SA TAME THE INFLATION BEAST?
Nobody should doubt the resolve of the Reserve Bank when it comes to bringing inflation down, even if it means hiking rates into a recession
The risks are rising that inflation is going to remain sticky this year, which means the Reserve Bank could have to keep hiking interest rates in a rapidly slowing economy, given its firm resolve to get the inflation genie back in the bottle.
It may seem senseless for the Bank to be contemplating further rate hikes when its own forecast is that South Africa will experience 250 days of load-shedding this year 60% worse than 157 days in 2022 and that economic growth will slow to just 0.3%.
But, as the Bank frequently explains, inflation is bad for everyone especially the poor. And that’s regardless of whether it is caused by overheating domestic demand, intense loadshedding, which drives up input costs, or by external shocks that are beyond the country’s control.
Even when growth is slowing, the Bank is duty bound to act against second-round effects (when higher initial input prices feed through to higher long-run consumer prices, which in turn beget higher wages). The Bank must also prevent inflation expectations from drifting upwards and becoming self-fulfilling, otherwise it will have a more difficult, longer-term problem on its hands.
The Bank could also point out that local interest rates are well below those of some peer economies, and that this adds to rand weakness. For example, Brazil’s policy rate is at 13.75%, Mexico’s is at 11% and Hungary’s is 13%. But more important is that with consumer price inflation (CPI) for February at 7%, and the repo rate at 7.25% at the time of writing, the real repo rate is just 0.25%. In other words, it is barely positive after a long period in which real rates have been in negative territory and the Bank cannot stabilise prices with persistently low or negative real rates.
The good news is that the Bank expects CPI to be back at the 4.5% midpoint of the target range towards the end of this year, dragged down by subsiding fuel prices and slowing growth. But the upside risks are considerable.
Bank deputy governor and monetary policy committee (MPC) member Rashad Cassim identified four big risks to the inflation outlook in a recent speech at the Central Banking Conference in Cape Town. He expressed concern that, in light of these risks, the Bank may not be able to engineer a soft landing for South Africa.
The first worry, he said, is that load-shedding may be giving food inflation a second leg-up as electricity shortages start to disrupt the production and storage of food, pushing up input costs across the food production chain.
In February, food prices jumped 14% year on year, which was a big driver behind the rise in headline CPI to 7%, from 6.9% in January. That this occurred despite sharply lower global food prices and some improvement in local production due to favourable weather suggests firms can no longer endure margin squeeze and are starting to push the cost of load-shedding onto the consumer.
High diesel costs, lower farm output due to load-shedding and the weaker rand all pose upside risks to food inflation over the rest of the year.
The second inflation risk, said Cassim, is that the outlook for the rand has become “more worrying”.
The rand is being battered by a toxic mix of global risk aversion, negative local news flow, South Africa’s weakening growth prospects and continued dollar strength. A weak rand complicates the conduct of monetary policy, as it raises the cost of imported goods, stoking imported inflation.
Currency analysts expect the rand to retain its weakening bias as long as the dollar remains strong and the US Federal Reserve keeps hiking rates.
Earlier this year, the consensus was that US inflation would fall off swiftly, allowing the Fed to pause in its hiking cycle. But the process has become complicated by the sticky nature of US inflation and the unprecedented tightness in the US labour market on the one hand, and worries about the potential for a mini-banking crisis on the other.
Last week the Fed raised its policy rate by 25 basis points (bp), marking its ninth hike since March 2022 and taking the upper bound of its funds rate to 5%. Though this was in line with expectations, Fed chair Jerome Powell’s tone was far less hawkish than previously. It was a reflection of the uncertainty created by the recent collapse of Silicon Valley Bank and Signature Bank, as well as the plight of Credit Suisse, which has caused a significant shift in interest rate expectations across the globe (see graph).
“Powell and his colleagues are clearly concerned about the impact of recent events on credit conditions, which may affect lending to households and businesses, slow the economy, and weigh on inflation,” says Oanda senior market analyst Craig Erlam. “While this would do some of its job for it in bringing inflation back to target, it won’t do so in the way it will have wanted.”
The Fed’s median forecast is for the policy rate to end 2023 at about 5.1%, which implies one more hike. But further increases are no longer assured.
Another major consideration for the Reserve Bank is that inflation expectations are continuing to creep higher.
The Bureau for Economic Research’s fourth quarter 2022 survey of inflation expectations registered a forecast of 6.1% inflation for 2023, up from 5.9% in the previous quarter, and 5.6% for 2024, up from 5.3%.
Rising inflation expectations are an understandable response to South African inflation, which peaked at 7.8% last July, having been outside the Bank’s 3%6% target range since May 2022. The last time the country was close to the midpoint of that range where the Bank aims to stabilise inflation was about a year before that.
But what really worries the Bank are inflation expectations for five years ahead. The fact that these now average 5.5%, up from 5.4%, suggests that South Africans do not expect the Bank to succeed in getting inflation down to its 4.5% target over the medium term. If people start to see a higher level of inflation as normal, second-round effects could begin to take hold. If this happens, the Bank would be duty bound to act.
“We are therefore monitoring [inflation] expectations closely to see if people recover their faith in our target or if we need to do more to stabilise longer-term expectations close to 4.5%,” said Cassim.
For a sense of underlying inflation pressure, another important area that the Bank watches is core inflation headline CPI excluding volatile food and energy prices.
INFLATION HURTS THE POOR THE MOST
Income deciles 1-3 are experiencing double-digit inflation
The acceleration of core inflation from 4.9% in January to 5.2% in February may worry the Bank as it suggests that price pressures are broadening and second-round effects through wages and inflation expectations may be starting to take hold.
However, Absa economist Peter Worthington argues that the rise in core inflation was driven mainly by health insurance costs, which have started to adjust higher after two years of unusually low increases.
“Therefore, we do not see the rise in core CPI as reflective of a broad-based underlying price pressure that will be sustained,” Worthington says.
“While upside risks remain, we expect the core CPI print of 5.2% to be the peak, and forecast that headline CPI inflation will resume its broad easing trend from March.”
The Bank’s January MPC forecast is for core inflation to peak at about 5.4% in the second quarter of this year, even as disinflation trends continue to pull headline CPI lower.
“Perhaps we can hope our core forecasts will be too high,” said Cassim. “Of course, if we do not see services coming down later this year, then we will have a problem. We are not going to be able to achieve our target over time if services inflation gets stuck in the top half of our target range.”
So, what is the likely path of interest rates over the rest of the year, and where will the terminal repo rate likely end up?
The most recent Thomson Reuters consensus forecast is for the repo rate to be raised by 25bp to 7.5% at the MPC’s March meeting this week and then stay at this level until the end of 2023, with the first rate cut occurring in the first quarter of 2024.
According to Cassim, the future path of the policy rate will depend on whether the Bank feels confident that disinflation is proceeding as it foresees and that CPI will subside to 4.5% later this year.
“If the disinflation story does not play out as expected, we won’t get real rates where we need them,” he said, adding: “Because we cannot stabilise prices with persistently low or negative real rates, in this scenario there will be more work to do with rate changes, and the trade-offs between output and inflation will be more difficult.”
The bottom line is that while it initially looked as if the path to lower inflation would be a relatively smooth one this year, the risk is rising that more monetary policy action will be required than was initially foreseen to get South Africa there.
“And so,” Cassim concluded, “while we hope for a soft landing, we are also prepared for worse outcomes.”