Is this the end of the Central Bank of Egypt’s Tightening Cycle?

Throughout most of 2008, fighting inflation was the primary target of Egypt’s  policy makers. However, with the reduction in international food prices, a global slowdown, and other easing inflationary pressures, priorities for the Egyptian economy have been adjusting.  For the fifth month in a row, Egypt’s consumer prices have continued to fall,  dropping to 14.3% in January 2009 after peaking in August 2008.

image001_512_41.gifSource: Bloomberg

The process of fighting inflation began in February 2008 with monetary tightening that continued through November 2008 raising both the deposit and lending rates by 250 bps.  In November, the Central Bank of Egypt (CBE) began a policy of holding interest rates constant.  In their second- and last- meeting to halt rates in December 2008, the CBE held the key overnight deposit rate unchanged at 11.5% and the overnight lending rate at 13.5% as inflation -despite dropping to 18.3%- continued to be at double the target.  However, the CBE made two key announcements at the end of the year; 1) monetary policy will support economic growth; and 2) Egypt may start reducing interest rates if the January data continue to show an easing in consumer price growth. Given the drop in consumer prices as per January’s figures, economic growth has replaced inflation to become the top priority for Egypt and prompting the CBE to start monetary easing.

image002_512_43.gifSource: Bloomberg

Inflation is still supposed to plummet significantly over the course of 2009 as economic growth slows, food prices decline,and the lagged impact of monetary tightening continues.  Egypt’s growth rate has sharply dropped to a low of 4.1% in the last quarter of 2008 (from a high of 7.2% in the fiscal year 2007/2008). Also, food prices-in December 2008- fell to their mid-2007 levels due to falling oil prices and to the global economic woes. Such sharp drops were even sharper than expected despite the fact that revenues from exports, tourism, and the Suez canal have been dropping and global trade has been contracting, and may very well continue to do so.Such low figures may act as a futher impetus to prompt the Central Bank of Egypt to start monetary easing almost immediately when the Monetary Policy Committee meets on February 12th.

Monetary easing may additionally be prompted by the widening interest rate differential with US and the Eurozone after their continued rate cuts resulted in unintended monetary tightening in Egypt.  Money supply also posted its most sluggish annual growth in more than eight years at the end of Jan 09, suggesting that inflation would continue to fall as the economy slows.Thus, if the CBE does not cut interest rates in their February meeting, given the cautious means by which monetary policy has been conducted, the CBE may risk the need to cut rates much more aggressively at a later point.

Any concerns about the risk of spiraling inflationary pressures as a result of any monetary easing –even if the exchange rate depreciates– should cease to existfor a number of reasons. First, the CBE needs to concentrate on competitiveness to boost the country’s revenues. Second, the global liquidity squeeze and deleveraging crisis has already sucked capital out of Egypt – a trend that is likely to continue- which resulted in the first annual current account deficit since the start of the decade, and to a loss of foreign exchange reserves going into 09. Third, the lagged impact of monetary policy actions implies that monetary easing might be the remedy needed as Egypt’s economy and price growth slow further through 2009.  However, if the interest rate cuts were overdone, inflationary pressures may arise which will surely threaten food prices on a domestic level. Such a scenario maybe unlikely, however, given the cautiousness of the CBE and their continued efforts to support disinflation. Within such context, the EIU expects inflation to average 9.5% in 2009 and 4.6% in 2010.

On the other hand, Egypt’s government has announced that it will double its economic stimulus plan to 30 billion Egyptian pounds ($5.4 billion) in attempts to boost the ailing economy. Egypt has previously announced a $2.73bn package for the 2008/9 fiscal year which ends in June 2009. The government planned to increase spending in 2008/9 as a means to stimulate growth but it is doing so at a time when government revenues are likely to fall, which will put the fiscal accounts under more pressure. The best scenario in this case would be to support this countercyclical fiscal policy with monetary easing.  The IMF had explicitly announced that counter-cyclical policies are risky given Egypt’s poor initial conditions—large fiscal deficit (6.8% of GDP in 08), high public debt with much of it at short maturity, and high inflation (18% in 08). However, this risk is worth taking in light of the current circumstances, and the goals of the policy makers in Egypt.

There seems to be enough evidence that inflationary pressures have eased- and will continue to do so- which may signify an interest rate drop between 25- 50 bps.  If an interest rate cut does not occur now, and inflation continues to fall at such a rate, aggressive monetary easing at a later point might be inevitable, and that would be the real threat as the effectiveness of a countercyclical monetary policy in supporting growth might be diluted.