Tag: Interest Rates

After the MPC: Interest rate expectations and the rand

The money market has raised the probability of an early increase in short term interest rates (in three months’ time) following the meeting of the Reserve Bank’s Monetary Policy Committee (MPC) on Thursday that maintained the repo rate at 5.5%. The short term three month Forward Rate Agreement curve (FRA) of the banks moved higher by between 10 and 30bps across the range of forward rates beyond the next three months late last week.

Interest rates expected over the longer term, beyond four years, have remained unaffected. The zero coupon yield curve implies that the one year government bond rate, currently around 6% per annum, will rise consistently to a level of about 9% in four years’ time and then stabilise at this level.

These expectations remain consistent with inflation compensation priced into the bond market in the form of the yield gap between conventional RSA bond yields and their inflation linked alternatives. This gap remains consistently above 6% regardless of the rate of inflation.

Our own interpretation of the MPC statement and the press conference is that the Governor and the MPC would be extremely reluctant to take any interest rate action before the economy has regained its potential growth, which it is still some way from attaining. However further increases in fuel and food prices and the headline inflation rate might force them in this direction for fear of second round effects on inflation itself. In other words, more inflation expected would lead in turn to still more inflation.

We have found comprehensive evidence that inflation in SA does to a small degree influence inflation expected, as measured for the Reserve Bank by surveys conducted by the Stellenbosch Bureau of Economic Research for business, trade unions and financial institutions. However, the reverse has not been true, although the Reserve Bank seems to believe otherwise.

Moreover it is clearly concerned to preserve its inflation fighting credentials even if this should mean having to raise rates. This is so even when it is clear that the inflation it is attacking is not under its control and when higher interest rates might lead to slower growth and a wider gap between actual and potential output and employment. The striking feature of inflation expectations in SA is just how stable they have been and how they remain above the inflation target band of 3% to 6%.

As we indicated in our first reactions to the MPC statement, the outlook for interest rates in SA will depend primarily (and unfortunately) on the rand price of oil and the continued upward direction of administered prices and not on the state of the economy that might be intolerant of higher interest rates. There should be a better way of running monetary policy in SA with more sensitivity to the state of the domestic economy and with the media and the financial markets well able to understand that a shock to the inflation rate does not imply permanently higher inflation. Keeping interest rates on hold in such circumstances when demand pressures are subdued does not mean being soft on inflation. This better way is indicated by the inflation targeting mandate itself, which does not demand adherence to inflation targets regardless of the causes of inflation and the consequences of higher interest rates for the economy, as is indicated explicitly and clearly in Paragraph 4 of the Mandate.

The rand has however weakened in recent days despite an earlier expected increase in interest rates. This again confirms that the influence of movements in interest rates on the value of the rand is not easily predicted. As we show below the rand lost about 4% of its trade weighted value last week.

Perhaps the market is being influenced to a degree by the unknown outcomes of the municipal elections in SA on Wednesday, which have become a test of the national government and its competence to govern. A small additional protest vote would probably be welcome as an incentive for the government to improve its delivery. An unexpectedly large vote for the opposition might be regarded as a serious longer term threat to the powers that be, and would perhaps have unpredictable outcomes for the ruling party, its leadership and its policies. As we know markets do not appreciate uncertainty.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 16 May: After the MPC: Interest rate expectations and the rand

Interest rates: A change of heart at the MPC?

The Monetary Policy Committee of the Reserve Bank (MPC) as expected left the Reserve Bank repo rate unchanged yesterday. While the rate was unchanged the tone of the MPC statement and of the answers to the questions posed by journalists at the media conference was very different, in our estimation, from the previous meeting. Interest rate increases were clearly very far from the minds of the MPC. The pause button on short term rates remains very much in place. The focus of the statement and the subsequent discussion was clearly on the risks to the growth and employment outlook for the SA economy rather than the risks to the inflation outlook. This was despite the inflation forecasts being revised upwards in response to higher oil and fuel prices on global markets: these are expected to approach the upper band of its 3-6 percent inflation target band.

The money market and bond market will have to revise its view of the timing of the next increase in short term rates and was in the process of doing so yesterday. Higher policy determined interest rates will be postponed until the outlook for the economy can be predicted with greater confidence and the economy is operating much closer to its potential. We regard this evidence of Reserve Bank restraint as entirely appropriate and very encouraging for the outlook for the real SA economy. Most importantly from our perspective is the explicit recognition that these price pressures are of the cost push variety rather than of demand pull variety. To quote the MPC statement: “Since the previous meeting of the Monetary Policy Committee, the risks to the outlook for domestic inflation have increased on the upside, mainly as a result of cost push pressures. The domestic growth prognosis has improved, and the recovery is expected to be sustained, although not at rates sufficient to make appreciable inroads into the unemployment situation in South Africa.

“…….At this stage there are no discernible inflationary pressures coming from the demand side of the economy….”

And in concluding remarks:

“…The MPC is of the view that the risks to the inflation outlook are on the upside. However, these risks and underlying pressures are mainly of a cost push nature…”.

To further quote the MPC:

“The trajectory of the CPI forecast of the Bank has changed somewhat since the previous meeting of the Monetary Policy Committee. Nevertheless, inflation is still expected to remain within the target range over the entire forecast period. Inflation is now expected to average 4,7 per cent in 2011 and 5,7 per cent in 2012. This represents an upward adjustment of approximately half a percentage point in both 2011 and 2012. Inflation is expected to peak at 5,8 per cent in the first quarter of 2012 before declining to 5,6 per cent in the fourth quarter. The upward adjustment is mainly due to revised assumptions regarding the international oil price over the forecast period.”

What monetary policy can’t do
Presumably the Bank has referred to cost push rather than demand pull forces on the inflation rate because monetary policy and interest rates can do little to influence cost push pressures on prices in the short run or over the relevant forecast period. This important distinction was not one easily made by the MPC before when it would refer to the danger to inflation itself of inflationary expectations themselves. Such references were happily absent this time. It has always seemed to us an argument not at all well supported by the evidence. That is inflationary expectations, as surveyed, or inflation compensation made available at the longer end of the bond market, have been largely impervious (almost always about 6% pa) to the direction of inflation itself: this has moved sharply in both directions over recent years.

The only time when inflation compensation in the bond market (being the difference between yields on conventional government bonds and inflation protected yields) moved sharply lower and then higher was at the height of the global financial crisis when risk aversion and deflation, rather than inflation itself, became the primary concern of investors.

The MPC has become anxious about the global economy and therefore the dangers of what it regards as an increasingly uncertain global economy for the SA economy where a modest recovery is now under way. The troubled sense of the MPC view of the world and of the dangers this represents for the SA economy is well captured by the following observations made in its statement: “The global economic recovery, although uneven, is expected to continue, led by a strong performance in global manufacturing. However significant downside risks remain, due to the confluence of shocks that have the potential to stall the nascent recovery. Growth in emerging markets remains robust, but Asian economies in particular may be negatively impacted by the recent developments in Japan. The global growth outlook may also be dependent on the extent to which the authorities in China manage to slow their economy down.

“….Domestic growth prospects appear to have improved moderately. Real gross domestic product grew by 2,8 per cent in 2010, and at an annualised rate of 4,4 per cent in the fourth quarter. The forecast of the Bank has increased somewhat since the previous meeting of the MPC, with GDP now expected to average 3,7 per cent and 3,9 per cent in 2011 and 2012 respectively. These growth rates, while an improvement, are still too low to have a significant impact on the unemployment rate which measured 24,0 per cent in the fourth quarter of 2010….. There are indications that although consumption expenditure growth will remain relatively robust, it is unlikely to accelerate to excessive levels in the short term…..The various house price indices all indicate that house prices are either falling or increasing at very low nominal rates. This, combined with the recent decline in equity prices, may contribute to a moderation of the impact of wealth effects on consumption.”

We welcome the emphasis the MPC is placing on the state of the economy and on the absence of demand side pressures on the economy. There is much more than inflation at risk for the SA economy and the Reserve Bank has made this very clear. This represents good news for the SA economy and we are confident that what we would regard as a change of heart of the Reserve Bank will be well received in the market place, including the currency market. Initial reactions in the bond and currency markets were positive and they are likely to remain constructive. Brian Kantor

Inflation and interest rates: The glass is half full

While headline annual consumer inflation was unchanged at 3.7% in February, the underlying trend indicates a somewhat faster rate of inflation of about 4.2%. These trends may be calculated as the monthly move in the seasonally adjusted and smoothed CPI, which is then annualised, or as the quarter to quarter annualised increases in the CPI. Both are running at a similar rate of above 4%. If the current trends are sustained the inflation rate will approach 5% over the next 12 months.


To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:
Daily View 24 March – Inflation and Interest Rates

The forces pushing up prices are in part global in the form of rising dollar prices for food and energy. These, as the Reserve Bank pointed out in its Quarterly Bulletin, have been rising sharply as a result of increased demands and some supply side disruptions or expected disruptions in the supply of oil from the Middle East.

Breaking down the February data
The counter to such pressures has been the strength of the rand over the past 12 months. This counter pressure has been more effective in the case of food and less so for the petrol price. The food price component of the CPI is up by 3.6% compared to a year ago. Food prices actually fell by 0.1% in February 2011. The petrol price rose by 3.1% in February and higher oil prices, as well as higher excise taxes on petrol, took the year on year increase in petrol prices to 12.1%.

Food and non-alcoholic beverages account for 15.68% of the CPI basket while transport costs have a large weight of 18.8%. However Purchase of Vehicles carries by far the largest component of transport costs with a weight in the basket of 11.8% out of the 18.8% allocated to transport generally. Petrol has a weight of 3.93% and Public transport also influenced by the petrol and diesel prices has a 2.73% share of the CPI.

Owing to the downward pressure the strong rand placed on new vehicle prices, the overall transport component only increased by 2.6% over the past 12 months despite the higher petrol price. Including the prices of new vehicles rather than their implicit or explicit leasing or rental rates is surely an anomaly in the calculation of the CPI. It is the opportunity implicit or explicit leasing costs of owning a vehicle rather than the price of a vehicle that matters to households. The price of a new or used car furthermore is hardly something clearly indicated on any price list. It will be affected by financial arrangements and by warranties as well as residual and trade in values, all designed to help make a sale.

This anomaly (rentals or prices) is avoided in the case of another important category that makes up the CPI. That is the item Owners’ Equivalent Rent that makes up 12.21% of the basket with Actual rentals for housing making up a further 3.49% of the basket. Electricity prices, which rose by 18.6% over the past 12 months, have a weight of but 1.87%. Actual rents are estimated to have increased by 5.4% and owners’ equivalent rents by 3.9% over the past 12 months. Rentals were unchanged in February, presumably because they were not surveyed last month.

The future of rentals and the rate of inflation will be determined by the state of the housing market. Short term interest rates and the availability of mortgage bonds will clearly influence house prices, rents and rental returns and these will take their cue from the rand. However if house prices rise rapidly landlords may well accept a lower rental rate of return and vice versa. When house prices fall rental may prove much stickier leaving the direction of rentals somewhat independent of house price inflation.

Nevertheless home owners are likely to spend more rather than less as their balance sheets improve with higher house prices, which is unlike the case when most other prices rise. Higher (relative) prices generally restrain rather than encourage extra demands.

The right medicine
This brings attention to the most important contributor to the monthly increase of 0.7% in the CPI. Increased costs of insurance, especially medical insurance, rose by 5.2% in the month and contributed 0.4 percentage points of the increase in prices. These insurance costs are also only surveyed annually rather than monthly and revealed a year on year increase of 4.2%. Are not such increases reflective of the increasing real shortages of skilled medical personnel rather than demand side pressures on prices?

Such shortages of skills are exacerbated by the difficulties imposed by our immigration policies. They show up also in the rate of inflation of educational services provided to households. Primary and secondary education became 10.2% more expensive over the past twelve months and tertiary education was up by 7.9% over the same period.

The forces that restrain domestic inflation and the pricing power of local suppliers are the prices paid for imported goods and services and also the employment benefits received by the internationally mobile owners of scarce skills. Thus the value of the rand is the key to the underlying rate of inflation in SA.

Efforts taken to weaken the rand mean more rather than less inflation. They would also mean slower rather than faster growth, particularly in household spending, which responds favourably to lower prices and lower interest rates that follow lower prices. Growth and inflation in SA over the next twelve months will depend mostly on the global forces that determine resource and commodity prices and capital flows to emerging markets, including SA.

The most favourable outcomes for the SA economy – faster growth with low rates of inflation – will be those associated with rising commodity prices and so a strong rand. High prices for metals and minerals and inevitably also the price of oil (and also coal that we export so much of) represents good news for the SA economy. These forces proved most helpful in reviving the economy in 2010. We must hope for further fair winds to blow in from the global economy in 2011 and restraint from the SA Reserve Bank.

Minding the Gap

The Monetary Policy Committee (MPC) of the Reserve Bank opted to keep the repo rate unchanged at 5.5% yesterday, in a move entirely in line with market expectations. Perhaps of more interest was the MPC’s outlook for inflation, which it upped to 4.6% for 2011 (from 4.3%) and 5.3% for 2012 (from 5.8%). We discuss the monetary stance of the MPC elsewhere in Daily View, but there has certainly been more talk in recent weeks of higher inflation later this year, as a weaker rand and rising commodity prices take their toll.

Continue reading the Daily View here: Daily View 21 January 2011