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Opinion

Economic notes

August 7, 2018

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Creeping inflation


Beginning in October 2014, Pakistan enjoyed a long spell of low inflation and price stability. This seems to be ending now. The inflation rate for July should be a cause of concern for economic managers.

This July, the year-on-year (YOY) inflation (versus July 2017) was registered at 5.8 percent; the highest since October 2014. In the last nearly four years, there have been minor indications of resurgence in inflation. But this time, there is an unmistakable trend observable across the full spectrum of inflationary measures, showing a sustained resurgence of inflation. The trend has been visible since March 2018, when inflation was 3.2 percent, and it has increased uninterruptedly to the present level since then. As July is the first month of the fiscal year, the average inflation is also 5.8 percent, but with the trend rising, the average inflation during the year is bound to increase.

The intensity of pressure on prices is captured by month-on-month (MOM) inflation, which rose by 0.9 percent over June. Similarly, the numbers for the months of June, May, April and March, over their previous months, were 0.6 percent, 0.5 percent, 1.8 percent and 0.3 percent, respectively. Clearly, a rising trend is visible in monthly inflation even if we normalise the exceptional increase of 1.8 percent. There are other indications supporting the apprehension of inflationary pressures evolving.

A more robust measure of sustained inflation is called ‘core inflation’. This measure removes the effects of commodities whose prices are volatile due to both seasonality or unpredictable behaviour of international markets. These items include energy and food. Interestingly, for quite some time now, even when the overall inflation has been low, the core inflation (non-food, non-energy) has been stubbornly showing a rising trend. In July, the core inflation was recorded at 7.6 percent YOY – again the highest since October 2014.

Two more indicators support our thesis of sustained inflationary pressure. First, the Sensitive Price Index (SPI), computed on a weekly basis and comprising 54 commodities which have a major impact on households’ budget is also showing a rising trend since March 2018. Second, the Wholesale Price Index (WPI), comprising commodities used as inputs in various industries, has shown a rising trend in both YOY and MOM inflation during the year. Both these indices are early-warning signals that further inflation is in store.

There are a number of factors contributing to this new wave of inflation. First, international crude oil prices have risen by more than 60 percent since last July. From $48 per barrel on July 1, 2017, Brent rose to nearly $80 per barrel before sliding back to less than $75 per barrel in more recent days. Analysts are apprehending a significant surge in prices as the date (November) for Iran sanctions approaches. Some have predicted – based on the possible disruption in supplies from Iran, which contributes nearly 2.5 million barrels per day to global supplies – that the price will rise to $85 per barrel in the near future.

Second, the recent depreciation in the exchange rate could not have been more ill-timed. The last two adjustments made by the interim government were not even needed. From July 2017, when the rate was Rs104.8 per dollar, to mid-July 2018, the rate has depreciated to an astounding Rs128.50 per dollar, or about 23 percent.

Now, taken together – the increase in oil price and the rupee depreciation – we have a harmful combination of factors which will impact inflation in the broadest spectrum of prices of goods and services. Inflation may very likely be spiralling, as there are secondary effects when these pivotal prices are absorbed in the prices of other goods and services and those prices begin to increase. In fact, one gets a reason to pass on perhaps more than the justified increase in these prices; such as transporters.

Third, even though the oil price shock is exogenous, the battering of the exchange rate is of our own making. The high aggregate demand has been fuelled primarily by last year’s unbridled fiscal deficit that was estimated at 7.1 percent of GDP, or Rs2.5 trillion, compared to the budget target of 4.1 percent, or Rs1.5 trillion – highest since 2012.

Consequently, the balance of payments deficit has shot up to nearly six percent of GDP, or $18 billion – highest in more than a decade. The deficit was financed by loans from SBP or from foreign lenders. The growth in broad money was counteracted by the decline in net foreign assets due to loss of reserves. Despite that, both the reserve money (M1) and broad money (M2) saw double-digit growth, and one can imagine the lagged effects on inflation going forward.

Fourth, there is a great deal of inflation that is in store on account of delays in adjustment of administered prices. Most significant is the price of gas, which the previous government did not adjust for full five years, even when, under law, this is a straightforward exercise. This was partly justified when oil prices were decreasing, but this justification was over-used.

Ogra has determined a gas price tariff that implies an average increase of 46 percent. More worrying is the adjustment required for domestic consumers, where an increase of 300 percent is determined. The bill of an average consumer paying a monthly cost of Rs450 will rise to Rs1,350. This will become quite burdensome. In the meanwhile, huge arrears have accrued for both gas supply companies due to delayed adjustment. A sum of Rs300 billion, nearly one percent of GDP, has been determined on this account, which Ogra has asked the companies to recover in instalments. This would be an added charge after the increased price.

Finally, electricity prices, where negative fuel adjustment was a relief for quite some time, have turned positive with adjustment of more than Rs1.5 in the last two months. The increase in electricity prices will have a major impact on overall inflation. The settlement of circular debt will have an impact on inflation as well, as it would inevitably increase the budget deficit.

The key to fighting inflation is controlling the aggregate demand, of which the largest part is contributed by fiscal deficit. Reducing deficit will be the hardest challenge the new government will face. A combination of expenditure cuts and revenue measures will have to be immediately put in place to achieve this objective.

The writer is a former finance secretary. Email: [email protected]

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