As High Base Effect Thins Out, will Headline Inflation Trend Higher Again?

Nigeria’s Headline inflation rate has trended lower since peaking in January at 18.7%. However, the moderation is largely on account of high base effect from 2016 which has offset a steep increase in Month on Month growth of the Consumer Price Index (CPI) observed since February. Month on month CPI growth averaged 1.7% from February to May (relative to an average of 1.0% in July 2016 to January 2017) due to sharp rising food prices attributable to seasonality effect. Food Inflation reached an 8-year high of 19.3% in April (slightly moderated 3bps in May due to high base factor) in contrast to Core inflation (all items less farm produce), which declined for the seventh consecutive month in May to 13.0% (from 14.8% in April). From our analysis of CPI numbers, the moderating effect of high base factor on Core inflation is fast running out; hence, we forecast Y-o-Y Headline Inflation for June (due for release next week) to marginally increase 15bps to 16.4% as we expect sustained pressure on food prices to keep M-o-M CPI growth elevated at 1.8%.

Historically, the country’s planting season starts in February and lasts till July while harvest begins in September. Thus, the Food Sub-index has remained pressured in the last four months and we expect this trend to be sustained as the impact of the planting season continues to weigh on food prices. Other possible factors which might result in lower crop yield during harvest is the recent flood & erosion caused by the raining season as well as the roads for transportation of farm produce. Although there are long term solutions to fix infrastructure in the 2017 budget, the planned record capital spending will do little to ease transportation bottleneck in the near term due to significant time-lag between budget passage and actual cash releases. Similarly, not so much could be achieved by monetary policy since the nature of the renewed pressure on prices is to an extent structural, hence outside the purview of monetary policy tools which are traditionally more effective in anchoring Core inflation expectation.

In situations like this, the CBN might be prompted to ignore the pressure on the Food index and start to slightly ease market rates. In comparison with short term market rates, real returns (inflation adjusted) have swung positive since February. Nonetheless, we do not expect policy easing in the near term as the main monetary policy anchor – foreign exchange rate – is  in a fragile stability due to renewed volatility in oil prices and subsisting significant spread between interbank and NAFEX exchange rates. Moving to a fully market based FX regime or effecting a large depreciation in the interbank market could give the CBN some needed space to slightly ease interest rate. However, devaluing interbank rate is a political decision as much as it is a monetary policy one, considering the positive correlation between petroleum product prices and interbank exchange rate. Hence, we do not expect any changes in monetary policy or market interest rates in the near term until a convergence in exchange rates and sustained stability in core prices.

In the financial market, inflation at above 16.0% level will continue to incentivize high yield environment as the CBN will likely stick to guiding rates at a substantially higher level to achieve real return. We are of the view that this will possibly sustain the current inversion in the sovereign yield curve as more appetite towards shorter term fixed income securities is more probable to dominate. Barring any distortion in the current structure of the Investors’ and Exporters’ FX Window (NAFEX), the equities market will remain fundamentally driven and propelled by foreign investors while local players will more likely tilt towards short term debt securities.