Stakes are too high for rate hike
IT SEEMS almost inevitable that the South African Reserve Bank will hike interest rates next week. Last week, prior to a statement made by US Federal Reserve chairwoman Janet Yellen that a rate hike there next month was a “live possibility”, there was hope the Reserve Bank would be able to stave off another increase this year, but this seems unlikely.
As we have all come to expect, Yellen’s hawkish comments gave further impetus to the dollar and triggered a sell-off in vulnerable emerging market currencies such as the Turkish lira, Singapore dollar and, of course, the rand.
A depreciation of the rand is of itself not the end of the world, but the Bank is concerned about a prolonged and significant depreciation on long-run inflation.
It goes without saying that further depreciation of the currency — more than 25% over the past year and counting — is going to have an effect on inflation. Although September’s increase in the consumer price index (CPI) came in below expectations at an unchanged 4.6% for the month, the bank expects headline inflation to average more than 6% in the first and fourth quarters of next year, before declining again to 5.7% by the fourth quarter of 2017.
The only saving grace is that the economy’s slow growth and the persistence of a negative output gap has damped the pass-through effects of the currency depreciation to headline CPI.
What this means is that the economy is doing so badly that manufacturers aren’t even bothering to restock at imported higher prices. Of course, the flipside is that as soon as the economy does start to grow again, the effects of the weaker currency will hit us hard.
To be clear, the depreciation of the rand is not the only contributor to higher inflation.
Above-inflation wage settlements and increases in administered prices have also contributed, as have inflationary expectations.
The economy is already in a bad way and tightening policy any further might well push us into a recession We raised rates a few months ago and what good has it done for inflation or the currency?
These expectations are perhaps the Bank’s biggest fear.
Given that inflation is expected to run above the Bank’s target range for two quarters next year, the Bank is understandably wary of a possible “unanchoring” or upward drift of inflationary expectations. It is this fear that lies behind the bank’s repeated assertion that it sees itself in a gradual monetary policy-tightening cycle and is ready to raise interest rates if the conditions deteriorate.
The majority of analysts expect a rate hike next week. According to Bloomberg, forward-rate agreements — used to speculate on interest rates — are predicting a 70% chance the Bank will hike rates by 25 basis points, although some analysts feel a 50 basis points hike would be a better option.
For my money, I hope it doesn’t. For starters, the economy is already in a bad way and tightening policy any further might well push us into a recession. Finance Minister Nhlanhla Nene has already cut this year’s growth forecast to 1.5% from 2%. Add to this possible tax increases next year, a contraction of the agricultural sector as the drought starts to grip, and a widening budget deficit (and rising debt to gross domestic product ratio) and it’s clear the economy needs every bit of help it can get.
The fact is there are a whole mountain of things the Bank has absolutely no control over. Lower mining commodity prices, slowing growth in key trading partners and adverse global liquidity conditions brought about by the Fed’s willthey-won’t-they monetary policy will all put exchange rates under pressure in the coming months. — especially for those currencies that are commodity-based or classified as emerging market.
More important, there is very little evidence that raising rates will have any meaningful effect on inflation or the rand.
Sasfin Securities deputy chairman David Shapiro questions the rationale behind following textbook policy and raising rates when the economy is already on its knees. “Platinum is heading below $900/oz, the rand is R14.30/$ and food prices can only head higher as the drought grips. The rand may improve slightly, but we raised rates a few months ago and what good has it done for inflation or the currency?” he asked.
Nedbank Capital’s head of strategic research, Mohammed Nalla, is similarly sceptical about a rate hike and hopes the Bank will hold off until January.
“If the Fed hikes rates in December, we are going to feel the pain irrespective of whether the Reserve Bank increases rates next week,” he said.
Nalla makes the point that by hiking rates in July this year, the Bank has unofficially pre-empted the Fed’s rate decision, and it didn’t offer any support.
“It’s the classic stagflation dilemma: inflation is rising for exogenous reasons and there are no demand-side pressures, so we have run out of policy options.”
With this in mind, Nalla is of the opinion that given the low liquidity environment between November and January, it would be wise for the Bank to wait and see what the Fed does next month and then make a decision in January after the dust settles. I have to agree.
Before I get into trouble, I should be clear that Bank governor Lesetja Kganyago has explicitly stated there is no intention to defend the currency, and that no amount of central bank involvement will do anything to stop the rand from aligning to its macroeconomic fundamentals — which, as we know, are very poor.
That said, even if a rate increase did offer some support to the rand or manage to rein in inflation, it is clear it would be at the expense of the economy. Prices tend not to rise when you kill demand, but I don’t think anyone would consider that a positive outcome.
The good news is that the Bank is already patently aware of the damage that raising rates in the current economic climate will do.
At a Credit Suisse Conference in Cape Town last week, deputy governor Francois Groepe made it clear that procyclical monetary tightening can negatively affect economic growth and employment, and over time, could contribute to financial instability. This strong message came in side by side with the hawkish comments about being at the ready to intervene and raise rates if necessary.
Ultimately, the question is whether the monetary policy committee doggedly decides to defend the Bank’s mandate and follow the book or risk inflationary expectations running away next year.
It’s a very tough call, but my feeling is that inflationary expectations are the lesser of the two evils — rates can always be increased later.