Cautious SARB feeling its way forward

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By Cees Bruggemans, Chief Economist FNB

Are we really fighting inflation?

There are times when understanding inflation is easy. Big demands are placed on all resources, shortages arise, profit margins can be inflated, cost and price increases easily passed on, in a spiraling kind of way.

Expectations of accelerating price increases (faster inflation) become embedded and feed the inflation spiral.

Handling that is easy. You hit it on the head. Less easy to handle is the output sacrifice incurred along the way as demand falls, resource slack builds up, discipline is restored to expectations and price acceleration is with difficulty transformed into price deceleration, even price freezing or declines.

Output sacrifice implies pain. Reduced real wages. Unemployment. Hardship. Always difficult to accommodate, especially in a democracy where leadership incompetence is quickly criticized (“You owe me full employment, a rising living standard and everything I haven’t got yet. Deliver or be gone”).

Our current inflation reality still has elements of what is depicted here. But hitting it on the head is another matter. For who, pray, would we be hitting on the head? A market economy responds to price signals, but a political movement doesn’t take kindly to spiked clubs. And the larger world is outside our control.

In certain respects we remain price makers, in others we are price takers. As to hitting it over the head, forget it. Instead, ride shotgun and hope for the best.

We are hardly at present experiencing overstressed demand conditions, resulting shortages and free and easy pricing mannerisms, and haven’t done so for two years now. Yet the nature of the inflation process hasn’t changed, even if its propulsion mechanism has.

The following themes are evident. Redistribution. Public incompetence and inefficiency. Global resource dynamics. State of the world economy and trade competition. Rand exchange rate. And not forgetting Mother Nature.

The first two of these themes are domestic and non-market driven. Undisciplined redistribution is a powerful force for change.

Municipalities, education, health care and airport charging do not seem to be connected to any market processes. There is resource hunger, budget shortfalls are perennial and there are free and easy ways of meeting these challenges (tax, borrow, charge, spent).

Closely connected are other forms of redistribution and inefficiency. The catch-up of our electricity and water realities foremost.

If these extremes making for high price increases (double or triple average inflation as norm) weren’t bad enough, we face even greater uncontrolled urges from the outside world. Here the prognosis is either feast or famine.

Last year saw oil climbing to $150, then collapsing to $35. Agricultural commodity prices rose steeply and then also collapsed. The Rand moved from 6.80:$ to 11.85:$.

This year oil has doubled (again) to $70, but foodstuff prices have moderated further. The Rand has recovered to 7.40:$ territory. The world encountered a deep recession, creating disinflation tendencies, in any case present in intense global trade competition, with us importing the resulting traded goods deflation.

Most of our labour force and business owners are price takers, not price makers, facing this political and global onslaught. Some are better positioned than others to defend their interests.

Unionised labour (one quarter of the deployed labour force), politically protected workers (another quarter) and scarce skills (another quarter) insist on historic inflation compensation plus an opportunistic ‘living wage’ premium, which can vary, depending on the degree of opportunism.

Some employers accept this stoically because they are big and strong enough to be able to pass on such demands in their charging (the state and public monopolies foremost, less so large private businesses as these ultimately still have to face constrained consumers and/or compete with the outside world).

Closing the parade is Mother Nature periodically showing her hand with abundance or famine.

This hotchpotch of unlikely alliances (political interests, public ineptitude, global commodity dynamics, global trading conditions, the Rand, Mother Nature, defensive and opportunistic labour elements and strong business franchises) create an inflation reality which in turn gets absorbed into general expectations, driving the next round of defensive and opportunistic behaviours.

During 2006-2008, CPI inflation rose nearly five-fold to 13.5%, this year more than halving to 6.4% (so far). Some more sagging lies ahead in 2010, CPI probably falling by another third or more, mostly externally driven (Rand, possibly oil, certainly trade deflation). Backward-looking wage settlements will ease even as productivity rises in a jobless recovering economy, halving unit labour cost increases to below 5%.

Interest rate policy gives the impression of mostly helplessly riding shotgun on this miasma of forces. Can’t change any of it, but merely ensure that its expectation consequences don’t give rise to yet more distortions if money were to become underpriced.

For the rest, global output shocks, Rand overvaluation, loss of confidence, restrained credit, postponement of replacement decisions and reduced risk-taking appetite has opened up a new output gap and will likely maintain this through an anemic recovery process that won’t start reabsorbing resource slack anytime soon.

Such underperformance is known to exert its own political pressures. It may yet move policy goalposts, though the Minister of Finance has done everything he can.

There remains the guard riding shotgun over our inflation expectations. Here the heavens are steadily turning, with oil potentially facing a longer stay in purgatory (dare we believe $50-$60?), the Rand is steadily streaking firmer towards 6-7:$ territory, global trade deflation is awesome and unit labour cost inflation probably to halve.

Though we won’t overcome political redistribution or ineptitude, this need not prevent further general inflation collapse accompanying a yawning output gap (much resource slack).

Such an outlook offers its own promises regarding our interest rate prospects where we may not as yet have reached bottom. Prime 10.5% continues to look rich.

Source: Cees Bruggemans, FNB, September 28, 2009.

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