Interest rate policy options facing the South African Reserve Bank

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By Cees Bruggemans, Chief Economist of FNB.

For the past two years we have been experiencing cyclical economic recovery and an upturn in inflation since late last year. By late last year this started creating market expectations of a less accommodative monetary policy and start of interest rate increases.

Since Easter this year, thinking first shifted to neutral (policy to be unchanged for long), with recent months increasingly hearing the case for more interest rate easing.

Under what circumstances could one expect interest rate easing taking place?

The debate centers on three dimensions, namely inflation performance, economic performance and global crisis.

Of the three, the inflation dimension is probably most neutral. CPI inflation reached a low of 3.2% a year ago, is now 5.3%, will probably peak in 6%-6.5% territory shortly and from next year subside back towards 5%-6% UNLESS new events dictate otherwise.

This is an inflation trajectory that is mostly target-bound and doesn’t require much policy response, if any (except that eventually real interest rates may have to rise in line with a better performing economy, but that is something that clearly isn’t pressing now).

That places most of the focus on the state of the economy and the global crises playing out.

Here one notes that the economy is underperforming, with many sectors struggling, and a large output gap of about 2.5% of GDP being maintained (reflecting low capacity utilisation, high non-residential vacancies and high unemployment).

One response would be to say (imitating Fed chairman Bernanke) that the growth underperformance is fixable but it needs supply side reforms, a political responsibility of government and NOT within the ambit of the SARB.

Be that as it may (another Bernanke favourite saying), after the sermon one may want to assist in getting demand to respond more vigorously (also a Bernanke intend).

With the SA economy underperforming, and fiscal policy fully occupied with regaining budget balance (and reportedly somewhat falling behind on its good intentions), there is therefore a case to be made for lowering interest rates.

Given the state of consumers (still high debt loads) and the changed credit culture in the country making for low single-digit credit growth for some years to come, such lower interest rates would probably not encourage another durable goods and housing boom.

But it would on balance assist households with further deleveraging their high debt loads and help to strengthen business profit performances, cash flows and balance sheets. All that would constitute repair and improve the chances of a more generalised improvement in demand and output in the economy.

If that were to be the only issue, after months of poor local data flow, and global growth projections also reduced, an interest rate decision could have been very imminent now.

But this brings us to the third dimension: global crisis and the possibility of more upheaval.

Going by past public speeches by SARB Governor Marcus, especially the mid-August one, the possibility of a major European crisis soon is rated high, with the promise of the SARB in such an instance taking ‘appropriate’ action.

This suggests a willingness to cut interest rates in the event of a major crisis cutting our exports and growth prospects.

Also, the Minister of Finance has indicated a willingness to use the foreign reserves ($50bn) in the event of a crisis, though being careful about liquidity implications, without spelling out what that means.

It could mean that if a global crisis were to turn the world more risk-averse, triggering a huge sudden capital flow reversal, SARB would fund such outflows at least partially from accumulated forex reserves, moderating the currency depreciation (and inflation shock).

Both interest rate and forex decisions would be aimed at maintaining ‘stability’ (growth, inflation, asset markets) as much as possible at a time of global, market and economy ‘shock’.

In taking this stance, no mention has so far been made of responding to domestic economic weakness in its own right.

This has been taken to mean (along with the rather high inflation trajectory) that SARB might only be willing to keep interest rates at their present levels for long (throughout even 2012).

However, there is potentially another explanation.

SARB is very much focused on global crisis conditions as the main risk (as local growth keeps ticking over, if very low, and inflation is broadly within acceptable parameters).

As such SARB may prefer “to keep its powder dry”, in any case sensing a new global shock is in the works, and only wanting to use its interest rate weapon to maximum advantage, namely at the moment of a shock event arising.

That’s when you get the best bang for your buck.

It is perhaps instructive that the Brazilians went through the same motions but came to a different conclusion, in a ‘surprise’ move cutting their interest rates 0.5% on 31 August.

Their central bank explained the move as follows:

“the present international turmoil will only have ‘one quarter’ of the impact on Brazil as the 2008 crisis, but the longer-term outlook for the global economy is weaker than it was then. Economic modeling has shown that the deterioration in the international scenario would be more persistent than seen in 2008-2009 but less acute in the absence of extreme events”.

Here we have a Latin American commodity producer very much aware of the turbulent global condition and how this will play for Brazil.

But instead of focusing on the imminence of another extreme shock event, the Brazilians were willing to simply respond to the subpar growth prospects already baked into the global cake.

The current slowdown is real (while another major crisis may or may not happen and is presumably to be responded to in any case if and when it happens).

So where does that leave our SARB?

We are currently short of some crucial information.

SARB has effectively promised it will act appropriately in the event of another major global crisis.

But what will it do while we wait, with the domestic economy slowing and the global growth prospect in any case not promising, something the Brazilians (and Turks) have already acted upon.

It could be that SARB wants confirmation first that the growth slowing locally is for real and not temporary.

One can understand such caution, but given the way things are moving one would hope not too much time would have to go by to provide such confirmation.

The same applies globally.

Even if there isn’t a US/EU double-dip, their growth prospects aren’t hot and will likely keep the world economy back, possibly for a longish while.

Other emerging central banks are reportedly considering easing policy next. Mentioned are Chile, Mexico, Israel and (yes) South Africa.

Adding it all up:

  • Inflation seems predicable and target bound (unless something new turns up).
  • The economy is underperforming though one may want some more confirmation about how temporary as compared to how durable (but don’t take too long).
  • There may be another EU crisis (perhaps, in which case we are going to crisis stations next – that’s a firm promise).
  • In the meantime we in any case have a prolonged downgrading of global prospects (at least according to Brazilian models).

Decision: don’t wait too long with a rate cut. It could provide some more needed balance to an unsteady ship as we await global events.

Unlike Western countries we haven’t used up all our policy instruments, with their toolboxes now pretty bare and increasingly non-standard.

We still have plenty ammunition. Perhaps use some of it judicially in the short term while holding the best ammo for later, in need?

Source: Cees Bruggemans, FNB, September 13, 2011.

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