Flashing Taylor suggests single digit prime

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By Cees Bruggemans, Chief Economist, FNB

The goal posts, they are a-moving (paraphrasing Bob Dylan about the changing times he lived in).

If we take for granted that the SARB prefers a constant real interest rate over time as a stability anchor for the broader economy, what else gives?

Mostly inflation, output gap and feedback loops from the firming Rand (these past six months, but especially the next 12-18 months).

CPI inflation was 6.7% but is this week expected to drop to 6.3% (or lower). That gives an inflation gap of 6.3% minus 4.5% (midpoint target range) equals +1.8%.

The inflation forecast for 4Q2010 is a moving feast. For the past year most observers have been punting 5%. But that has been eroding in recent weeks towards 4.5% (or even lower). And to this we must still add a seriously firmer Rand outlook.

The Aussie Dollar is currently 1.153:$. For those liking clean benchmarks, the Aussie Dollar could potentially be heading back towards parity with the Dollar in coming months. If we were to keep pace (why not?), it suggests a Rand near 6.30:$.

That should suppress especially our PPI inflation, but even CPI inflation should see its effects, heading for 4% (or even lower) by late 2010.

Meanwhile our output gap (estimated at -4% to -5% below potential) is not getting any smaller, with the South African economy only in recent weeks emerging from recession.

Labour slack could by yearend be as much as 10% of deployed labour, when making assumptions about formal jobs lost in this cyclical dip (some 350 000), employable new entrants to the labour market (some 250 000 or two-out-of-three who passed matric this year, and allowing for tertiary pass-through), some 100 000 skilled returnees from abroad and overall an equivalent number of unskilled unemployed seeking work (including many eager immigrants from Africa).

With the economy barely recovering to trend growth next year (3%-3.5%), the output gap will not start shrinking (indeed probably for some while) as we will need ABOVE trend growth for that.

As to asset price gains, it may be way too early to get overly excited from a policy point of view.

Our house prices have dropped some 10% from their nominal peak and are effectively stabilizing, with some nominal gain possible from next year. No early resurgence is expected. If anything, according to Erwin Rode, real house prices have still some downward adjustment to absorb in coming years from demand/supply realities prevailing.

As to the JSE, our shares prices are ‘only’ up by 40% since their October 2008 and March 2009 lows, compared to the 100% gain for the FTSE Emerging Index and the 60% gain for the S&P500 index. Then again, our share market never fell as far as overseas markets and is today about 20% from its all time high (and as such one of a clutch of global outperformers).

Yes, corporate earnings are off, as are dividend payouts, but the price/earnings ratio isn’t unduly overpriced. This is one way of saying that we may no longer be pricing in recession, but pricing in exuberance (bubble) would be something else entirely.

As such it remains early days to incorporate an asset term along side inflation, output and exchange rate gaps in estimating Taylor.

Lastly, I do assume an unchanging real interest rate as stability anchor over time, but a case can be made for tweaking this a bit, up in good times, down in bad times (and they don’t get worse than the present).

But in order not to upset any purists, let us not start messing with stability anchors supposedly dampening the cycle (rather than injecting even a hint of pro-cyclicality into the proceedings).

Adding all these components together we get a proximate hint of what the prime interest rate ‘should’ be today:

* real rate stability anchor (long-term average)     5.5%

* expected CPI inflation 4Q2010                           4.0%-4.5%

* half current inflation gap 0.5(6.3%-4.5%)          0.9%

* half current output gap 0.5(-4% to -5%)            -2.0% to -2.5%

This adds up to an estimated current prime interest rate of 8.5% TODAY as suggested by applying a rough-and-ready Taylor Rule.

As things stand, prime is still 10.5% and the SARB’s Monetary Policy Committee is this week bending its collective head over the vexed question whether or not to keep interest rates unchanged.

In light of the reducing upside risks and the increasing downside risks to the inflation forecast from global forces via the firming Rand, the large prevailing output gap and the likely slow return to modest growth in the economy, there remain excellent reasons to expect further interest rate cuts.

Whether these materialize this week is entirely up to the committee. One wishes them well in their important deliberations.

Source: Cees Bruggemans, FNB, September 21, 2009.

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