By Cees Bruggemans, Chief Economist of FNB.
With prime interest rate at 9.5% after 600 points easing these past two years what further rate downside is there?
And when can we expect first increase?
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SARB remains guided by inflation-targeting, in which both the outlook for inflation and the expected state of the economy figure centrally in any interest rate decision.
Eventually the state of financial markets may also be considered, especially when overly excited and giving rise to excessive credit gearing.
Though bond and equity prices remain firmly in rising phases, they have probably not yet reached levels creating concern for future financial stability.
The housing outlook remains credit constrained, with real prices still having downside, if anything supporting another rate easing.
That leaves inflation and growth performances relative to desired medium-term levels as main policy drivers.
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Inflation target is 3%-6% with a 4.5% midpoint. At 3.2%, our inflation has moved far into the lower target range.
Though many observers feel inflation has already reached its lowest cyclical level, with now only upward potential over the next few years, our goalposts may not have ended their surprising downshifting of recent years.
The main reason for assuming a rebound in inflation is high multi-year infrastructure-related tariff increases well above accepted inflation norms.
Also, organized and talented labour keeps demanding high increases in remuneration. Even when allowing for managed labour layoffs and large parts of the labour force not equally benefiting, average unit cost increases remain high and are not a reason for expecting lower inflation.
Importantly, global commodity prices are key inputs into our inflation, especially energy (oil) and foodstuffs.
Oil is again on a rising streak, after averaging in the $70s and lately having moved into the $80s reflective of Asian demand and fears about Dollar downside.
Global food shortfalls have again pushed food commodity prices sharply higher, though locally tempered by good climatic conditions and ample held-over stocks.
The writing here is on the wall. Commodity prices will probably rise higher, though accompanied and partly neutralized so far by a firming Rand.
In contrast, the case for yet lower inflation hinges on low global inflation (indeed trade deflation) imported by us, further reinforced by a stronger Rand.
Also, despite many local producers pricing cost-plus with currently still modest earnings, the after-effects of recent recession and still low capacity utilization probably continues to prevent high price increases from fully ‘sticking’.
This makes for an inflation outlook these next two years which though rising may turn out below expectations.
Taken on its own, such an inflation reality and outlook are broadly in line with the current interest rate stance of prime 9.5%.
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Policy, however, reads such an inflation outlook in conjunction with the expected state of the economy.
Here we continue to notice growth below long-term average of 3.5%, and lots of resource slack.
The labour market has experienced cumulative losses of 500 000 formal jobs these past two years, during which the net addition of successful matriculants and graduates from universities and technikons were 900 000. As only 200 000 of these will have been absorbed by replacing retirees, the labour market on a formally employed labour force of 9 million is currently showing much slack, of the order of 13% plus. And the 2010/2011 cohort is about to join the labour market pushing potential slack to 17%.
Also non-residential building vacancies are still rising, though offices probably topping out. Capacity utilization in manufacturing dropped from cyclical high (86%) to a recession trough (78%), thereafter recovering to 80% lately, giving impression of being stalled (possibly reinforced by strike action in 3Q2010).
Final demand seems to be advancing moderately, with strong Rand, tight credit criteria and electricity acting as constraints on external demand, fixed investment, household consumption and output.
The existing output gap is sizeable and likely to narrow only very gradually on present trends.
Read together with inflation conditions, this seems to warrant slight further easing of interest rates shortly.
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Financial markets have for some weeks put a 50%-60% probability on another 0.5% rate cut this week. If not forthcoming, probability of a cut rises to 100% by January 2011.
Any further interest rate downside beyond this would have to be guided by further inflation downside surprises, such as yet further Rand appreciation, less commodity price upside and more domestic pricing discipline than projected and/or yet more growth disappointment keeping the output gap wider than expected.
Clearly these are not low hurdles.
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Our interest rates are expected to stay ‘low for long’ in line with accommodative global conditions keeping the Rand strong. This may well extend through 2011 and even well into 2012. Markets are currently discounting a first rate increase by mid-2012.
If, however, our growth recovers faster than expected, narrowing the output gap more rapidly, and inflation starts surprising on the upside, especially if global commodity prices prove lively next year, the first rate tightening could be brought forward.
Source: Cees Bruggemans, First National Bank, November 15, 2010.
