Priced for perfection

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By Cees Bruggemans

Most of our economic forecasts now look suspiciously priced for perfection, reflecting a bet that inflation will plunge and interest rates will come off.

But will these two indicators perform as billed?

CPIX inflation is supposed to plunge from its imminent 13.5% 3Q 2008 peak, already going into single digits from January 2009, getting back near the SARB’s 3%-6% target zone by 2H 2009.

This is the main reason for expecting interest rate cuts, possibly as early as December-January, otherwise by April 2009 and at the latest by June 2009.

Timing is a matter of things working out and the SARB being prepared to buy into the proposition that future inflation risks are sufficiently subsiding.

What could still go wrong with most of these forecasts?

For one, reality may improve even faster than assumed. This would mainly require a further drop in oil prices (below $100), further moderation in food price inflation, and possibly a firmer rand.

For this scenario to come about, we need geopolitical stabilisation (Russia, Iran), more oil demand destruction, improved supply, also on the food side, and an improving global risk appetite supporting emerging markets, by implication also the rand.

Fed chairman Bernanke sees US weakness sufficiently well developed for it to erode commodity inflation and also contain second-round (wage) effects.

Global inflation could thus subside quite quickly next year, and doubly so if commodity prices slide more than expected. And the more so for us if the rand outperforms.

That combination could get us into the 3%-6% target zone by as early as mid-2009, also because we will have statistical reweighting working in our favour.

But the main risks, at least perceptional, seem still to reside on the other side of the forecast. Could oil rebound, food prices prove intransigent and the rand suddenly weaken?

Such caution recognises that oil demand/supply dynamics remain tight, the global geopolitical condition is as always full of surprises, and market speculation capable of turning around and boosting oil prices anew. If that were to rub off sympathetically on agricultural prices, any global inflation fall-off may become retarded.

That combination would rekindle the commodity-driven inflation surge, potentially even negating our coming technical drop in inflation on account of reweighting, especially if accompanied by more rand weakness.

But there is a possible third combination of events, essentially a hybrid configuration of all these assumptions. Arguing for the downside in commodities also could imply an even bigger rand risk on the downside. If the latter were to overwhelm the former, our inflation could still badly surprise on the upside.

The main risk here is the US economy, with cameo roles for Europe and Japan. Call it the Nouriel Roubini-Martin Feldstein axis.

According to this academic duo, the US and European banking play-outs currently under way are far worse than assumed. The bank bad debts are double those currently assumed, bank capital is draining away and cannot quickly be augmented, and bigger bank failures loom.

This implies even greater credit deleveraging than seen so far and more economic contraction as businesses and households become starved of credit.

US interest rates at 2% are already at their lowest allowable level, and won’t be able to overcome the economic contraction.

Martin Feldstein is especially scathing about the US housing outlook, with US house prices potentially falling further. This wealth effect could weigh yet more heavily on US households.

In his view US fiscal policy is impotent to do much about all this in the short term. The recent US tax cut had minimal follow-through. On previous occasions, US households would spent over 50% of any tax cuts, with multiplier benefits implying a bigger GDP contribution than the tax cut given, amounting to real stimulus.

This time only 20% was spent, the remainder used to pay off debt. So the tax cut added $100bn to the US national debt and only a fraction was added to GDP, a very expensive cure that can’t be repeated too often.

This school of academics sees the US credit meltdown progressing further, also drawing Europe in its wake. Emerging-market exports in turn should disappoint.

The implied growth decline should pull commodity prices further down. Our concern, however, has to be whether global risk appetite could falter, potentially also hitting the rand hard. Repeating 1998 or 2001 comes to mind.

The SARB has signalled its latent concerns about oil upside, but also rand downside. These potential inflation exposures will probably keep the SARB conservative until greater clarity prevails globally and how it impacts us.

That suggests delayed rate cutting into next year, but also rising growth sacrifice as the economy continues to lose momentum, given its present positioning.

What is needed is more information about what is going to happen next. Unfortunately, the future will not be hurried with divulging its intentions.

And thus we wait, hoping we have priced the future correctly but too well aware as to how differently things could still play out.

Source: Cees Bruggemans, FNB, September 1, 2008.

 

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