The Monetary Policy Committee (MPC) of the SARB met on Tuesday 28 January with the rand down about 30% against the US dollar on a year before. Predictably, given the openness of the SA economy to exports and imports, the SA inflation rate had picked up and was forecast to exceed its inflation target range of 3- 6% later in 2014.
The next day the MPC decided to raise its key repo rate by 50bp from 5% to 5.5%. The rand in response weakened further, by about 3% by the close of trading on the Wednesday 29 January.
The Reserve Bank of Australia (RBA) decided on 3 February to leave its cash rate unchanged at 2.5%. The Aussie dollar (which had also lost a significant amount over the last year, approximately 17% against the US dollar) responded favourably to the decision, gaining about 1.6% against the US dollar on the day.
These market reactions help prove a point we have made repeatedly: higher interest rates may not necessarily support a currency; thus leaving interest rates alone, or even reducing them, may support a currency, especially in times of exchange rate volatility.
Higher short term interest rates may imply a deteriorating growth outlook, meaning lower rather than higher expected returns on flows of risk capital to and from an economy. As a result, the net outflows of foreign exchange may exceed the inflows, leading to a weaker domestic currency and more rather than less subsequent pressure on consumer and producer prices. Lower or unchanged interest rates, by contrast, may improve the economic outlook and prospective returns and attract more rather than less net foreign capital. It is growth prospects rather than nominal interest rates that drive capital flows to businesses and economies.
Australian cricket prowess may wax and wane. But Australian monetary policy has proved consistently adept at ignoring large movements in the Aussie dollar exchange rate, even welcoming the opportunity provided for more balanced growth. In the words of RBA governor, Glenn Stevens, from its media release of 4 February:
“The exchange rate has declined further, which, if sustained, will assist in achieving balanced growth in the economy.”
The picture presented of the Australian economy is not however without its challenges for policy. As shown by further extracts from the media release, there are threats to Australian growth, employment and prices – enough to keep interest rates at their currently low accommodative level in expectation of an improving outlook over the long term:
“In Australia, information becoming available over the summer suggests slightly firmer consumer demand and foreshadows a solid expansion in housing construction. Some indicators of business conditions and confidence have shown improvement. At the same time, with resources sector investment spending set to decline significantly, considerable structural change occurring and lingering uncertainty in some areas of the business community, near-term prospects for business investment remain subdued. The demand for labour has remained weak and, as a result, the rate of unemployment has continued to edge higher. Growth in wages has declined noticeably.
“Inflation in the December quarter was higher than expected. This may be explained in part by faster than anticipated pass-through of the lower exchange rate, though domestic prices also continued to rise at a solid pace, despite slower growth in labour costs. If domestic costs remain contained, some moderation in the growth of prices for non-traded goods could be expected over time.
“Monetary policy remains accommodative. Interest rates are very low and savers continue to look for higher returns in response to low rates on safe instruments. Credit growth remains low overall but is picking up gradually for households. Dwelling prices have increased further over the past several months. The exchange rate has declined further, which, if sustained, will assist in achieving balanced growth in the economy.
“Looking ahead, the Bank expects growth to remain below trend for a time yet and unemployment to rise further before it peaks. Beyond the short term, growth is expected to strengthen, helped by continued low interest rates and the lower exchange rate. Inflation is expected to be somewhat higher than forecast three months ago, but still consistent with the 2–3 per cent target over the next two years.”
By sad contrast the outlook for the SA economy has deteriorated, with no sign that domestic spending (linked inevitably to deteriorating conditions in the labour market) can lead the economy out of its doldrums. Still higher prices for goods with high import and export content will depress spending further and higher interest rates will further discourage very slow growing demands for and supplies of credit. The remarks made by governor Stevens about the poor outlook for investment in the Australian resource sector are also not encouraging for the SA resource sector. The hope must be that the weak rand and the much improved operating margins in the export sector and for firms competing with imports can lead the economy onto a faster growth path –labour unions permitting.
The problem for the SA economy and its interest rate sensitive sectors is that not only did short term interest rates rise last week, but they were immediately expected to rise significantly further by as much as an extra 2% over the next few months by the money market.
Such increases would be most unwelcome to a hard pressed economy – even unthinkable had they been imposed last week. These higher interest rates would be unlikely to help the rand in the near future and the inflation outlook any more than they have helped to date, for the reasons we have indicated.
In our response to the MPC decision we cautioned against the danger of such an interest rate spiral heralded by the 50bp increase in the repo rate. We noted that a spirited defence of the case for not raising rates will be as imperative the next time the MPC meets, should the rand not have gained strength by then and the inflation outlook remains as unsatisfactory as it is now.
We noted further that without such an argument, the economy may well set off on a 1998 like spiral of higher interest rates in response to a weaker currency and the more inflation that follows that leads to still slower economic growth.
Monetary policy needs to be not only data dependent, but also accompanied by good and appropriate guidance for the market about monetary policy that makes good economic sense.
We are therefore much encouraged by the guidance offered by governor Gill Marcus this week when, in an interview with Reuters, she remarked: “Money market expectations of a 200 basis point rate increase this year were exaggerated.”
In response to these remarks, interest rates along the RSA yield curve moved lower and the rand has held up well against most currencies, excluding the Aussie dollar. This provides further evidence of how to manage exchange rate volatility the Australian wa