Third time lucky as interest rates pause

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By Cees Bruggemans

The SARB again decided to keep interest rates unchanged in August, the third time it has now done so since it started its tightening cycle way back in mid-2006.

This time, though, we may have seen the peak of the interest rate cycle. The next move may be down, provided economic events continue to unfold to our advantage. It is generally recognised, also by the SARB, that CPIX inflation has still some way to go, with peaking above 13% expected during 3Q 2008.

Thereafter, however, the CPIX should start declining. Part of the decline will be for technical reasons, with StatsSA reweighting the CPIX index from January 2009, in the process probably causing an abrupt decline in year-on-year inflation.

However, the more important policy questions pertain to the instigating first-round price shocks coming from abroad (oil and food mainly), domestic second-round effects (wages and administered prices especially), future risks we still face (including the rand) and how economic growth develops.

Since mid-July, global commodity prices led by oil have heavily come off the boil, reflecting growing caution about global growth prospects going forward and commodity demand. If such commodity pricing moderation could last into next year, CPIX inflation could decline substantially during 2009.

Although wage increases have risen worryingly since last year, they mainly reflect the rising CPIX inflation, as scarce skills, unionised labour and those politically protected effectively find their incomes indexed.

But what applies on the way up also applies on the way down. As headline CPIX peaks and starts to decline under the moderating influence of reversing commodity price shocks and for technical reasons, so will the wage increases granted.

If technical reasons and moderating commodity price inflation were to cause CPIX inflation to drop to 6.5% by mid-2009, public sector wage settlements, for instance, would reflect this, as opposed to being granted 10.5% plus 1% as happened this year.

Second-round inflation effects should therefore also follow the first-round effects lower in 2009.

Furthermore, international developments are seeing slower growth, and inflation trends everywhere should peak in a manner comparable to our experience. This will probably see less vigorous central bank action globally.

Our domestic economy is still weakening under the influence of past events, and will probably weaken some more in coming quarters, even as the electricity-induced weakness of 1Q 2008 moderates somewhat in 2Q 2008.

If this picture were to solidify, with commodity prices playing out supportively in the coming months, headline CPIX peaking and starting to decline, especially noticeably so from early next year, with inflation expectations increasingly seeing us moving back towards the 3%-6% target range between mid-2009 and mid-2010, the SARB will have reason to start cutting interest rates.

This could commence as early as December 2008, although the SARB may want to wait for the January 2009 meeting to begin this process.

Thereafter nominal interest rates are expected to fall steadily in 0.5% moves at every Monetary Policy Committee meeting, prime falling from 15.5% now to 13% in 2H 2009.

Any further interest rate declines from this level are considered unlikely for now, given the lingering global risks we may still face to the inflation outlook, in oil and food, but also regarding the rand, given our very high current account deficit.

The global environment is likely to remain tumultuous, making a high interest rate defence advisable as an insurance policy against unexpected shocks.

Source: Cees Bruggemans, FNB, August 14, 2008.


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