HOW LOW CAN THEY GO?

Covid-19 has delivered such a huge disinflationary shock to the SA economy that it could keep consumer inflation below the floor of the target band for the coming year

At 3.75%, SA’S repo rate is the lowest it has ever been. But it is set to fall even lower, according to several economists who believe SA is heading for a prolonged period of below-3% inflation and negative real interest rates.

Both events would be almost unprecedented in a post-democratic SA, indicating just how deeply Covid-19 is gouging the economy.

Last week, the Reserve Bank’s monetary policy committee (MPC) cut its growth forecast from -6.1% to -7% for 2020, and dropped its average consumer price index (CPI) forecast from 3.6% to 3.4% for the year ahead.

The repo rate will turn slightly negative in real (inflation-adjusted) terms over the year ahead and headline CPI will remain at or below the 4.5% target until the end of 2022.

But several economists think the Bank is underestimating just how low inflation and the repo rate could go. They think CPI could remain below the 3% floor of the target band for almost a year. If so, several more staggered rate cuts could be on the cards.

BNP Paribas economist Jeffrey Schultz expects CPI to average just 2.8% in 2020, which would be a 17-year low, and to remain below the 3%-6% target range for almost a full year from June 2020, re-entering the band only in April 2021.

“If realised, this would be only the second time in the country’s inflation-targeting history that the CPI has averaged below the Bank’s low“for er bound for an extended period,” he says.

His bullish inflation view is premised on SA achieving a very gradual, muted rebound from the pandemic to grow at just 2.3% in 2021, from -8.5% in 2020. Therefore, even with inflation gradually picking up towards 4% by the end 2021, he thinks the Bank will find it difficult to raise rates aggressively.

In fact, he thinks another staggered 75 basis points (bps) worth of cuts is likely in the current cycle, with the first hike occurring only in the final quarter of next year.

Schultz says the ingredients for SA to experience “low for longer” inflation were entrenched well before the crisis. Covid-19 is likely to reinforce these. For instance, even more significant job and profitability losses are now expected this year and a prolonged period of job insecurity will likely endure beyond the crisis, limiting wage demands. There is now also a greater likelihood that the public service will implement negative real wage growth this year.

Schultz cites at least four more reasons that inflation is likely to remain benign over the coming year.

First, heightened disinflationary and deflationary trends are likely to persist globally in the initial aftermath of the pandemic due to weak demand. This is likely to override any hits to supply channels. The collapse of the global oil price is a case in point.

a net oil importer like SA this is good news and has created room for very strong deflation in domestic fuel prices,” he says.

Second, global food prices are abating, despite disruption to global supply chains. SA is likely to continue to benefit from a healthy maize harvest and ample grain supplies, according to BNP, which is forecasting food inflation of 3.9% in 2020, marginally up on 2019’s 3.1% rise.

Third, Schultz expects the inflationary effect of a weaker rand to be more than offset by weaker demand, noting that over the past decade the pass-through effects of exchange rate depreciation into inflation have more than halved across emerging markets as a group, including SA.

Fourth, there is scope for certain price categories to experience sharp deflation (outright price cuts). Public transport and package holiday prices have already dipped into deflation, while prices for restaurants and hotels, and maintenance and repairs, have been moving steadily lower in recent months. These are likely to slow further, given SA’S ongoing lockdown constraints.

Double-digit deflation in data communication costs is also likely, given the increased competition between telecoms companies since the start of the lockdown. This alone could subtract 0.2 percentage points from headline inflation, Schultz estimates.

“Looking further ahead, this could be another disinflationary byproduct of an economy becoming more geared to an online way of living and consumption, stemming from digitalisation and e-commerce,” says Schultz.

While the MPC believes the overall risks to the inflation outlook remain to the downside, it expressed concern last week over

electricity and other administered prices. Inflation pressure could also emerge from heightened fiscal risks and sharp reductions in the supply of goods and services, it warned.

Despite these risks, the MPC expects SA’S economic contraction and slow recovery to keep inflation well below the midpoint of the target range this year and “well contained” over the medium term.

Like Schultz, Citibank economist Gina Schoeman thinks the Bank is still underestimating how low inflation could go.

Given that her 2020 GDP growth forecast, at -10.1%, is substantially worse than the Bank’s, and her CPI forecast substantially lower (averaging 2.7% for 2020 and 3.5% in both 2021 and 2022), she expects the Bank will soon be revising down its forecasts, creating scope for another 50bps cut in July.

One of the reasons for her below-consensus inflation outlook is her expectation that rental inflation, which makes up almost 17% of the CPI basket and is currently growing at 2.6% year on year, will trough at 0% by year-end.

Covid-19 has inflicted an “abrupt demand shock” that is affecting the rental market in two main ways, Schoeman says. Directly, tenants

HEADING NEGATIVE

may struggle to pay rent, leaving landlords reluctant to increase rentals. They may even cut them outright.

Indirectly, weak demand means the housing market will underperform. This could cause some sellers to rent out their properties instead, adding supply to the rental market, which would depress prices until demand returns — something which could be years away.

Intellidex head of capital markets research Peter Attard Montalto also expects SA to enjoy a sustained period of inflation below 3% from this June to next May. He estimates that CPI could drop as low as 1.6% at times over this period, averaging 2.4% in 2020, 3.4% in 2021 and 4.4% in 2022.

“We see the Covid-19 shock as disinflationary, with dramatically lower oil prices and weak demand offsetting the weaker foreign exchange rate and higher input costs, and [health] compliance costs,” he says. “The oversight of the Competition Commission should also have a dampening impact on margin-rebound risk in the coming year.”

Intellidex thinks there is room for the

Contemporaneous real interest rates %

12

10

8

6

4

2

0

-2

-4

Bank to cut the nominal repo rate all the way to

2%. However, Attard Montalto fears this will do little to stimulate the economy at a time when confidence and demand have collapsed.

Consumers are too risk-averse to take on more credit and, anyway, are afraid to go shopping; firms with ample inventory and spare capacity are reluctant to invest with demand so weak; and banks, which want to conserve capital and avoid risk, don’t want to lend.

This makes the new loan guarantee scheme, whereby the National Treasury has guaranteed R200bn in loans to encourage on-lending to distressed firms by commercial banks, a far better way of stimulating the economy, he feels.

RMB Morgan Stanley economist Andrea Masia agrees that there is no need for the Bank to lean so heavily on the policy rate. He suggests the time may have come to dig further into its macro-prudential toolkit and liquidity interventions to support the economy.

“The MPC isn’t interested in a race to the zero lower bound, and already the prime lending rate is set way below the yield on benchmark government bonds,” he says. “That doesn’t bode well for credit supply.”

For Isaah Mhlanga, executive chief economist at Alexander Forbes, what happens to consumer confidence will be a key determinant of SA’S future inflation path. This will depend on two main factors, he says: job security, and how long it takes before consumers feel safe to go out.

“Job security is possibly at its lowest in democratic SA given the expected company liquidations in the months ahead, even with fiscal support,” says Mhlanga.

“Safety will depend on the underlying Covid-19 infection prevalence and observed death rate.

“These two [things] will keep consumer confidence and therefore discretionary spending depressed, which will in turn have the potential to lead into a deflationary phase in the months ahead.”

Even so, the emerging consensus is that the MPC must be close to the bottom of its cutting cycle, having delivered 275bps in cuts so far this year. The Bank’s latest quarterly projection model suggested two 25bps cuts would be warranted in the second half of this year, but by cutting by 50bps last week, the Bank has brought these forward and delivered both in one go.

“Cutting rates further is not without risk, especially in terms of further currency weakness,” says Stanlib chief economist Kevin Lings.

“This suggests that while the Bank may cut rates by a further 25bps or 50bps before year-end, a significant and aggressive further reduction in interest rates will probably require either a further and significant deterioration in the SA economy, a stable or stronger rand exchange rate, and/or a further downward surprise to SA inflation.”

Source: SA Reserve Bank, Stanlib

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