Overall Inflation Climbs Again in Third Quarter

UNCLAS NAIROBI 004378

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DEPT FOR AF/E, AF/RSA
DEPT ALSO PASS TO USTR FOR BILL JACKSON
TREASURY FOR LUKAS KOHLER

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E.O. 12958: N/A
TAGS: ECON EFIN EAGR KE
SUBJECT: Overall Inflation Climbs Again in Third Quarter

REF: Nairobi 3261 Nairobi 1808


1. After falling in the second quarter from the drought-induced
March peak thanks to a good rainy season, overall inflation began
climbing again in August. Since September 2005, food prices have
risen 20%, which impacts the poor most heavily. Interest rates
began rising in August. The Central Bank of Kenya (CBK) predicted
that overall inflation would continue to rise in the next two months
due to dry weather and high oil prices. However, the CBK raised its
Central Bank Rate (CBR) 0.25% on August 2 and increased sales of
securities to soak up excess liquidity to keep underlying (core)
inflation within its 5% target level. Underlying inflation, which
excludes food, energy and transportation, also began increasing in
August, but remains about 4%. It appears the CBK will be able to
keep monetary growth and inflation under control in 2006, and
forecasters continue to predict economic growth over 5% in 2006.

How the GOK Measures Inflation
--------------

2. On a monthly basis, the Central Bureau of Statistics (CBS)
releases Consumer Price Indices (CPI) and inflation rates for
Nairobi and 12 other urban centers, and for lower and upper income
groups in Nairobi. The "overall" (headline) inflation rate is based
on prices for 10 categories of goods and services. The CBS measures
"underlying" (core) inflation by removing the volatile categories of
food and energy, but the CBK also removes transportation, since it
relies so heavily on energy prices. The CBK targets its underlying
rate in its monetary policy planning and implementation.


3. The titles the CBS, CBK and media use for the time series
inflation measures are misleading and inconsistent. Here are the
translations.

Month-on-Month or 12-month: Actually year-on-year (YOY) change in
prices, since it compares the CPI in the current month with the CPI
in same month in the previous year.

Average Annual: Compares average CPI for the last 12 months with the
average CPI of the preceding 12 months. This measure serves as the
seasonally-adjusted inflation rate, and is less volatile.

Overall Inflation Rates Fall in Q2 with the Rains...
-------------- --------------

4. Overall inflation climbed into the double digits in January
2006, when failure of the October 2005 rains created or perpetuated
drought in many parts of Kenya, driving up food prices. When the
next rainy season began on schedule in March, food price increases,
especially in the basket of basic vegetables that form the basic
diet for lower income people, decelerated or declined, and the CPI
began falling. In March 2006, YOY overall inflation peaked at
19.15% and average annual (seasonally adjusted) peaked at 11.36%,
the highest rates in more than two years. April-July, both rates
declined steadily, as food, energy and transportation inflation
decelerated. The CBK welcomed the declining CPI and predicted it
would continue.

But Increase Again in August.
--------------

5. In August, food and fuel prices accelerated again, driving the
CPI and overall inflation up. The distribution of rains across the
March-May rainy season had been uneven, reducing vegetable
production on rain-fed farms, causing markets to rely on irrigated
farms, with their higher prices. Higher fuel prices and
inefficiencies in production, transportation and marketing also
drove prices up. YOY overall inflation rose 11.5% in August and
13.8% in September. Average annual jumped from 11.4% in August to
12.1% in September, the highest rate observed so far in 2006. The
CBS noted that food prices in September 2006 rose 20% YOY, followed
by energy prices at 11.9%, alcohol and tobacco at 9.2%,
transportation and communication at 8.5%, and housing at 3.7%. The
other five categories rose 2%-3%. Although it had predicted in
early August that food prices would stabilize and inflation would
continue to fall, by early September the CBK acknowledged that food
prices and inflation were once again on the rise. In its October 6
weekly report, the CBK predicted that overall inflation would
continue to rise in October and November due to dry weather and high
international oil prices.


6. The price increases hit the low income group in Nairobi hardest,
since CBS weights food expenditure at 56% of their expenditure. CBS
weights food expenditure in the other urban centers at 50%. Facing
such weights and such high inflation, econoff asked analysts from
CBS, CBK and other agencies how the over half the population
allegedly living on $1/day avoided starvation. The analysts
acknowledged the CPI survey did not cover rural areas, where the
majority of the population resides, nor the food that urban
residents receive from their families' farms. They also guessed
that uncounted remittances from Kenyans abroad (estimated by the
Economist Intelligence Unit (EIU) at about $685 million in 2006)
helped many Kenyans survive price increases. They were eagerly
waiting for the results of the nation-wide, district level household
survey CBS completed at the end of May to help them refine their
analyses and produce a clearer, more comprehensive picture.


7. In addition to the rising prices of goods and services, the CBK
was also facing other inflationary pressures. Confronted with
unexpected growth in the money supply and high liquidity levels due
to strong dollar inflows from remittances, plus a strong growth
outlook for 2006, the CBK raised the Central Bank Rate (CBR) from
9.75% to 10% on August 2. Over the next two months, the CBK also
increased its purchases of repurchase agreement securities (repos)
to soak up excess liquidity. In response, interest rates on GOK
T-bills, repos and interbank loans all rose. T-bill rates have been
rising for the last nine weeks. In the October 5 auction, the
91-days Treasury bill rate increased by 12 basis points to 6.79
percent, while the average 182-day Treasury bill rate increased by
26 basis points to 8.25 percent. In early October, the CBK decided
to maintain the CBR at 10% because underlying inflation remained
under control.

Underlying Inflation Rises More Slowly
--------------

8. The CBK's underlying inflation rate, which excludes food, energy,
and transport and communications because of their volatility, fell
from a peak of 4.9% YOY in December 2005 to 3.6% YOY in July. In
August, underlying inflation rose to 3.9% YOY, and then to 4% in
September. However, average annual underlying inflation (seasonally
adjusted) has been declining steadily in 2006, falling from 5.4% in
December 2005 to 4% in September 2006. The CBK therefore reports it
has inflation under control.

Comment
--------------

9. Kenya's government and private sector analysts agree the GOK
needs to improve their understanding of Kenyan household income and
spending patterns in different geographic and income sectors, and
more finely tune its price collection and analysis techniques to
provide more effective information to guide monetary and fiscal
policies. One could argue that CBK, by narrowing its definition of
core inflation, has set itself too easy a target for controlling
inflation. If the October-December rains are adequate and evenly
distributed, both geographically and temporally, food prices and
inflation will likely begin to fall before the end of 2006. Or not.
The GOK has announced other policies that could also, over the
longer run, reduce costs for producers, like improvements in
transportation, power and telecomm infrastructure, or increase
efficiencies in the food marketing chain.

HOOVER