Interest rate forecast – a rapidly moving target

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By Cees Bruggemans, Chief Economist of FNB.

With interest rates now at historic lows, prime reaching 10%, the lowest since 1981, the main questions are whether the rate cycle has reached its lowest point, how long it could be moving sideways, and when and by how much it could be moving higher.

There is a technical and non-technical side to these questions.

The visible technical focus falls on actual inflation, the inflation forecast and inflation expectations, the risks governing these and the state of the economy and its rate of improvement.

Non-technical considerations are political in nature, mostly deep background, yet also presumable important.

The SARB gives the impression of being forward-looking (taking into account forecasts) but not necessarily always forward-acting (apparently often responding to the present, given the nature of risks it faces).

The SARB inflation forecast projects inflation within the 3%-6% target zone these next two years. As we move forward, the SARB’s two-year horizon also moves forward.

Private inflation forecasts vary regarding cyclical bottom (4%-5%) and subsequent trajectory (5%-7%).

The main upside drivers are public tariffs and oil. Downside drivers include imported global goods prices, food (initially), the Rand (initially) and the local output gap (initially).

Given the balance of risks (at present), the inflation rate could still head lower than consensus forecasts (the reality for much of the past year) and should then at some point cyclically rebound. But when and by how much?

If the downside risks to inflation were to become outsized, with potential disappointment in closing the output gap (for instance through a further sizeable firming of the Rand, but not ignoring things like food price declines and disappointing job recovery), the SARB could still cut rates one more time by 0.5%, prime falling to 9.5%, possibly in May, thereby potentially also still fulfilling any non-technical considerations.

But if inflation risks remain balanced, the SARB may resist further rate cuts preferring to keep rates stable.

At some point in 2010-2011, the focus would shift to the upside risk potential, especially regarding oil and food, but also the Rand and the rate at which the output gap keeps narrowing as growth proceeds.

With actual inflation passing its lowest cyclical point later in 2010, by how much will it lift through 2011-2012 and how will this shape inflation expectation?

Though GDP growth may average 3% through 2012, this won’t be enough to close the output gap. Indeed outside of the public sector, job growth may remain disappointingly low and productivity gains high.

For as long as inflation is not seen as decisively breaking the 6% upper target boundary, this real sector condition may keep the SARB from raising rates early, indeed perhaps preferring to see the Rand weaken as global policy actions in 2011 start to strengthen the Dollar (but not necessarily as yet Euro and Sterling for structural reasons).

Any shock developments (pushing oil and food prices higher, Rand weaker) could push the SARB into pre-emptive mode, starting the tightening cycle. Once activated, inflation could disappoint by up to 2% (from target midpoint), potentially making SARB willing to match this with two to four 0.5% tightening moves during 2011-2012.

Given global policy projections (Fed starting tightening by 2H2011), commodity, Rand, domestic output and formal employment projections, SARB could remain on hold through mid-2011 or longer, but not certainly forever.

Shock developments would presumably prompt early responsiveness, possibly by early 2011.

All these considerations will be up for review every two months. Much is bound to happen between now and mid-2011 making the interest rate forecast a volatile and rapidly moving target.

Source: Cees Bruggemans, FNB, April 13, 2010.

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