Rand biggest threat to inflation outlook

THE latest inflation print reaffirmed that inflation is becoming less of a problem. The moderation in food inflation — particularly grains, vegetables and fruits — seems to be slightly more pronounced than initially expected and could potentially surprise to the down side, limiting the overall impact of higher meat prices on food inflation.

Added to this, demand in the economy remains weak and is unlikely to pick up. Household consumer spending slowed to 1% in 2016, and spending on durable goods is expected to continue to contract this year. Spending remains constrained by weak confidence, muted demand for credit and bleak employment prospects.

As a result, retailers have not been able to pass on higher costs to the consumer.

Our estimates suggest that inflation should be anchored below 5.5% this year, before temporarily falling below 5% in the first quarter of 2018. There is, however, uncertainty around the Eskom tariff increase, which may have an impact on the inflation outlook. While the regulator has granted Eskom a 2.2% tariff increase, the utility can apply for higher tariff increases if the 2.2% threatens its financial stability.

Wages are another concern. According to the Reserve Bank, unit labour costs have been running well above 6% and could surprise on the upside, lifting core inflation.

The rand, however, remains the biggest risk to the inflation outlook. The currency has gained back the losses that followed the cabinet reshuffle and consequent downgrade. Increased risk appetite and attractive yields bode well for emerging markets, and South Africa has received its fair share of these flows.

Investors have continued to pile money into domestic bonds and equities — it is estimated that foreigners hold around 39% of local currency bonds. A similar episode two years ago unfortunately did not yield the same result. It is, however, important to note that since then South Africa’s external imbalances have improved, there has been an attempt at fiscal consolidation, and economic growth is expected to lift modestly from 0.3% in 2016.

These factors have contributed to South Africa’s attractiveness as an investment destination for portfolio flows. The sustainability of these flows remains uncertain, and could reverse if monetary policy tightens aggressively in the US, or commodity prices fall notably.

While the looming downgrade by Moody’s (to one notch above sub-investment grade) has been priced in, there is a risk of further downgrades which threaten South Africa’s place in the Citi World Government Bond Index and other bond indices. A downgrade to subinvestment grade of our local currency rating will result in huge capital outflows. Foreign ownership of South African

Downgrade of local currency rating will see capital outflow

bonds is at a record high.

The IMF estimates that forced sales could amount to 2.5% of GDP if the randdenominated debt is downgraded to sub-investment by S&P Global Ratings and Moody’s.

The path for monetary policy will be largely influenced by associated risks to the rand. However, a sustained and notable decline in headline inflation and inflation expectations that are well anchored within the target band may be enough to motivate an interest rate reduction in the future.

A reduction may offer some relief to consumers, but it will not be enough to lift economic growth significantly given that monetary policy has largely been accommodative.

Nxedlana is FNB chief economist