October inflation trends higher
Last week, the National Bureau of Statistics reported a rise in Year on Year (YoY) inflation to 10.5% for October 2011 (September: 10.3%). This marks the second month in double-digit territory, following two consecutive months of single-digit inflation. On a Month on Month (MoM) basis, inflation rose 0.5% in October, as the Rural All Items Monthly Index rose 0.90% MoM and the Urban All Items Monthly Index declined 0.10% MoM. The largest contributor to inflation was higher fuel prices - kerosene (DPK) and diesel (AGO) accounted for the bulk of the price increase.
Food inflation unexpectedly higher
I expected downward pressure on food prices in October in the aftermath of the year’s major harvest. However, Food CPI rose 9.7% YoY in October, as compared to 9.5% YoY in September. On a MoM basis, food inflation rose 0.2%, compared to 0.9% MoM in September and my forecast of a 1.6% decline MoM. I suspect that the rise in the Food CPI, contrary to my expectation, was the result of higher transportation costs, which resulted from an increase in diesel prices. Farm produce prices have historically trended lower MoM in October, on account of increased supply following the harvest which usually commences in the middle of September[1]. Available data suggested that while prolonged dry spells across the North-East Zone, in September, and excessive rains in the South-West, North-Central and South-South Zones, destroyed farmlands, fishponds and crops[2], these events did not significantly affect farm produce prices. As a result, the Farm Produce index declined 0.2% MoM.
Energy inflation – ahead of our expectations
Energy CPI showed a slight moderation in October. The index declined to 14.8% YoY from 18.7% YoY in September (I had forecast Energy inflation of 17.5% YoY). This moderation was primarily due to the impact of a negative base effect—resulting from the electricity tariff hike earlier in the year— which continued to impact Energy CPI for a full annual cycle following implementation. My model suggested that the marked differential between our forecasts and actual YoY energy inflation was the result of an overestimation of the impact of higher electricity tariffs from a hike that occurred earlier in 2011. However, Energy CPI rose 1.03% MoM, largely driven by higher diesel and kerosene prices in rural areas.
My outlook for inflation
Core inflation: Likely to stay in check
My analysis indicates that demand deposits and currency in circulation are important drivers of core inflation – the measure of price increases in components other than food and energy. Currently these monetary aggregates are above the Central Bank of Nigeria’s (CBN) annual target levels and I expect them those aggregates to remain elevated. However, the lagged effect of MPC’s October decisions —particularly raising the benchmark rate by 275 bps and the CRR by 400 bps to 8% — and expected tightening should moderate the upward pressure on core inflation. Overall, I expect core inflation to remain moderate through the rest of the year. However, I note that higher energy prices could potentially filter through to some core components, exerting upward pressure on core inflation.
Headline risks persist
In spite of the scale of damage in flood ‐ and drought‐affected areas across the country, these areas of below‐average production account for less than 20% of the total annual food production[3]. I note that in 2011, croplands have experienced above average rainfall and increased cultivation. As such, I expect higher crop yields YoY and a normal to above average harvest. Accordingly, farm produce prices should moderate in the months ahead -- with the Food CPI following closely in line. However, I note that higher transportation costs and fuel prices portend potential risks to my expectations for food inflation -- as was the case in October. Furthermore, I expect YoY Energy CPI to remain elevated, even as further hikes in electricity tariff and deregulation in the downstream petroleum sector are expected early next year.
Ammunition for the MPC
The initial market reaction to these inflation figures was an almost unanimous 45bp upward adjustment in the yields on OMO bills. This is perhaps understandable in the light of recent comments made by the Governor of the CBN in an interview granted to Reuters on 31st October, 2011, indicating that monetary policy was likely to remain tight for the foreseeable future in order to “ward off inflationary pressures”. With these comments as context, ahead of this week’s Monetary Policy Committee (MPC) meeting, it would appear that the reinforced upward trend in inflation may provide justification for further tightening. Furthermore, the increased frequency and value of Open Market Operations (OMO) following the MPC’s emergency meeting in October (where it increased MPR by 275 bps and raised CRR by 400bps) suggests that the outcome of its policy measures might have been less than satisfactory. At current levels, further OMOs are likely to come at considerable cost to the CBN. Consequently, the MPC is likely to be motivation to explore other monetary options in an attempt to manage inflation, as Naira devaluation and deregulation of the downstream sector take effect.
Stay short, buy the tightening
In view of my outlook for inflation in the near term and the potential upside risks, I would expect the CBN’s hawkish posture to persist as policy makers and market participants come to better grips with unfolding developments in the currency and debt markets. Clearly, this consideration may lead investors to demand higher compensation for risk and supports the view that current yields may trend higher in anticipation of further monetary tightening – or following actual policy action. Accordingly, I believe short dated debt instruments provide the optimal vehicle to exploit such conditions. Indeed, I note the upward trend in short dated yields pre-MPC decision and highlight the opportunity to selectively increase exposure to this asset class, as it is likely to experience a modest rebound post-MPC decision – partly due to significant liquidity inflows, particularly in the form of higher year end FAAC allocations.
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