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Inflation drop tips the scales in favour of low interest rates

INFLATION

Prices of food, mainly driven by vegetables, have dropped significantly since the onset of the rains three weeks ago – pulling down the food segment of the Consumer Price Index (CPI) to 16.24 per cent from a high of 20.31 per cent in March

A steep drop in food prices slowed down the pace of inflation by 2.5 percentage points, easing the pain of the high cost of living that has afflicted consumers since last year. 

Also read: Cost of living still high despite gains in exchange rate

The latest data from the Kenya National Bureau of Statistics (KNBS) indicated that inflation dropped to 13.06 per cent in April, down from 15.6 per cent in March, marking the largest margin of decline in two years.

(Also read editorial on inflation)

Headline inflation was last close to this level in May last year when it stood at 12.95 per cent.

It was not clear what impact the much lower inflation rate would have on monetary policy in the coming months but official records show that the Central Bank of Kenya’s policy rate was at 6.25 per cent and the average exchange rate at Sh85.43 to the dollar, when the cost of living was last in this range.

Also see: Private sector wants Kibaki to address inflation, polls date

The April 2012 data also shows that core inflation, which measures the increase in prices excluding food and fuel, also dropped to 9.98 per cent from just over 11 per cent in March.

This is traditionally the basis of monetary policy as it factors out supply shocks.
Some analysts believe the latest drop in the inflation rate provides the Monetary Policy Committee (MPC) with enough headroom to start the downward movement of the policy rate.

“There are higher chances that the MPC will ease interest rate in May, a month earlier than we thought given the decline in inflation,” said Razia Khan, the StanChart head of research on Africa.

“If the CBK is cautious, it may go for a cut of 50 to 100 basis points compared to our earlier forecast of a 100 basis point cut in June with continued fall in inflation that began in January,” she said.

Ms Khan said that a one-percentage point drop in CBR would be in order given the scale of the fall in inflation, but added that it would still depend on whether the MPC believed that there are lower inflationary expectations.

But other analysts have argued that such action risks inviting turbulence back to the exchange rate market, citing the fact that Kenya has yet to deal with the fundamental issue of reducing the huge current account imbalance.

KNBS said the drop in food prices was the greatest contributor to the slowdown in headline inflation confirming how tightly the Kenyan economy remains tied to weather.

Prices of food, mainly driven by vegetables, have dropped significantly since the onset of the rains three weeks ago – pulling down the food segment of the Consumer Price Index (CPI) to 16.24 per cent from a high of 20.31 per cent in March.

Rainfall is expected to be normal or above normal in main food basket areas in the Rift Valley and Western Kenya while staying within the normal or just below normal range in other parts of the country.

Should the MPC respond to the decline in inflation with a cut in the policy rate, a further decline in commercial bank lending and deposit rates could unfold in the coming months, giving the economy the impetus it needs to move closer to the target rate of five per cent this year.

Several banks have since March announced marginally lower base lending rates but kept effective lending rates at highs of up to 31 per cent.

The high interest rates have been at the centre of a bruising battle between the Treasury and bankers on the one side against Members of Parliament who have been pushing for legal caps on deposit and lending rates.

StanChart has predicted a 400 basis points reduction in the CBR in the course of the year as the MPC embarks on an easing cycle.

“Looking at inflation numbers, we are rapidly approaching the tipping point at which the MPC must cut the policy rate,” said Ms Khan.

“We have seen a rally on Treasury bonds in recent times and this seems to indicate there is rising confidence in the economy and expectation of lower inflation.”

Inflation has been declining since December, after peaking in November at 19.72 per cent – the highest since the method of its calculation was revised in February 2009.

Inflation stood at 14.6 per cent in February 2009 when the new method of calculating it was introduce and declining steadily thereafter to 3.18 per cent in October 2010.

The cost of living measure then rose steadily from November 2010 for 12 consecutive months peaking at 19.7 per cent in November 2011.

Diamond Trust Bank chief financial officer Alkarim Jiwa said that given the drop in inflation, the MPC could cut the CBR by the same margin in coming months.

“If the MPC believes that the inflation has fallen enough to allow easing of the CBR, then that would also drive down lending and deposit rates quickly,” said Mr Jiwa.

Such a drop in lending rates would be in line with the Treasury bill rates that have been falling in recent weeks tipping the scales in favour of a lower policy rate.

“If we continue having a steady food supply and there are no external shocks from sources such as oil prices, then we should expect that the fall in inflation will continue. This in turn is going to cause interest rates to fall,” said Mr Jiwa.

The 2011 escalation in inflation levels was mainly driven by a number of supply shocks in the food and oil markets following the political turbulence in the Middle East and North Africa region and a steep depreciation of the Kenya shilling.

These developments saw MPC raised the benchmark rate to 18 per cent last December where it still remains.

Commercial banks raised their lending rates citing higher funding costs including higher rates they have had to pay depositors.

By the end of the year, the weighted average base lending rate stood at about 20 per cent, but the actual rate an average of about 25 per cent.

Deposit rates stood at 8.01 per cent in February this year, up from below five per cent in the same month last year.

Due to the high lending rate, customers have responded by shunning loans. CBK data for the period to February this year shows that there has been minimal growth in loans as the total figure on outstanding loans stands at about Sh1.2 trillion, the same level since last September.

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