South African interest rate outlook

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By Cees Bruggemans, Chief Economist of FNB.

The year 2011 offered much scope to test to destruction two propositions: that higher inflation would trigger early SARB rate increases (the fear of 1H2011) and the possibility that modest growth and large lingering output gap would trigger more SARB rate cuts (2h2011).

In the event, neither outcome played, with SARB keeping rates unchanged, while noting inflation rising as expected (though core much better anchored than headline) and also noting the modest GDP growth performance and lingering output gap (disappointingly so).

Much more pronounced was SARB’s unease about global tensions, in particular the EU sovereign debt and banking crises and what this still might mean for other parts of the world, South Africa in particular, with growth downside uneasily flagged.

There followed repeated promises that in the event of a major shock, SARB could be depended upon to take ‘appropriate’ action.

Meanwhile, the policy powder was being kept dry.

Is there any reason why this picture will change much in 2012, triggering a policy shift at the SARB?

The simple answer appears to be “no”, though there is a fiendish complex of risks potentially playing havoc with any tranquil policy stance, for which reason SARB keeps signaling it comes prepared for all eventualities.

Besides being in permanent ‘crisis mode’ two other important aspects deserve highlighting.

Firstly, South Africa’s macro policy stance isn’t tight or neutral but generously accommodating, supportive and stimulatory.

Secondly, using a simple Taylor Rule, the expected inflation and output gaps over the next year or so would warrant slightly higher interest rates than currently prevailing, with prime 11% when using headline CPI and prime 9.5% when using core CPI as opposed to the prevailing prime 9%.

In other words, at prime 9% SARB could be said to be straining at the policy leash at its most accommodative end, signaling some comfort that inflation won’t go out of control, unease about slow growth and output gap, and a risk bias that favours support over tightness.

When considering South Africa’s overall macro stance, the fiscal deficit has been allowed to widen towards 5.5% of GDP at a time when global manhood is being measured by the extent to which fiscal austerity undo such deficits.

During 2011 SARB has maintained the lowest nominal interest rates in 35 years, which in real terms made the 5.5% repo rate slightly negative as inflation rose above 6% (not a minor feature).

The Rand was eventually in 4Q2011 shocked beyond 8:$ by overseas financial events, shedding its overvalued condition in favour of a more neutral level.

Taken together, these three macro stances offer important support for the economy in present circumstances and are indicative of anti-cyclical policy.

That the economy doesn’t grow much faster than 3% under these circumstances has much more to do with our many own supply-side shortcomings (electricity and railway constraints, new credit culture, public sector manpower issues, regulatory inhibitions).

Also, it reflects our business defensiveness regarding domestic political risk, societal under-performance and global crisis conditions.

And also, beyond these restraints, that European recession this year may constrain some of our exports.

Thus there is much over which our macro policies have little control. Indeed, one is reminded of Europe (and far less of the US), where the ECB is unwilling to become the soft tool of politicians sidestepping hard decisions to clean up financial messes and improve growth dynamic.

Similarly, our macro stance is as accommodative as it judiciously can be. Beyond this, in order to improve our GDP growth performance, the world condition needs to improve (please), but especially more reform needs to be undertaken domestically to improve the supply-side performance of the economy and make private agents more willing to take risk and support faster expansion.

If in the absence of such needed structural improvements the macro policy stance were to be made too supportive, we might end up pushing inflation higher while weakening the currency rather than improving the growth dynamics longer-term.

This still leaves the main risks facing the country, namely a sudden oil price shock (if higher, pushing inflation higher) and a further EU crisis shock (implying more SA export downside and capital outflow risk, weakening the Rand and pushing inflation higher).

At present, SARB seemingly is prepared to look past a headline CPI inflation peak of 6%-7% in 2012 to renewed subsidence into 2013, and also accepting only modest GDP growth near 3% with lingering output gaps in mining, manufacturing, building, construction and especially the formal labour force.

But if mainly outside events were to push inflation and growth unacceptably beyond these levels, SARB may need to take ‘appropriate’ action.

The nature of such action would depend entirely on the circumstances. So depending on the mix of scenarios one could end with a firming or weakening Rand, and higher or lower interest rates, or no change if things cancel out.

Until we know more about 2012 (surprise, surprise), the most likely outcome will be no change in interest rates, with likely Fed, BOE and ECB policy stances remaining highly accommodative.

Tellingly, visiting IMF Managing Director Christine Lagarde encouraged the SARB this weekend to maintain an accommodative monetary policy 2012, given likely global developments, especially in Europe.

And so we await events.

Source: Cees Bruggemans, FNB, January 10, 2012.

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