SARB goes easy once more
This post is a guest contribution by Michael Kafe and Andrea Masia of Morgan Stanley.
SARB Cuts Repo Rate 50bp on Improved Inflation Prospects
The South African Reserve Bank (SARB)’s Monetary Policy Committee (MPC) reduced the country’s policy repo rate by a further 50bp to 5.5% on Thursday. This decision was largely supported by an improved outlook for domestic inflation, as well as concerns about the anaemic pace of the global – and as a corollary, domestic – recovery. The decision was also in line with our qualitative analysis, and the decisive signal generated by our proprietary SARB EazyMeter for this meeting (90% probability of a rate cut).
The MPC now expects CPI inflation to average 4.3% in 2011, before rising marginally to 4.8% over 2012. These latest forecasts are lower than the previous indication of 4.8% and some 5.1%, respectively. While the SARB’s 2011 forecast is exactly in line with ours, its 2012 profile is much lower than our forecast of 5.5%. According to the MPC statement, the improved forecasts were based on the combination of downward revisions to administered price expectations, a stronger exchange rate than previously expected, as well as recent lower-than-expected inflation outcomes which have contributed to a lowering of the starting point of the inflation forecast.
Strong Currency and Lower Admin Price Outlook Help Improve Inflation Profile
First, we believe that the SARB has now lowered its expectations of electricity tariff increases: In its October 2010 Monetary Policy Review, it was careful to mention that, at the September MPC meeting, it had made provisions for electricity tariff increases of 20 % per annum for the next three years.
At that stage, it probably expected further significant increases in electricity tariffs from municipalities in the August CPI data that were to be published at the end of the month. Given that the August CPI data only showed a 1.5%M increase in tariffs, thereby taking the cumulative increase between July and August to 17.8%, the SARB may have taken the view that future increases are likely to come in below 20% as well. Also, the SARB may have taken a more benign view on other administered costs such as education, health and communications, given that increases in these costs are sometimes backward-looking with regard to CPI, and appear to be decelerating.
Second, is the ZAR. The MPC also provided reasons to believe that the rand could trade stronger for longer than it had previously expected. Most importantly, it mentioned that the recent resumption in quantitative easing by the US indicates that monetary policy in that country is likely to remain highly expansionary for some time. The search for yield resulting from this increase in liquidity has implications for the exchange rates of recipient countries such as South Africa. As a result, rand appreciation pressures “are expected to persist for some time”, and the MPC believes that “The exchange rate therefore remains a downside risk to the inflation outlook.”
Recent CPI Undershoot Shaves 0.2pp Off Inflation Trajectory
The final predominant driver of Thursday’s decision was the recent lower-than-expected inflation outcomes. As we indicated in previous research (see South Africa: Rate Call Change – We Expect a 50bp Cut, November 1, 2010), at the September MPC meeting, the SARB expected CPI to bottom out at 3.7%Y in 3Q10, before rising to post an average reading of 4.8% in 2011 and an annual rate of 5.1%Y in 4Q12. However, given a July CPI print of 3.7%Y at the time, simple arithmetic would suggest that the SARB’s forecast for August and September CPI must have been in the region of 3.6-3.7%Y. Since then, August posted a 3.5%Y out-turn, while September came in at 3.2%Y, taking the quarterly average (and, as a corollary, the 2011 forecast) down by 0.2pp. Against this background, it is clear to us that lower-than-expected outcomes account for 0.2pp of the SARB’s 0.5pp downward revision to 2011 CPI (from 4.8% to 4.3%), while a stronger currency and lower administered prices account for the remaining 0.3pp in 2011 and 2012 (from 5.1% to 4.8%).
Easier Money to Boost GDP?
While the MPC highlights a number of downside risks to GDP growth, such as the broadly sideways movement in its leading indicator since April, still-weak private sector gross capital formation, a collapse in manufacturing production, etc, we could not help but notice that the SARB kept its 2010 GDP forecast unchanged at 2.8%, but marginally upgraded its forecasts from 3.2% to 3.3% in 2011 and from 3.5% to 3.6% in 2012. We suspect that this represents the impact of easier money on GDP in the coming two years.
We Believe That Policy Rates Have Bottomed
Looking forward, we believe that this should be the last rate cut in the cycle, for two key reasons. The first is that we believe that CPI has bottomed, and should start grinding higher from here: Our forecasts of 3.3%Y for October and 3.5%Y for November compare with the most recent outcome of 3.2%Y. A turnaround in the inflation trajectory should raise the psychological bar for further policy easing, we think. Further, the SARB’s relatively benign CPI outlook for 2012 reduces the scope for further downside revisions going forward, in our view.
It is also clear that the decision to cut rates was driven in part by the recent weakness in manufacturing production. The MPC concedes that industrial action was largely to blame for the sharp fall in output. Nevertheless, it decided not to look through the noise. Looking forward, we expect a technical bounce in the October manufacturing production (i.e., once the impact of the strike falls out of the wash). This should help to lift both the October and November annual readings above the 1.4%Y that was printed in September, thereby obviating the need for a further rate cut.
Risks to Our Call
There are two key risks to our call, however. First is the exchange rate: Our baseline assumption is for USDZAR to close the year at 6.80 before ending 1Q10 marginally weaker at 6.90. Were the currency to appreciate much more than we expect (e.g., USDZAR breaches 6.50), this could have a significant impact on the inflation outlook, thereby allowing the SARB to ease policy further. Second, is the uncertain global environment. Were the problems in the peripheral European countries to spread to the core, thereby impacting negatively on global GDP growth, the SARB could well feel obliged to cut rates again. This is not our base case, however.
Source: Michael Kafe & Andrea Masia, Morgan Stanley, November 19, 2010.
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