July Inflation: Downtrend in inflation now has ‘legs’

Inflation slows down for the sixth month 

Last week, the National Bureau of Statistics (NBS) released the much delayed July 2017 inflation report and for sixth consecutive month, the headline reading declined to 16.05% y/y. That said, much of the focus in the press has been on food inflation which hit an eight year high of 20.3% y/y meaning that a drop in core CPI inflation to 12.2% y/y underpinned the decline in the headline number. However a focus on the headline number, given the large base effects from 2016, is misleading as the underlying inflation pattern from looking at the m/m readings where headline and food pulled back from the elevated readings in H1 2017 suggests things an inflection point.

Specifically, the monthly headline reading slowed to 1.2% from 1.6% in June on account of a second consecutive deceleration in m/m food inflation to 1.5%. An examination of the underlying reveals continued declines in farm produce primarily, and processed & non-alcoholic beverages, as source of the softer food inflation reading. Declining farm produce inflation stems feed-through from lower transport costs as the price of diesel, the chief fuel in powering the heavy duty trucks which transport food items across Nigeria, has declined following the improvement in FX supplies. PMS prices fell to N148/litre from N1 Core inflation continued its moderation largely powered by base effects.

Overall, the continued slide fits the emerging theme I noted last month of declining m/m inflation from stubbornly high levels on an improving FX supply.

Figure 1: Trends in m/m inflation

monthly inflation

Source: NBS

Inflation trajectory now headed south as harvests stream out

In setting out my outlook for August inflation, I think it is important to remind readers about the drivers of 2017 inflation patterns. The declining pattern in the headline reading in the first half of the year stemmed from base effects given elevated m/m readings climbed throughout the period. The re-establishment of seasonal patterns in July appears to suggest that the distortive impact of the exchange rate depreciation are now wearing off. Going into August, most field surveys point to an above average harvest in 2017 as naira weakness and the jump in prices in 2016 has incentivized higher planting activity. Consequently, prices should recede as early harvest start to filter out to grain markets. Tuber harvests are already getting underway and should garner steam over August. Alongside, further moderation in diesel prices and stable exchange rate at the parallel market, food inflation is liable to further downside. Nonetheless, recent floods along the agrarian Niger-Benue axis poses downside risks to prices amid a weaker base effect in H2 2017.  My model spits our m/m anywhere between 0.93-0.95% for August which results in headline inflation between a range of 15.96-15.99% y/y.

Beyond that the re-establishment of domestic food drivers and waning impact of the exchange rate implies a more benign outlook for inflation over the next 6-12months and my guess is that, baring any wild currency moves, headline CPI could be under 12% by June 2018.

Figure 2: Headline inflation (actual and forecast)

Headline and Forecast CPI

Source: NBS 

CBN to continue down the path of liquidity tightening, for now

Although inflation has been declining, it has yet to come to the attention of the CBN which constantly pushes a circular argument about why preliminary easing is bad. However, at the July 2017 MPC, the CBN governor created a bit of a target for markets with the mention of a 12% threshold beyond which inflation is growth inhibitive. Given my forecast scenario over the next 6-12months, the CBN is likely to continue liquidity tightening over 2017 in defense of the naira with little regard over inflation readings. Markets appear to have keyed into this view and as such expect little reaction. That said, the elevated interest rate amid a declining inflation pattern is likely to draw attention of the finance ministry and the Nigerian political elite. Should this scenario play out, pressure could be brought to bear on the CBN to soften which raises a low probability of 50-100bps rate cut in September or November. Curiously, this view could already reflect CBN reluctance over the course of last week to mop up liquidity at prior rates.

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