A sombre outlook for the domestic and the global economy was presented yesterday by Reserve Bank governor Gill Marcus, helping the case for leaving rates unchanged, as had been confidently expected. The case for higher rates any time soon was weakened by the arguments presented in the MPC statement and in the Q&A session that followed. The opportunity to lower rates was not considered, as we were informed, though perhaps it should have been. Cost push pressures on inflation were again emphasized in the statement – and second round effects of higher inflation expected (on inflation itself) were regarded as not in evidence. Inflationary expectations, as measured for the Bank, were reported as stable to lower.
The Reserve Bank expects the small breach of the upper 6% band of the inflation targets by the first quarter of 2012 but is of the view that this breach will be very temporary and therefore no reason in itself to raise the repo rate. Base effects are pushing inflation higher in the second half of 2011 and will reverse in 2012. The key to the inflation target remains the foreign exchange value of the rand and this is proving very helpful and we think will continue to be so – to the point that the Reserve Bank is over- rather than underestimating inflation.
Prominent reference was made in the statement and in the Q&A to the “core” rate of inflation, that is inflation excluding food and energy prices, which is of the order of just over 3%. An inflation target set in terms of core inflation rather than headline inflation is preferred by many of the leading authorities on inflation targeting and the Reserve Bank may well be moving in that direction. This represents an important and welcome departure from previous Governor Mboweni’s practice and rhetoric, who was determined to allow no such distinctions or escape clauses for meeting the inflation targets. This different mindset reinforces our argument for and prediction of low interest rates for longer. Moreover it raises the likelihood of generally more stable short term interest rates in the future which would be very helpful for SA business and its customers.
Closing the gap
At the Q&A, so called output gaps received interesting attention, that is the gap between potential GDP and actual levels of output. This gap is judged still to be open but is said to be closing with current growth rates ahead of potential growth. Potential output growth this year was indicated as only 3.5% with second half growth slowing down rather than picking up. This represents a very pessimistic view of SA’s long term growth potential and is not one consistent with much growth in employment and the government objectives for employment growth.
This Reserve Bank sense of potential growth is presumably derived from a limited estimate of SA’s ability to attract foreign capital, equivalent by definition to the sustainable size of the current account deficit – both usually measured as a share of GDP. We have argued that such pessimism may be unjustified and that growth can lead capital inflows that finance and sustain growth. In other words, grow faster to improve the returns on capital invested, and the capital from global sources will be forthcoming. There is a potential virtuous circle for SA that was in evidence between 2003 and 2007 (grow faster- attract more capital – sustain the value of the rand – holds down inflation and interest rates). But expressing faith or confidence in such possibilities of faster growth with less inflation aided by foreign capital, is not behaviour expected of inflation vigilant central bankers.
GDP growth is expected by the Reserve Bank to be about 3.7% in 2011 and 3.9% in 2012, increasing to 4.4% in 2013. When the presumed output gap is finally closed (on these assumptions) late in 2012 the case for raising rates will then be more confidently made. Pressures on global food inflation are however thought by the MPC to have peaked. The MPC outlook is for inflation at the upper band 6% rate by year end and is expected to remain above this 6% upper band for the inflation target until the second quarter of 2012 and receding thereafter.
Something in reserve …
Had we been at the Q&A session we would have asked the Governor and her bench of advisors why the Reserve Bank thinks it still useful to add to its already abundant supply of foreign exchange reserves. These are large enough for any conceivable emergency that might shock the SA balance of payments. The governor indicated her own confusion about the forces that drive the rand. Clearly Reserve Bank interventions in the currency market have had no predictable influence on the rand. The realised strength of the rand has made such intervention very expensive for the SA taxpayer on whose behalf the Treasury borrows rands at 6% to 8%, to offset the impact of dollar purchases on the money supply, for the Reserve Bank to invest in US dollars and Euros that return around 2% at best. It has been an expensive and futile exercise in trying to resist market forces.
We might suggest that the behaviour of the rand is not that mysterious and will continue to take its cue from global risk appetite, well reflected in emerging equity and bond markets. The well understood rand does not make it easier to predict. This remains the essential problem for monetary policy in SA, which is to hold inflation down not for its own sake but to encourage long term economic growth (lest we forget the purpose of inflation targeting).
To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 22 July