Karachi, August 16, 2023 (PPI-OT): PKR depreciation and POL prices could alter monetary policy outlook

Depreciating PKR and rising international (and consequently domestic) POL prices are beginning to alter the shape of inflation expectations, which could have implications for monetary policy outlook.

With open market PKR rate depreciating 4.5% in 6 weeks, gap between open market and interbank PKR/US$ rate has now widened to 3%, against IMF's restriction at 1.25% (for not more than five days running) highlighted in its recent report.

PKR depreciation and interplay with higher POL prices may trigger inflationary impact, with food (34% weight) and transport costs (6% weight) being most vulnerable, with some items bearing a double whammy from both PKR and POL price moves.

From a monetary policy and real interest rate perspective, sensitivities suggest 12M forward CPI in Sep-23 (next MPS) could start indicating readings above 22% - present Policy Rate - rendering forward looking real interest rates potentially negative.

PKR slides 4.5% in open market, widening gap to 3%

After positive sentiments taking PKR up by 4% post IMF’s Stand-By Arrangement at end of Jun-2023, we have witnessed PKR/US$ sliding down 3% and revisiting 3-month lows. Meanwhile, open market rates of PKR/US$ have slipped even more, reflecting a PKR depreciation of 4.5% during the same time. The importance of movement in open market rates has increased with IMF recommending a maximum

1.25% gap between open market and interbank rates in its recent report for Pakistan. At present, the gap between open market and interbank has widened to 3%, which may indicate a similar movement in interbank rates, which could in turn trigger another round of inflationary impacts.

Select food items and transport costs most vulnerable

Pakistan, being a net importer, has a material amount of its CPI basket exposed to PKR movement. While POL prices, related segments and energy related utility prices amount to 11% of CPI basket, food items, mostly imported, contribute at least another 2%. Moreover, other segments directly linked to food, such as Readymade Food are another 5% weight, totalling US$-based pricing weight to at least 19%, almost one-fifth of the basket.

Moreover, the impact of PKR depreciation is compounded in imported segments of and related to food prices that are further impacted from higher POL prices. The weight of segments facing a compounding impact of PKR movement and POL product prices total to at least 7% (imported foods and Readymade food segments), in addition to the complete Food segment contributing ~35% to the basket. This compounding impact is also on the conservative side as higher transport costs impact other cost of businesses and living as well, albeit indirectly.

PKR depreciation can continue inflation spikes

We recall the recent sharp PKR depreciation (~17%) during the first few weeks of CY23 triggered successive sequential MoM CPI increase of ~300bp over Jan-2023 to May-2023, a rare streak witnessed in Pakistan’s history. This was driven by ~350bp monthly increase in Food inflation and ~325bp MoM increase in Transport inflation during the same period.

While we emphasize movement of PKR/US$ on the timing and quantum on external inflows, which has improved to a great extent as compared to a couple of month ago, shaper volatility in the same could be detrimental for Pakistan’s inflation readings. We try to assess impact of sharp rounds of PKR depreciation against US$ on the national CPI and present sensitivity of higher price increases on (1) import-related items and (2) compounding impact on the segments mentioned above.

We present data of 12M forward CPI from each month, e.g. Jul-2023 12M fwd CPI is CPI average of Jul-2023 - Jun-2024, Aug-2023 12M fwd CPI is CPI average of Aug-2023 - Jul-2024 and onwards.

Watch out for deviation in inflation estimates

The above calculations receive a multiplier effect with the ongoing rise in international oil price, where domestic POL product prices have increased by ~Rs38/ltr (~15%) in the last one month, where the increase is a mix of global oil price increase and recent PKR depreciation.

Standing on the brink of a forward-CPI based positive real interest rates scenario after 3 years, CPI estimates from here onward hold much importance. The above sensitivities reflect possibilities of 12M forward CPI numbers remaining above 22% - the present Policy Rate, standing in Sep-2023 (the next monetary policy announcement), where these projections include a 40% gas price hike as well.

While the monetary policy committee had reasoned a status quo in the last policy announcement in Jul-2023 with the 12M fwd CPI estimates landing between 20% - 22%, any deviation in estimates may change the course of market expectations of a halt or continuation of the monetary tightening cycle.