The CPI in December 2014 was no higher than it was in August 2014.
The Consumer Price Index (CPI – based to 100 in December 2012) reached the level of 111 in August. In December the CPI fell by 0.2 points and was back at the 111 level. In other words, on average, prices in SA have not changed in five months.
Headline inflation is measured as the year on year change in the CPI. Prices since December 2013 have risen 5.3%. However, if we measure the change in prices over a shorter three month period, this inflation rate is zero, way below headline inflation. If current trends continue and are extrapolated using a time series forecast, SA is heading for significantly lower inflation, perhaps below 4% by the end of 2015. Lower petrol and diesel prices in January may send the CPI still lower and reduce the forecast rates of inflation further, though it is highly likely that if the rand oil price stays where it is, the government will impose an additional excise tax on petrol, diesel and paraffin in its February Budget proposals.
The bond market, where interest rate contracts between the government and pension funds can be written for 20 or more years, the risks of more or less inflation are fully reflected in long term interest rates. Inflation-protected bonds offered by the government enable lenders to avoid the risks of inflation turning out higher than expected and provide a riskless certain real return (provided governments measure inflation objectively and stand by the contract). The difference between the nominal and real yield on RSA bonds of similar duration (say 10 years) therefore represents compensation for bearing inflation risk and is an objective market-determined measure of expected inflation.
Less inflation in SA, linked to the accompanying stability of the rand on a trade weighted basis and lower oil and commodity prices (when expressed in the strong US dollar) has helped lead interest rates in SA lower. The gap between the yields on nominal inflation-exposed benchmark 10 year RSAs and their inflation-linked equivalents (RSA 212) has also narrowed recently and has followed headline inflation lower.
Less inflation leads to less inflation expected – the Reserve Bank is wrong to think it can go the other way round – there is no good evidence for the so-called second round effects (more inflation expected that are assumed to lead inflation higher). But it should also be appreciated that inflation compensation in SA is very sticky about the 6% level. It has stayed close to that level even as inflation came down sharply from high levels after the Global Financial Crisis and crept higher in the second quarter of last year. The Reserve Bank will have little influence on these inflation expectations – provided inflation behaves “normally” – and it should recognise that its policy targets can only be about inflation and also growth, not inflation expected.
It may take inflation well below 6% and sustained at that level over an extended period of time to reduce inflation compensation in the bond market well below the 6% level. RSA bond yields (lower or higher) will continue to take their cue from global interest rate trends – to be led by euro rates, as they have been led in 2014. It is the interest rates in Europe (reflecting fears of deflation and central bank reactions to deflation) followed by lower rates in the US, that have attracted flows from off shore into to the rand bond market causing SA interest rates to fall while helping the rand to strengthen. The stable to stronger rand has helped reduce inflation while having a much more subdued influence on inflation expected.
The importance of these trends, all well beyond Reserve Bank influence, will mean that the Reserve Bank is very unlikely to raise its repo rate this year and may even reduce it next year should the economy not pick up momentum. A mixture of less inflation with faster growth in SA, encouraged by stable interest rates, is the new welcome opportunity provided by global deflation for the SA economy to lift its growth rates. Such optimism is already being reflected in the buoyant recent performance of the interest rate sensitive stocks listed on the JSE: the retailers, banks and property companies.
More growth expected and the improved profitability associated with faster growth will attract more capital to SA, as it has been doing over the past few days. These flows support the rand and make faster growth with less inflation more likely. These are good reasons why the Reserve banks should focus its attentions on what it can do to assist growth in SA and leave inflation – over which it has little influence – to the global market forces that drive the rand and long term interest rates.