Falling inflation should pave way for prolonged monetary easing cycle: Capital Economics

Elsayed Solyman
12 Min Read

A recent research note issued by Capital Economics London has expected Egypt’s monetary policy to ease in the few coming months on the back of falling inflation.

Egyptian inflation rose to its highest rate since 1986 in July, but it has been pushed up by a number

of one-off factors, which will fade over the next six to nine months, the report noted.

“Indeed, we think inflation has now peaked and will begin to fall more quickly than most expect. This should pave the way for significant monetary easing,” it added.

Why should inflation fall more than expected?

Inflation jumped from a single digit in early 2016 to 33% year-on-year (y-o-y) in July 2017. This increase has

prompted the Central Bank of Egypt (CBE) to pursue a more aggressive monetary tightening cycle than many analysts had anticipated.

However, the increase in inflation has been driven by one-off factors. The most important has been

the devaluation of the pound last November, but a series of indirect tax hikes and subsidy cuts over

the past year have also accelerated the rise in inflation. The key point is that these one-off boosts to

inflation have now peaked and should start to unwind in the coming months.

We estimate that the fading impact of the pound’s fall will cut inflation by as much as 10%-pts by

early 2018. Similarly, the contribution of fiscal measures to headline inflation will decline by a

further 3-4%-pts over the same period.

Beyond that, there are good reasons to think inflation will fall further. For one thing, the period of

weak growth since the Arab Spring appears to have created some spare capacity in the

economy. This should keep a lid on wage and price pressures. At the same time, the CBE

looks more determined to pursue orthodox policymaking in order to tame inflation. It has stopped

monetising the government’s budget deficit, and it has also adopted an inflation-targeting framework.

Overall, according to the report, it is believed that inflation will fall below 20% around the turn of this year. It may then decline to about 11% by the end of 2018 and into single digits in 2019. Forecasts are lower than the consensus and would comfortably meet the CBE’s targets.

This, in turn, should allow the CBE to loosen its policy. We expect the benchmark overnight deposit rate to be lowered by 100bp to 17.75% at the Monetary Policy Committee’s (MPC) meeting in December of this year. The easing cycle should then gather pace. The report expects the policy rate to drop to 12.75% by end-18 and 10.5% by the end of 2019. That is significantly more loosening than the consensus currently anticipates.

In this focus, we argue that inflation in Egypt has peaked and will now begin to fall sharply and by more than most expect, over the next 18 months. That will allow the CBE to start a prolonged easing cycle. Indeed, we expect more interest rate cuts than the consensus currently anticipates.

Egyptian inflation jumped from single digits in Q1 2016 to a peak of 33% y-o-y in July of this year—its highest rate since June 1986.

The main driver of the jump in inflation has been the CBE’s devaluation of the pound last November, when the currency subsequently fell by 50% against the US dollar.

Alongside that, fiscal consolidation measures, including the introduction of a new value-added tax (VAT) and several rounds of subsidy cuts, have also pushed up inflation.

The CBE hiked interest rates at the time of devaluation effect should fade the devaluation. But it then took the markets by surprise by raising rates further in more recent months.

The benchmark overnight deposit rate was increased by a cumulative 400bp in May and July, to 18.75%—the highest level since this rate was introduced in 2005.

Reading between the lines, this seems to have been a signal from the IMF that Egyptian policymakers should raise rates.

The key point when it comes to the inflation outlook is that the increase over the past year or so has been driven by one-off factors (the pound’s devaluation, subsidy cuts, and indirect taxes). The impact of these, however, has now peaked and they should start to unwind in the coming months.

Starting with the currency impact, it is believed that the big adjustment in the pound has already happened. While we expect the currency to weaken a little further in the coming years, the move is likely to be modest.

To illustrate what the exchange rate forecast means for inflation, the report has constructed a measure of the price of goods which, historically, have been most sensitive to swings in the pound.

These include a number of food products, clothing, medical goods, TVs, and cars. In total, those goods comprise around 35% of the CPI basket. The report has covered the cost of production and estimated that they termed this “exchange rate sensitive” inflation.

The year-on-year decline in the exchange rate—which is what matters for inflation—should ease markedly towards the end of this year and in early 2018.

On that basis, inflation in “exchange rate sensitive” goods could decline by around 30%-pts over the next six to nine months. This alone would knock around 10%-pts off headline inflation rate by early 2018.

Turning to subsidy cuts, after a slow start in President Abdel Fattah Al-Sisi’s early years in office, this is now well underway.

As part of the IMF programme, the authorities have committed to raising fuel prices to production cost by the fiscal year (FY) 2018/19, while subsidies for electricity are to be eliminated by the end of FY 2021/22.

To provide a rough estimate of how far fuel prices need to rise, the report has compared current prices in Egypt with average pre-tax prices in the US and Europe.

Working on the basis that Egyptian fuel prices would need to rise to this EU-US average to cover the cost of production, estimates show that they probably need to increase by an additional 140% by 2018/19, which translates into a 55% rise in 2018 and again in 2019.

As for electricity prices, the report estimates that they need to rise by a total of 40%, or an average of 10% per annum, over the next four years to reach the cost of production.

By our estimates, the impact of subsidy cuts is likely to fall by about 1.5%-pts in November of this year as the fuel price hike imposed in November 2016 drops out of the annual price comparison.


Further out, the impact of subsidy cuts on headline inflation is likely to stabilise.

Finally, the impact of the introduction of VAT will keep inflation high in the next few months, but then also start to fade.

VAT was introduced in September of last year to replace a general sales tax. It covers a wider range of goods than the sales tax did, and was set at a higher level, so it pushed inflation up.

By the report’s estimates, inflation was raised by 1.5%-pts when it was introduced in September, and by a further 0.5%-pts in July following the increase in the VAT rate from 13% to 14%.

However, unless the government hikes the VAT rate again, its inflationary impulse should fully unwind within a year.

Overall, the fading impact of subsidy cuts, tax hikes, and pound devaluation should bring inflation below 20% by the turn of the year.

Beyond that, other factors are likely to become more important in determining the inflation outlook. And in this regard, there are several reasons to think inflation could fall even further.

CBE deficit monetisation affect inflation 

Egypt’s budget deficit has exceeded 10% of GDP for much of the past decade. Historically, the government has relied heavily on the commercial banking sector to purchase government debt in order to finance the deficit.

But from the beginning of 2013, the authorities turned to the CBE to fund the deficit, via the use of credit facilities.

This filtered through into the wider economy via faster money supply growth. The rise in credit facilities to the government resulted in an increase on the asset side of the CBE’s balance sheet.

There was a counterpart on the liability side, as it credited banks’ deposits at the CBE, which led to an increase in the monetary base.

With more money chasing the same amount of goods, this led to a rise in prices. Indeed, core inflation was 4%-pts higher during the period of deficit financing than in the preceding few years.

Meanwhile, shifts in the CBE’s policymaking priorities are likely to help bring inflation down.

First, the CBE has halted its financing of the budget deficit. Between early 2013 and late last year, the government had relied increasingly on “credit facilities” provided by the CBE to fund its budget shortfall.

Indeed, we had previously estimated that the CBE had covered 10-15% of the government’s gross financing requirement during the period.

However, following demands from the IMF to cease the practise, it appears to have come to an end. The CBE’s net claims on the government have levelled off.

Conclusion: inflation will be in a downward in the few coming months

To sum up, the report expects Egyptian inflation to fall sharply over the next six to nine months as the one-off factors that pushed it up over the past year begin to fade.

Beyond that, improvements in the CBE’s policymaking and spare capacity in the economy means that inflation should return to single digits in 2019.

Falling inflation should pave the way for a prolonged monetary easing cycle and, ultimately, interest rates are likely to be lowered much further than most expect.

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