Interest rate cuts ahead in South Africa
By Cees Bruggemans
Events have marched on to a point where the first of a series of SARB rate cuts are coming into view, timing as always the prerogative of the SARB.
But do paint in a very high probability for December 2008 and a near certainty for February 2009 for the first cut.
In contrast, the consensus keeps looking well into 2009 for that first rate cut. I have maintained for some time that events may be moving much too fast for that. Expect rate cutting sooner rather than later.
And that is with impressive shock absorbers already fully extended. This refers to oil at $60 rather than $150. Also, the fiscal stance becoming supportive by the equivalent of 2% of GDP this year and probably again next year. The Rand’s 40% depreciation so far this year compared to 2007 average (and about 30% depreciation on trade-weighted). And the decline in real interest rates (however calculated), as rising inflation and inflation expectations this year outpaced rate increases.
So in order to suggest nominal interest rate cuts sooner rather than later, one apparently believes the economy’s decline is worse than what these impressive shock absorbers can handle. Or the inflation rate is about to collapse impressively, in the process boosting the real interest rate to Kingdom come at the very moment that the economy finds itself in the middle of an old-fashioned recession.
Or more likely one believes both these propositions.
Let’s test them both before moving the focus to the SARB.
Could the economy be weaker than thought? Easily so, as economic data and perceptions lag rather badly coming out of a high-performance growth era accompanied by even higher future expectations and dire political need for good news and little interest in bad news.
But the shock absorbers may not all be what they are cracked up to be at first blush.
Take oil. Nice, to see it collapse from $150 to $60. But unfortunately our Dollar export commodity prices have fallen even further, starting with platinum, from $2250 to $800.
That takes care of the Dollar oil windfall. Worse, we produce 40% of our own liquid fuel requirements. That boosted Rand incomes when the oil price was rising, but the oil price fall will be contracting Rand income at our oil producers. That’s growth-suppressive.
The Rand decline of 40% since 2007 is a great income booster, until one allows for the Dollar export commodity declines, but also declines in export volumes once global recession is fully discounted.
Exporter Rand incomes may have been partly shielded by Rand decline, but not fully so. Households and businesses will have some benefit from the falling oil price, but most of the benefit is eroded by the depreciated Rand.
So yes, exporters are not falling off a cliff, but our households are not getting much of an oil price windfall either.
Meanwhile, the nominal interest rate increases of the past two years are steadily grinding away at household consumption growth, which by this time is probably already negative. Private fixed investment also suffers in part, in addition to the effect of constrained electricity supply. There is evidence of inventories being reduced. Real household income may be under pressure from real wage adjustments, employment and flexible income sources (bonuses, commissions and overtime especially).
Thus inflation may have outpaced nominal interest rate increases and may thereby have reduced real interest rates this year, but its beneficial effect is yet to start shining through in growth support.
Indeed, the 40% Rand decline, most of it occurring these past two months, has greatly increased interest rate anxiety, with greater fear of either further nominal rate increases, or delays in rate cuts, prolonging the period of severe household stress, in turn inducing yet greater willingness to postpone durable goods replacement and intensify belt tightening.
Has enough therefore been done to moderate the cyclical growth interruption? Probably not, indeed increasingly not, as external events keep piling up the pressure.
If monetary policy has so far chosen to increase nominal rates and keep them elevated, this is very much a reflection of the sharp increase in inflation and inflation expectations these past two years, and the risks of keeping them elevated through next year.
But that was the musical sheet of the past twelve months. Is it being overtaken by events? I think so.
CPIX inflation peaked at 13.6% in August, and undershot marginally at 13% in September. Coming months could see more undershooting if oil keeps heading lower, food prices have passed their peak, the Rand proves more resilient than expected and the pass-through from the weaker Rand is less than postulated.
It is true that OPEC has announced output cuts of 1.5mbd, with more probably to come. But high-cost marginal producers will probably cheat, Saudi will want to keep the Americans friendly (and not forgetting its own long-term interest in optimising oil wealth), and US domestic petrol consumption is now apparently 9% down (but for how long?). Anyway, futures markets are betting on $50 oil next year (though these bets have been wrong before).
But even if one doesn’t get too bullish on oil (the SARB certainly won’t), one has reason for quiet optimism regarding food, Rand, Rand pass-through, rebasing and reweighting, though rentals could be a bedbug.
Administered prices excluding oil are 15% of the CPI basket and apparently remain a great pain to the SARB. Government is simply not keeping to the prescribed inflation target of 3%-6%, understandably so for electricity (paying an enormous price for past incompetence), but less excusable elsewhere, especially in local government.
Despite these obstructionist elements in the inflation basket, recorded inflation could fall very sharply in coming months through mid-2009. Do expect a falloff in inflation expectations to follow as a matter of course. That would take care of many second-round effects, as would the weakening economy and increasing resource slack (though some unions and skills shortages will prove immune, as may some politicians).
So our real interest rates are now on a steeply rising slope, at the very moment that global interest rates are collapsing in union, with the exception of those few small economies with unsound policy frameworks under interim IMF tutelage.
The US is on its way to 0.75% (from 1% currently and 5.25% a year ago). Europe is on its way to 2% from 4.25% two weeks ago. Britain is on its way to 2%. Australasia is aggressively cutting rates. India may be aggressively cutting rates after so far moving twice by 1% and 0.5%.
Things are hotting up out there. The differential with our rates is going through the roof shortly. Do we really need that? It will only depress our inflation even faster, going by the historical record.
Globally, the financial crisis is finishing off (with the most difficult trillion disorderly written off and another more orderly trillion or so still to go).
The Fed, ECB, BoJ and IMF have started extending support to the EM universe where liquidity is needed, in the process soothing market anxieties (probably all that is really necessary).
What is increasingly coming into focus is deep global recession through next year, requiring extensive interest rate easing (where rates are not already at 0.3% as in Japan or 0.75% as in the US shortly), and fiscal support (impressively so in the US but not limited thereto).
Finance Minister Manuel is doing his bit (or rather the weakening economy and higher wage and infrastructure costs are doing it for him). Now it is the turn of the SARB to indicate where it feels it can contribute.
Perhaps on this score a useful aside is in order to better understand the forces at work in monetary policy.
In modern monetary policy there is a battle royal going on between those preferring pure credibility seeking (so-called inflation nutters focusing on inflation pretty much to the exclusion of all else) and those emphasizing flexibility (taking into account to a greater or lesser degree output considerations as well, smoothing policy responses over time rather than hammering things).
Indeed, when expressed in an equation, the old Taylor rule pops up. One component of this reaction function examines actual inflation and where you want it to be (target), thus defining an inflation gap, while the other component examines the output gap, whether or not output is overshooting or undershooting.
The inflation nutter simply focuses exclusively on the perceived inflation gap, arguing that if you can get that right everything else will follow.
The flexible approach, on the other hand, prefers to split the process of containing inflation into a direct and indirect component. It directly wants to address the inflation gap, and indirectly influence inflation by addressing the output gap, but in this manner also preventing undue output variability (and its potentially unfriendly political fallout).
The flexible approach comes across as perhaps more sophisticated, wanting to reconcile two potentially opposing gaps (inflation and output) simultaneously, optimizing the general economic condition over time while centrally addressing inflation.
But it is more complex than that.
Anyone starting out in life has no credibility. Acting strongly for a while in the dominant alpha tradition establishes one’s credentials. Once achieved, there is less need to keep on proving manhood.
Like Teddy Roosevelt a century ago, you can then move quietly while carrying a big stick. This condition, once achieved, allows one to become more subtle without being penalized for loss of credibility, being less imposing on the economy yet achieving more.
It would seem our SARB has evolved nicely in this respect, with or without help from political considerations. Our inflation targeting policy is well established, our markets respond well, and even the less flexible parts of our economy respond, if with a lag.
This has already for some time now allowed more emphasis on policy flexibility rather than credibility. It was explained like this in old Monetary Policy Reviews a few years back (though possibly ignored by too many even today). There is no harm in emphasizing it again today. Especially so as this policy characteristic has been on show the whole year, with interest rates not increased as fast as inflation, the SARB apparently being prepared to smooth the real rate effects over time.
But this renewed emphasis on monetary policy flexibility could not come at a more appropriate time, with the economy steadily weakening, high inflation now in remission, and external risks greatly diminished (oil), going there (food) or getting there (global financial crisis and EM exposure).
With the inflation gap about to start closing rapidly (let’s not argue too strenuously as to when we will re-enter the target as nobody really knows, but it may be sooner rather than later), and external risks diminishing daily (though keep a sense of proportion) even as the output gap is steadily deteriorating, it doesn’t require rocket science to see where this may be leading. Soon, too, by all appearances.
Expect a series of interest rate cuts, starting soon. Along with a more accommodative fiscal stance, this may assist in keeping the looming recession next year mild, meaning shallow and short, despite an increasingly intimidating global recessionary backdrop.
Politically, that would be extremely good timing, too.
Source: Cees Bruggemans, FNB, November 3, 2008.
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