Third interest rate pause beckons

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By Cees Bruggemans

After pausing twice before during its two-year tightening mode, in 1Q 2007 and 1Q 2008, chances are excellent the SARB may pause for a third time in 3Q 2008.

The reasons would be as before.

Given what we know today, and don’t know about the future, enough has been done to date in terms of the policy mandate. It may be time once again to sit back and watch what happens next before deciding on further action.

Yet another pause in our rising rate cycle could, as on previous occasions, herald the peak. But ultimately we cannot be sure. Much will depend on things working out.

On previous occasions they didn’t, and rate tightening resumed. Hopefully this time it will be different, with the fundamentals turning positive next year, heralding the next down-cycle in rates.

Third time lucky?

Certainly the loss of economic momentum in a very short period of time makes one hesitant to call for another rate increase at this juncture.

Oil prices are impressively off their recent peaks at $125, and the rand has clawed back much lost territory at 7.20:$. But neither condition may last very long.

Despite oil demand declining by 4.5% year on year in the US, it is as yet uncertain whether global demand destruction is enough to allow improvement in the slim 2mbd reserve buffer between oil demand and supply. There remains uncertainty about having seen oil cyclically peaking – this aside from geopolitical adventures in the Middle East and any oil consequences.

The rand’s strength may also be temporary. Besides global risk appetite improving, we have been borrowing our overseas funding requirements, not least by way of long-term infrastructure credits, shielding the rand.

But such borrowing can shield us for only so long, as can the attractiveness of high interest rates. As our external indebtedness increases and the next down-cycle in rates beckons, so one would expect rand sell-offs, as currently experienced in Australasia.

So it is really the growth sacrifice already incurred and still looming, given rate tightening to date, that is the more important reason for not unduly raising rates any further, unless one is prepared to incur the costs of an even more severe economic contraction.

In terms of the SARB’s brief, the inflation condition is central to any decision. Here also there is hope.

Although events to date have conspired to give us 11.6% CPIX inflation, which is about to rise shortly to 13.5%, the road beyond looks decidedly different.

Assuming oil at $125 p/b, and incorporating what we know about food prices, Eskom tariffs, the rand and proposed methodological changes to the inflation calculation from 2009, CPIX should finally roll over by late 2008, halving in the course of 2009 closer to 6%, with luck re-entering the SARB’s 3%-6% target zone by the time of the 2010 World Cup.

If this is a believable outlook for the next two years, interest rates won’t be able to remain where they are currently given the magnitude of the coming change. The focus should be on how much the SARB will ease, grudgingly, and when, rather than on whether it will still raise rates.

But, the argument goes, credit demand has surprised on the upside, GDP data may bounce because Eskom partially restored electricity supply, and second-round effects on wages, company prices and administered prices are huge.

Besides, India raised rates by a surprisingly severe 0.5% last week, an ominous sign as we seem to follow such international example closely. Yet New Zealand cut rates recently, mainly due to a weak economy.

It remains to be seen how much bounce our mining gives 2Q 2008 GDP growth, compared to secondary and tertiary sectors inducing more weakness.

As to credit growth, many commentators appear unaware that borrowers cannot immediately adjust their financial arrangements when interest rates rise. We therefore always see a temporary acceleration in credit extension following a rate rise as borrowers seek accommodation.

But with a lag financial adjustment does follow. The peak in credit growth at 30% lies two years behind us. Credit growth has eased to 20% now, and should be single-digits within a year.

It is really the second-round inflation effects that perturb the SARB most. But wage indexation also works in reverse.

If the public sector automatically got 10.5% plus 1% in mid-2008, by mid-2009 it can expect only 6.5% plus 1%, because that is where inflation is heading if oil, food and the rand hold.

Just the same for other unions. Implicitly, second-round effects will eventually reverse as impressively as they rose initially, once we are through the commodity inflation peak.

Because we can’t be entirely sure exogenous CPIX drivers (oil, food) have peaked, this isn’t a reason to simply push rates higher.

Current conditions warrant another rate pause, which may well eventually turn out to be the peak, once decisive evidence comes through in inflation as projected.

Asset pricing in our capital and equity markets signals the belief we are already there.

Source: Cees Bruggemans, FNB, August 4, 2008.


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