy and help further narrow down the output gap. Government's commitment to continue to limit its borrowings from the SBP would also be beneficial for lowering the expectations of inflation.