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Morning Call about Inflation and Monetary Policy Expectation – Arif Habib Limited

Karachi: Declining CPI Inflation warrants a 50-100bps cut in the reference rate

CPI headline Inflation rose by 1.03% MoM

According to Arif Habib Securities, the headline inflation continues to surprise the market expectations, which remained weak for the month of Sep’11, falling to 10.46%YoY against a consensus median forecast: 10.7%. However on a MoM basis the CPI rose to 1.03%. Food (in particular non-perishable food prices) continues to cast the largest impact (+3.37% YoY) on the headline prices. This was followed by house rental, gas, energy, gas and water registering a 15%YoY rise (+2.32% YoY, impact), much stronger than Arif Habib Securities initially pencilled in. Inflation expectations are rising on a MoM basis, in particular upside risks that eminent for food and higher commodity prices. All this raises its FY12 inflation forecast to 11.0% YoY. However Arif Habib Securities still thinks CPI inflation will continue to slowdown in the remaining 1HFY12 due to high base effect followed from FY11, while picking up later in the 2HFY12.

Near-term price still intact

Arif Habib Securities sees an upside price risk to persist in the near term, which mainly stems from food prices, remaining at elevated levels. With domestic food prices still remain downward sticky, owing to supply constraints emerging from recent Sindh Monsoon Floods teamed up with international prices pressure will continue to play in. Although recent dip in the commodity prices will provide a short-term relief, however the prices are still high enough to post a relevant threat.

Focus should move to Medium to long term risks

Arif Habib Securities believes the focus should now switch to medium to long term inflationary risks, owing to strong domestic demand. Loose fiscal and monetary policy over hang from the past will likely to feed in. To date the M2 has posted a YoY growth of 15.9%, led mainly from higher public borrowing (PKR 579.6bn, yearly flows, +42.5% YoY). Inflation expectations have already risen, as core inflation for the month of Sep’11 continue to show a rising trend registering 10.6%YoY, while WPI posted a 16.8% YoY growth. With external demand and commodity prices staying intact there is less to believe inflationary pressures to draw back in the medium to long term.

Implications for the upcoming Monetary Policy Statement (MPS)

Given the sharp dip in CPI inflation, Arif Habib Securities expects SBP to slash the reference rate by 50-100bps at minimum in the upcoming MPS. The secondary market yield has already seemed to factor in a 100bps cut, with 3M closing near to 12.5%. Arif Habib Securities thinks that SBP is likely to remain conservative in upcoming MPS and allow a gradual rate easing. This price easing Arif Habib Securities seeing currently, partially owes high base effect, while demand side factors are yet to reflect. In terms of growth prospective the MPS may restore to aggressive easing by reducing the discount rate by 150-200bps, which will likely bring the real interest rate close to -0.5% (given 12% SBP target and allowing a 150bps cut).

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