Interest rates won’t this time be different

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By Cees Bruggemans, Chief Economist of FNB.

Will the SARB start tightening interest rates early or late? Would the SARB be more compassionate this time, given modest growth and a lingering output gap? Or what?

Where the majors are concerned, Fed chairman Bernanke is probably most implacable of all, but ECB President Trichet isn’t that far behind.

According to Mr Bernanke, “until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established”.

And that would only be the first stage. The next stage would (also) last years, tiresomely re-absorbing into the active labour force the 15 million Americans that lost their livelihoods since 2007, as well as absorbing the 1 million newly entering the labour market annually (making for a 25 million US job target on a 150 million labour force this decade).

On this reading, the Fed won’t start gradually raising US interest rates before late 2012 at the earliest, with the US output gap fully closing only sometime during 2018-2020. Way to go.

With US inflation still well below the medium-term intention of 2%, Mr Bernanke is not about to get overhasty.

In a recent speech, Mr Bernanke also gave short shrift to the idea that commodity price rises presented any problem that would require a response from the Fed (as the deflationary impact of America’s huge resource slack far outweighs the impact of spiking commodity prices).

ECB President Trichet has a different approach, preferring from time to time to use the raised eyebrow and tough talking to keep everyone on the low inflation bandwagon (and his many governments reform- rather than backsliding-minded).

That can create expectations of higher interest rates earlier rather than later (and earlier than in the US), as the market knee-jerk reaction to his tough words again showed in mid-January (with the Euro suddenly firming rather than weakening further as widely expected).

Europe of course has a less intimidating output gap than the US, having managed its labour force better during the crisis conditions of 2007-2010, unlike in the US where one suspects an overreaction took place in favour of forcing productivity gains (when contrasting record high corporate earnings with record high labour slack today).

Still, in the main the two gentlemen don’t differ all that much. European inflation at 2.4% is now above target, but the commodity price surge may be temporary rather than mainly structural as hinted at by Mr Trichet.

Though commodity demand ex-Asia remains impressive, too many natural disasters worldwide these past twelve months have created price surges not reflected in longer term futures prices, such backwardation suggesting that many of the spiking prices won’t be sustained for too long.

Provided second-round inflation effects don’t come into being, European inflation is expected to subside later this year. Indeed, the raised Trichet eyebrows are mainly intended to prevent expectations of higher inflation taking hold.

Though some see the ECB starting its rate tightening cycle in 2Q2011, others think it will only start in 4Q2011. Europe will probably start earlier than the US. Other than that, hold those guns, it is early days.

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In many emerging countries and commodity producers, interest rates have been rising for some time already, in response to impressively performing economies, closing output gaps and now upward tendencies in inflation (for a variety of reasons – commodity price surges, liquidity driven and/or closing output gaps).

In many of these instances, central banks had taken extraordinary easing measures in response to the 2008 events. A large part of the 2009-2010 policy tightening in certain countries was therefore a ‘normalisation’ back to interest rate levels more normally prevailing in such countries under present recovery circumstances.

Only in a relatively few instances (China) has real policy tightening probably occurred.

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Our SARB manages the monetary policy of a hybrid country that shows some of the characteristics on show here.

South Africa still has a sizeable if mixed output gap, very large in its employable labour force (ratio-wise on a par with the US), sizeable in its building vacancies, reducing in manufacturing (utilization now back at 81.5%), non-existent in its electricity supply.

Given the prospect of modest growth (3%-3.5%) for some years, it may take a while closing the existing output gap fully, as much through expanding demand as constrained supply, with employable labour slack probably most intractable because of real labour cost trends (as much wage as non-wage costs).

Like the Fed and ECB, this should incline the SARB to caution about raising rates too early.

Unlike the Fed, however, the SARB does NOT have the luxury of an undershooting inflation rate likely staying below (4.5%) target because of enormous labour slack.

SARB will no doubt take notice of both Fed and ECB sentiments that the commodity spiking may be temporary and not add all that much permanently higher inflation.

Unlike them, however, our SARB faces an inflation forecast that sees inflation in any case lifting from 3.5% to 5.5% as a base case scenario.

That’s before incorporating early commodity price surges (oil, coal), delayed ones (Rand-linked) or late ones (food). In addition to which we seem to suffer more from European-like market inflexibilities, making for easy disturbance of second-round compensation demands.

This tale suggests that unlike in the US and Europe, we are likely to be soon overshooting our 4.5% inflation target, though hopefully remaining within the 3%-6% zone.

The risk, though, seems to be very much on the upside.

Given the extent to which real interest rates have been lowered (at least 2% below where they would otherwise ideally be, as hinted at in SARB speeches), the SARB clearly has provided policy support for the economy over the past year in the way it has lowered rates yet further, prime now 9%. Though bear in mind this was probably part compensation for the firming Rand suppressing inflation.

Also, global events (and our own cash flows, not least the SARB’s sudden appetite for more forex reserves this past month) have assisted in moderating the overextended Rand back to 7-8:$ territory, thereby lifting the inflation suppression modestly (if sustained).

Thus a few things come into focus.

The economy is growing at 3% plus, if modestly. The Rand inflation suppression should be moderating. Rising oil prices will be boosting inflation in the short term. Inflation as a base case will anyway shortly rise by 2%. And SARB has yet to start its own policy ‘normalisation’.

Is that reason enough to keep real rates cyclically low?

———————–

If all this wasn’t complicated enough, we still have the crisis angle to take into account. Real good crises can sink the Rand by 50%, as we know from repeated history.

The 2008 Anglo-Saxon crisis did precisely that. SARB has been living in dread of a European crisis doing the same (though so far no luck). But as the European risk seemed to be diminishing we find the Arab Street in revolt.

With global bond capital in any case in retreat as the global inflation scare (and improved growth outlook) changed bond yield prospects, we now have an additional capital withdrawal from (certain) emerging markets as perceived risk has risen (and rich country equity returns seem to be gaining in relative attractiveness).

This may raise concerns about ‘sudden capital reversal’ and plunging Rand weakness (and spiking inflation as in 2002 and 2009) all over again.

——————–

What to do?

When uncertain about precisely what comes next (standard condition most of the time), one can do worse than simply sitting tight. The SARB reaction function tends to be late for this simple reason, cyclically up and way down.

One could easily envisage SARB being unwilling to move early (in raising rates) because of a still sluggish, ‘fragile’ modestly performing economy well below potential as aspects of its output gap linger worryingly.

With the Arab Street in revolt precisely because very large slices of their populations are young, semi-educated, modern-savvy, unemployed, permanently luckless and increasingly angry to boot, one can see an inclination to pay more attention to this aspect, also in our own uneasily balanced society.

But then generations of SARB Governors, not only the incumbent (last as of last Friday and also in January 2011 at the last MPC meeting), have pointed out that monetary policy is not an effective tool to address structural issues. Other elements in society should take responsibility for that.

What SARB has also said before (last as of the December 2010 MPC meeting), monetary policy can and should address output slack relative to GDP potential where possible.

Of course, conveniently switching between these views as the occasion demands may only confuse watching audiences desperate for answers.

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So where are we heading? Probably for a tightening interest rate cycle.

The first rate increase will probably be relatively late, given the condition of the economy where expansion is now vested again but likely to remain modest.

This despite apparent SARB convictions about fixed investment cycles eventually responding to carrots such as low interest rates and rising utilization levels, and not least the politically managed public infrastructure effort.

Yet one should also keep a close watch on structural issues such as electricity buffers, credit access, ‘state capacity’ and changing rulemaking (as old certainties dissolve, and not only in traffic, with half Joburg traffic lights out of action on any given day). All these are critical micro constraints potentially hobbling a more vigorous expansion.

Also, lateness might be expected given global conditions so very complex one can never be quite sure about the next surprise, ambush and financial disturbance emanating from there.

———————–

But the first rate increase will probably be early, given the unpalatable inflation prospect, as much the standard expectation of inflation in any case rising 2% from the present 3.5% within twelve months, as well as all the other stuff in the air. Meaning higher priced oil, weaker priced Rand, and higher priced food probably around the next corner (and not forgetting the next wage round in the lead up to the local elections this year, where moderation is unlikely to be the central idea).

Never mind the Arab Revolt (Awakening) and its potential to hamstring global oil supply (depending on which scenario for the region one wishes to agonise about).

In essence this is a replay of the Anglo-Saxon banking crisis (oh my gosh, we are going to die), the European sovereign and banking debt crises (oh my gosh, we may get sunk too) and earlier such episodes in history (Commodity sell-off of 2000-2001, Asian contagion 1998, Apartheid 1985, Mexico 1982, Iran 1979, Israel 1973, Israel 1967, Bay of Pigs 1963, Suez and Hungary 1956, Korea 1950).

The Arab world potentially faces many scenarios at present and we know enough history not to be surprised by any playout, which can make the agonizing worse.

So, yes, hold your guns and use policy discretion, but don’t lose sight of the rising inflation tide.

July may be too early for the first rate increase, even though (Taylor) Rule suggested. And January 2012 may turn out to be six months too late once events have shown themselves more fully.

That doesn’t make September guaranteed, just because that is where the market now bets it will happen first.

There are many months and moons to traverse this year, during which we will learn much, about the condition of the economy, the trajectory of inflation and the lively bigger world out there shredding major themes nearly every week now in favour of the latest crisis fashion (worse even than eager, tech-savvy, clothes-crazy, music-hungry teenagers, frankly).

A reason to sit tight, at least for now. Reminds me of that old fliek, Men in Tights (A Robin Hood, Prince of Thieves spoof by Mel Brooks). Supposedly a comedy, but not when played in real life.

Source: Cees Bruggemans, FNB, February 8, 2011.

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