South Africa could also do with interest rate cuts

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By Cees Bruggemans, Chief Economist of FNB.

The SARB this year has been most decisive about inflation (rising, but so far not giving rise to second-round effects and likely relapsing back into target next year), most outspoken about the economy (a lingering subpar growth performance and sizeable output gap) and most concerned about Europe and its many crises (the worst could easily happen, and if so sideswiping us, too).

Throughout this year this has been a formula for keeping interest rates unchanged at 35-year lows.

This has been a rather unusual policy stance in terms of rising inflation towards 5.5% and projected to stay there on a three-year view (arguing in favour of higher real rates), but also unusual when considering insufficient demand keeping the economy subpar and the output gap large (arguing for even lower real rates, bearing in mind a supportive fiscal policy, even overly so).

So what kept them?

Mainly it has been the intimidating risks offered by a Europe on fire, and any possible contagion engulfing us, too, in case of a country and/or banking collapse.

This risk presumably made it advisable to keep the policy powder dry, in case market volatility were to also destabilise our conditions, in which case ‘appropriate’ policy action could follow alongside any Rand moves (the Rand remaining preferred shock-absorber-of-last-resort).

As the year progressed, our inflation rose ever higher (CPI 5.7% though core CPI excluding food/energy remaining anchored for now at a comfortable 3.8%), the economy’s growth undershoot gradually showed its full dimensions (some sectors still performing reasonably, especially on the consumption side, but many doing poorly), while the European crisis at times bordered on farce as it moved ever deeper into fearful territory.

So why resume cutting rates now rather than wait?

For one thing, inflation prospects have changed little, with summertime peaking in 6%-6.5% territory after which a renewed slide towards 5%-6% is expected in 2012 and lasting thereafter for a good while in 2013 (even 2014).

The SARB fully appreciates the key relative price changes underway at home, with the economy having to adjust to higher electricity and other user charges (transport, municipalities) and to higher oil, gas and coal costs.

Still, when excluding such wrenching changes, and even when allowing for politicised labour demands in key areas, underlying cost pressures apparently remain remarkably subdued, undoubtedly affected by low global inflation, intense trade competition and the disciplining of an overvalued Rand.

Regarding the economy, it remains consumer-led with especially new car sales holding up well (year to date +16.5% on a year ago), but retail sales have slowed modestly year to date.

In contrast, fixed investment is growing sluggishly, both public and private.

Going by sectors, mining and manufacturing output are barely 2% higher year to date, building and construction remain at low levels of activity, property generally is subdued with recession-like vacancies lingering in office, retail and industrial space.

Employment has seen some gains, especially in the public sector, but some of these gains appear overstated.

Household indebtedness at 76% of disposable income is only gradually easing while credit growth at 5% is barely half nominal GDP growth of 10% two years into recovery.

Such credit weakness indicates the extent to which the credit act of 2007 and the Basel 111 bank capital requirements have tightened credit standards and the cost of credit. Such structural changes may be a long-term benefit, but in the short-term it may keep growth back.

There is little evidence of consumer binging, reckless business expansion or speculative excesses in the economy. Instead, both business and consumer confidence came off in the course of the year, signaling the economy’s performance to be modest, also confirmed by the stagnating SARB leading indicator.

Although any interest rate cuts may not excite much extra demand in the economy, it would assist with the repair of household balance sheets (reducing indebtedness) while bolstering business cash flows, in both instances probably boosting confidence.

There has been progress on the political front in Greece and EU bank recapitalisation is underway. The short-term focus has now shifted to Italy, with its playout a cause of concern for many.

Meanwhile, severe fiscal austerity and evidence of a credit crunch as banks shrink balance sheets, along with falling confidence, appears to be steering the EU economy into a ‘mild’ recession.

This has made the ECB under President Draghi willing to ease its policy stance, cutting rates by 0.25% last week, with more cutting expected, thereby offering a lead to EM central banks to follow where this is deemed useful.

In contrast, US growth has improved compared to 1H2011, with no evidence of an imminent double-dip, while China also is maintaining growth momentum.

It is a global picture which is proving less threatening than it looked for a while during 3Q2011, with good reason to expect more progress in 2012, especially if Italy could also successfully addressing its problems.

Whether this will prove enough for the SARB to become less insistent on ‘keeping its powder dry’ and be guided more by domestic needs and cut interest rates another notch (as Aussie also did last week) we will discover later this week.

Source: Cees Bruggemans, FNB, November 7, 2011.

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