The Reserve Bank, as expected, kept its repo rate steady despite raising its estimate of inflation to come, now seeing inflation as marginally above 6% by year end. However it also predicted to return to within the band in 2012. The explanation of this increase was “cost push” rather than demand forces, therefore not justifying higher interest rates (in the absence of “second round effects”).
Second round effects are defined as higher inflation caused by more inflation expected. This, according to the theory of monetary policy, might demand higher interest rates to fight inflation expected, even if this depressed the economy. This dilemma – the unhappy trade off between inflation and economic activity – is something the MPC would naturally prefer to avoid. The big question is will it continue to do so?
Our own work has unambiguously identified the absence of second round effects. Inflation in SA has influenced inflation expected, not the other way round. Thus we do not expect second round effects to show up. But the inflation outlook remains particularly uncertain given the uncertainty about the direction of the US dollar and the oil price in particular. And if the inflation rate rises and is expected to stay above the upper band of 6% this policy dilemma will become more acute, with or without measurable second round effects.
We notice again and welcome the willingness of the Reserve Bank to think beyond actual inflation to the causes of inflation and the recognition that monetary policy must also bear the outlook for economic and employment growth in mind. The revised mandate for the Reserve Bank makes this very clear.
It should be pointed out though that, in answer to a question, this point about a broader focus than a focus on inflation only was not made by the governor. The governor, like all governors of central banks, would hate to be interpreted as being soft on inflation, particularly when inflation is expected to rise above the target band and even when there is very good reason to ignore “cost push” pressures. And so anti-inflationary vigilance must always be stressed by central bankers, for fear that their lack of monetary action being misinterpreted as evidence of a lack of anti-inflationary conviction by the market place.
However, as was made clear by the MPC, the state of the economy does not support higher interest rates. As we have previously indicated the Reserve Bank is also of the view that economic activity may have decelerated rather than accelerated recently. And so, until the economy does pick up significant momentum, accompanied by significantly faster growth in bank credit the Reserve Bank will prefer to keep interest rates on hold. Yet it might feel obliged to raise rates despite the weakness of aggregate demand (wrongly in our view) should the actual inflation outlook deteriorate even if such higher inflation is beyond the control of the Bank itself.
The oil price remains the big unknown for inflation to come. It was remarked at the Q&A session that food price inflation may have peaked according to the Bank. The consolation is that higher commodity prices will very likely be accompanied by a stronger rand. If the rand price of oil remains unchanged or falls, the danger of higher interest rates will be averted for perhaps up to a further 12 months, that is until the economy gains real traction, which it will if the rand remains stable and the oil price does not detract further from household spending.
To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 13 May: Think Beyond Just Inflation