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Investec’s Brian Kantor is once again knocking on the South African Reserve Bank’s door, pleading with them to focus on the things they have control over. This as the country prepares itself for another Monetary Policy Committee meeting due this month, with economists divided over an expected hike or for rates to remain steady. The repo rate has been increased by 1 percent since July 2015 to 6.75 percent. Kantor’s concern, and that of the Bank, is stagflation – a slow growth, high inflation environment. And while inflation is usually fought with higher interest rates, the problem is its not demand driven but influenced by outside factors beyond their control. Kantor says South Africa’s monetary policy should instead focus on limiting the damage higher interest rates have caused to the economy. And come to the realisation that they will not influence the outlook for inflation. Some great analysis. – Stuart Lowman
By Brian Kantor*
The problem for the Reserve Bank and the economy is stagflation: slow growth and rising inflation. Very little of the pressure on prices and the inflation rate is coming from the demand side of the economy – for which higher or lower interest rates are the obvious remedy.
Prices may rise for supply side as well as demand side reasons. Less supply and so upward pressure on prices is the result of a drought that has reduced agricultural output and is pushing up food prices. Upward pressure on prices is also coming from higher taxes on goods and also from the higher prices charged by our publicly owned utilities with monopoly power to charge more. Most important are the higher consumer prices that are following higher rand prices paid for import goods and services, including oil and now higher prices to be paid for imported grains. The recent trends in global food prices have become very unfavourable for South Africa recently as the Reserve Bank shows in its latest Bulletin. The global food price index- converted into rands has risen sharply as may be seen – as South Africa becomes a net importer of staple foods.
The higher foreign currency (US dollar) and rand prices of these imported staples is now putting additional upward pressure on costs and so on the prices charged to consumers. But a much more important influence on inflation over the next 12 or more months will be the movements in the foreign exchange value of the rand. A sharply weaker rand is equivalent in its impact on prices to any sharp reduction in the supply of seasonal vegetables to any food market. It may be regarded as a negative supply side shock to the economy, as would any abrupt strength in the rand be regarded as a positive supply side shock- something to bring down prices, or at least slow their upward momentum.
The state of demand in the economy may also make it more or less difficult for SA manufacturers, wholesalers or retailers to pass on higher or lower costs of imports to their customers. If demand is under pressure suppliers may well have to accept lower profit margins and vice versa. Should the economy be enjoying something of a boom and the exchange rate weakens- even higher inflation could be predicted.
The problem for the economy is that supply side shocks and higher prices (more inflation – that will tend to follow drought, higher taxes or utility charges and a weaker exchange rate) depress the spending power of households and firms. Higher prices driven by the supply side of the economy will mean less disposable income and so less spending that slows an economy down. Raising interest rates in such circumstances will further depress demand and the rate of growth of the economy.
There would seem to be a fairly obviously conclusion for monetary policy makers to come to. That would be to raise interest rates when the demand side of the economy can be held responsible for higher prices. On the other hand, one would keep interest rates on hold or reduce them when much of the pressure on prices is coming from a lack of supply – that will be further exacerbated by the still lower levels of demand that follow higher prices.
Unfortunately, the Reserve Bank of SA is very much inclined to ignore the reasons why prices are rising and to raise interest rates when prices are expected to rise faster and when inflation is predicted to threaten the 6% upper band of the inflation targets. It acts against inflation this way, regardless of its provenance, because it believes that inflation expectations can drive inflation ever higher – should it not react in the way it does.
These are the so-called second round effects of inflation that it feels it must guard against, regardless of the predictably negative impact its interest rates can be expected to have on economic growth. It argues that its mandate is a narrow one – its focus is to control inflation – hence to control inflationary expectations with higher interest rates should more inflation come to be expected. The notion that prices will be set with inflation in mind is well supported by the behaviour of the firms with price setting powers and responsibilities. More inflation expected will mean higher prices to be budgeted for. But higher prices will not necessarily be realised to satisfy some pre-determined profit margin over expected costs. The profit margins will be subject to what the market will bear and if demand is weak, profit margins may well be sacrificed and list prices discounted to encourage demand and minimise losses. Expected inflation on its own will not determine pricing power; the state of the economy will also be influential in the price outcomes. It begs the imagination of conventional economics that interest rates should rise into a severe drought.
However while interest rates have depressed demand in SA and are likely to continue to do so, this influence on prices is very likely to be overtaken by developments in the foreign exchange market. The most important influence on inflation and inflation expected will remain the exchange value of the rand.
Higher interest rates in SA have not proved to have any predictable influence on the value of the rand. They are as likely to be associated with a weaker as with a stronger rand. Indeed, if there is a feedback loop from less growth expected to less capital invested in SA (as there surely is), then higher interest rates that can be expected to lead to even slower growth, may well be the cause of subsequent rand weakness.
Thus if there is no predictable influence of interest rate setting on the exchange rate of the rand the link between monetary policy and inflation is a very unreliable one. Furthermore if the exchange value of the rand itself is very difficult to predict with any degree of conviction – as would strongly appear to be the case – the Reserve Bank does not have the ability to forecast inflation in SA accurately enough for the purpose of setting interest rates appropriately – even should interest rates have a predictable influence on the value of the ZAR.
In other words, the Reserve Bank has very limited capacity to predict and control inflation with its interest rate settings. Without such a capacity, an inflation targeting regime has very little logic to justify it. It means that interest rates can rise when the economy is slowing down and further depress the economy – because the exchange rate has weakened – for reasons well beyond Reserve Bank’s control. And interest rates will fall when the exchange rate strengthens and the inflation outlook improves, again for reasons beyond the influence of monetary policy. And lower interest rates then add further stimulus to the economy that may not need it. The 2003-2008 spending boom in SA was such a (welcome) episode of a cyclical upswing reinforced by highly accommodative monetary policy.
The insistence on inflation targeting, regardless of the causes of inflation, in SA can make monetary policy in SA highly pro-cyclical. It means interest rates can rise when the economy is slowing down (as it has done over the past two years) and will fall when the economy picks up in response to a recovery in the rand.
A recovery or further weakness in the rand could have its origins in global degrees of risk tolerance or aversion that impact favourably or less favourably on emerging and commodity markets- including SA and so the exchange value of the rand as well as other EM currencies. We can only hope for a fuller global tide rising in our favour. Or the rand responds to changing estimates of SA specific risks to capital invested here that change with political actions and policies that influence expected returns on capital invested in SA. As it clearly has done over the past few months. We can only hope for better news from our politicians.
Raising interest rates in these highly strained political circumstances can have only one predictable outcome. That is to further slow-down the SA economy. Higher short term interest rates will not influence the value of the rand and therefore the outlook for inflation. The exchange value of the rand over the next year will be dominated, as it always has been, by the mixture of global and SA risks. And if the exchange value of the rand is in the hands of SA politics and the outlook for emerging market economies generally, as it surely is, the Reserve Bank cannot hope to influence inflationary expectations with its interest rate settings.
Inflationary expectations will be dominated, as always, by expectations of the future value of the rand. The rand is still expected to decline by an average of 7% p.a. over the next 10 years, while expected inflation remains as high, consistently so given the exchange rate outlook. SA risk being the difference between RSA 10 year bond yields and 10 year US Treasury bond yields, is by definition of the interest parity equilibrium condition: the expected rate of depreciation of the rand against the US dollar. The difference between the vanilla RSA 10 year bond yield and its RSA inflation linked equivalent, is an objective measure of expected inflation in SA for which holders of inflation exposed bonds receive compensation in the form of higher yields to be paid out in money of the day.
The SA inflation rate is expected to be over 7% a year over the next 10 years because the rand is expected to depreciate at about the same average 7% rate over the same period. It may be noticed in the figure below that inflation expected and SA Risk rose sharply when Mr Zuma intervened in the affairs of the Treasury on December 9th 2015. It may also be seen that that markets have not returned to pre-Zuma levels, though late last week the spread between RSA and US yields narrowed by as much as 40 bp. Perhaps the Gordhan road show was responsible for this improved rating though Emerging markets generally had a much better week. This is revealed by a decline in EM bench mark spreads and in the SA default spread. Both declined last week but the difference between the higher EM and the SA spread narrowed indicating that the average EM debt improved its credit rating by more than RSA USD denominated debt. ( See figure 3 below) The wider this difference in yields the better the relative standing of SA debt. It should be recognised that the current CDS spread on RSA Yankee bonds means that SA debt is trading at yield well above Investment Grade that offers a maximum spread of about 270bp
Fig.2; SA Risk and Inflation Compensation represented in the Bond Market (Daily Data, January 2015- March 11th 2016)
Fig.3; RSA Vs Emerging Market Bond Spreads; Daily Data to March 11th 2016
Until the rand is expected to do better than this, inflation expected will remain above the inflation targets. And there is nothing the Reserve Bank should expect to do anything about. Its focus must be as it should always be: on the state of the domestic economy – a state that could benefit from lower interest rates.
- Brian Kantor is Chief Strategist and Economist, Investec Wealth and Investment. The views expressed in this article are those of the author and may not necessarily represent those of Investec Wealth & Investment.
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