Morning Call about Policy rate to cut by 50bps – Arif Habib Limited

Karachi: The State Bank of Pakistan (SBP) is scheduled to release the Monetary Policy Statement (MPS) for FY12 on October 08, 2011.

According to Arif Habib Limited, they expect the SBP to cut the discount rate by 50bps brining the discount rate at 13%. Underlying reason to Arif Habib Limited’s stance is the recent CPI headline inflation clocking in at 11.56% YoY for the month of Aug’11, due to revised calculation methodology. In addition to this, public sector borrowing, in particular that from CB, remains in tandem to the agreed borrowing threshold. Furthermore, Arif Habib Limited seeks possible CB policy response and its effectiveness, which may come as temporary supply shock, following the revised CPI inflation basket.

CPI headline inflation clock at 11.56%
CPI based inflation for the month of Aug’11, contracted considerably to 11.56% YoY against 13.78% YoY in Jul’11 (based on previous methodology). This is mainly attributable to revised CPI headline inflation basket. Currently the real interest rates stand in the green zone at +1.94%, justifying a possible policy rate cut in upcoming MPS.

What’s new in the calculation methodology…
The government has revised weights of different groups in the CPI basket. Food group weight is revised to ~35% from 40.34% earlier. Moreover, house rent index weight would constitute ~22% from 23.43% previously. Further modification in house rental index now includes actual survey based index, rather than the prior linkage of labour cost and the raw material (based on Wholesale Price Index). Additionally, the number of cities being surveyed have now been increased to 40 from 35 (urbanisation effect), while consumption basket now include 40 goods and services instead of previous 35, in an attempt to arrest changing consumption patterns. Lastly, the base year has been advanced to 2008 from 2000.

…holds a major implication in better monetary policy mechanism
Expect better monetary management days ahead, given the large weight command of food in the computation of CPI inflation. Combine this with consistently outstripping food prices and Arif Habib Limited sees a natural uptick in CPI headline inflation, thus warranting the monetary policy reaction. Hence in the wake of price shocks (food and oil, in particular), rate tightening by SBP become more or less a blunt tool, ineffectively trying to capture the relative price shock. In addition to this monetary policy becomes paralysed as a bench in provoking substitution effect in wake of price rise and thus the consumption slowdown that may come with it. Exclude the food price and CB are left to deal with exogenous price driver, the oil. Oil price risk as many argue is more of an ingrained nature, fundamentally driven through aggregate demand expansion, unseen by expansionary monetary cum fiscal policy, over the previous periods.

Towards a more core-oriented basket…
Second to the weight revision in the house rent index; which will now be based on actual survey rather than indicative price movement in labour cost and raw material (WPI), holds a similar implication of better monetary management. Clip out the volatile weights and you are left with house rent occupying the major chunk of the basket. So in retrospective, does ‘core’ inflation targeting offers a much better monetary policy management. Arif Habib Limited thinks it makes complete sense to target core inflation, which the current basket mixture might just provide. Think about it in terms policy rate volatility, if Arif Habib Limited establishes the food price rise is merely a temporarily effect and that of a supply shock then CB reaction to it propagates towards a short sighted inflation target approach.

Near-term risks to CPI headline inflation
Arif Habib Limited continues to worry about the potential for higher food prices especially after the Monsoon Floods in Sindh and the possible supply disruption it may bring with it. In addition to this consistently elevated international food prices, may play into domestic market anxiety. So far the oil measured as of Arab light is trading at USD 101/bbl, while food prices measured of UNFAO is still looking downward sticking ~30% YoY, in Aug’11. How SBP will react to any short term supply shock, will yet to be seen, but Arif Habib Limited thinks the current basket mix will offer a helping hand as it will be more likely to pass through supply shocks to food inflation.

Focusing on concerns that really matters…
In Arif Habib Limited’s opinion, focusing on demand side risks which predominantly emanates from over public sector leveraging (debatable) will be a key source of better monetary policy management and transmission. Hence Arif Habib Limited flags high public sector unabated borrowing will remain a key concern going forward. Although Arif Habib Limited sees some respite in CB borrowing (current stock at PKR 3,242bn, as of Dec’10), just loathing under default threshold of PKR 1,290bn. However a stark retrospective rise in schedule banks borrowing holds a bigger concern.

Fundamentally Arif Habib Limited should see a 50-100bps cut in policy rate
Although the fundamentals point a 100-150bps rate cut, but Arif Habib Limited remains conservative in its approach, hence its expectation for upcoming policy rate is down to 13%. The basis for its stance is volatile food and oil prices, which Arif Habib Limited thinks the SBP, can do little to minimise. In long run though, strong domestic demand with reference to monetary expansion requires more tightening measures.