South African interest rates could be too high

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By Cees Bruggemans, Chief Economist FNB

Let us for a change take somebody at his word.

Larry Summers, for instance. Economic advisor to US President Obama, Larry has been sending signals that could well shape also us in rather fundamental ways in coming years.

It could mean the Rand might be forced stronger and that our interest rates are too high.

Misreading such tealeaves would be very costly for us, with a too strong currency hitting exporters (our long-term Achilles heel) and too high interest rates keeping our domestic economy unnecessarily back.

Larry has been saying for some time it can’t be business as usual for the world. Whatever domestic origins of the US financial crisis, the global economic imbalances are not healthy, feeding the wrong behaviours.

Seeing and treating Americans as consumers of last resort for instance, neglecting their export capabilities, dabbling in exotic financial engineering, and simply importing whatever they don’t produce and paying for it by printing Dollar IOUs (with all this mainly benefiting up-and-coming Asian competition).

So once this crisis is over, growth is trundling along, the US fiscal deficit can be paired back, and the rising national debt stabilized, we are supposed to encounter a new America.

Two propositions come into view. US consumption needs to be constrained, and exports pushed, with higher savings funding domestic investment more fully, leaving less of a global dependency. If this sounds like China, that’s precisely right.

It doesn’t really matter whether wealth and income losses and future anxieties induce US consumers to save more at the expense of their consumption growth, or whether regulatory and cultural changes to US bank lending restrain credit access.

The idea is that US consumption takes a backseat, even as overseas, especially in emerging markets, domestic demand is pushed more vigorously, precisely because US consumption won’t be so supportive any more.

Even when allowing for cyclical watering down of all this once global recovery truly vests, do for once take Obama’s Larry at his word. Less US financial engineering, less consumption growth, more saving.

To still achieve above trend growth in order to reduce the yawing US output gap (high unemployment), there will also need to be more exporting. That will be pulled in by foreign demand growing faster, and could be pushed by a weaker Dollar.

In Fed chairman Bernanke, reappointed for another term only last week, the Obama administration has probably an unspoken ally in seeing the overvalued US Dollar ‘orderly’ devalued and US exports boosted.

One can talk the Dollar down (though now is not a good time because gigantic fiscal deficits need to be funded) or one can make the Dollar look less attractive. This suggests a role for monetary policy, by keeping US money competitively priced.

Provided US inflation remains low (it will), and US domestic growth recovery relatively slow (it probably will), there is an enhanced role for a weaker Dollar to boost US exports in a recovering world. Even the Chinese will see the inevitableness, though not liking it.

What does slow US domestic growth, low US interest rates, and weaker Dollar mean for South Africa?

As for so many other emerging countries (but also Europe and Japan), it probably means a firmer currency, driven by higher commodity prices (elevated by Asian demand and weaker Dollar) and capital inflows.

With the Rand already 7.70:$ in month two of what will probably be another 100 month global expansion, how much firmer can the Rand go (7, 6, 5:$)?

These global tendencies should suppress our inflation and improve our consumer purchasing power. That should add to domestic recovery. But our exporters could suffer income losses. That would detract.

Our interest rates could still be too high.

Currently tightened bank credit cultures (and cautious consumers) are holding back our interest rate-sensitive sectors (cars, furniture, housing). But down the road hot capital inflows, too strong Rand, and exporter woes may suggest the need to spread the incoming heat more widely in order to handle it better.

Shades of 2003, I know, but this time it wouldn’t only be Asian demand and Western speculation doing the driving. A weaker Dollar through 2012 would create its own unbearable pressures for us.

We may want stronger domestic absorption, less Rand overvaluation and less exporter penalties as we struggle to narrow our own output gap while facing these external pressures of Asian commodity demand, weak Dollar and another incoming capital windfall.

At least in its beginnings, one can manage such strains by accepting less arduous interest rates, especially if inflation were to obligingly sink some more.

Also, the resulting growth would reinflate tax collections, reduced the budget deficit and stabilize the national debt anew.

Could the cyclical low in our prime rate after all be single digit? It might well be, if China does what China does, and we can take Obama’s Larry at his word, with Bernanke benignly conducting the monetary orchestra.

And the Rand? It may be a firm 5-7:$ through 2012, with inflation caged, oil willing. Not unlike 2003-2005.

Source: Cees Bruggemans, FNB, August 31, 2009.

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