The Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) met on 26 – 28 March 2018 to deliberate an interest rate stance that anchors inflation to the middle of the 3 – 6% target rate.
To gauge the risks to the inflation outlook, the MPC will consider the plethora of local and international economic trends that has emerged since its last interest rate decision in January.
The economic implications of local developments, like the appointment of Cyril Ramaphosa as President of South Africa, the 2018/19 Fiscal Budget Speech and Cabinet Reshuffle (which saw Nhlanhla Nene move back into the position of Finance Minister) will likely feature as the MPC convenes this week. Furthermore, growing international protectionism and developed market monetary policy trends will also be on the central bank’s radar.
Key factors in favour of lowering interest rates
1. Inflation stabilises in the middle of the target range
After exceeding the SARB’s target range for most of 2016 and the first quarter of 2017, South Africa’s headline inflation rate has been on a downward trend, returning to the target range for the last ten consecutive monthly readings. Headline consumer price inflation declined to 4.4% year-on-year (y-o-y) in January, from 4.7% y-o-y in December 2017, which is the lowest reading in three years.
The decline in January’s annual inflation rate was associated with a reprieve in transport costs. Transport costs declined between December and January, falling 0.4% month-on-month (m-o-m). A 1.3% m-o-m decline in fuel prices followed a noticeable appreciation in the rand exchange rate during the second half of December as financial markets reacted favourably to the election of Cyril Ramaphosa as the new leader of the African National Congress (ANC).
The SARB considers inflationary trends in determining its monetary policy stance – with a stabilisation of inflation towards the middle of the target range the ultimate goal, as previously noted by SARB Governor Lesetja Kganyago.
2. Positive investor sentiment fosters stronger exchange rate
High frequency data suggests business conditions may be recovering. The Standard Bank South Africa Purchasing Managers’ Index (PMI) showed improved readings for February 2018, as higher order volumes drove optimism for an upturn in domestic demand – a key countervailing factor, as export growth recently took a dive from the pressure of a stronger currency.
In tandem with local political developments that were broadly viewed as positive by financial markets, the rand exchange rate appreciated by and 17% against the US dollar since mid-November 2017. A stronger exchange rate suggests lower import costs and helps mitigate fuel price inflation.
Recent National Treasury projections estimate economic growth will recover to 1.5% in 2018 on the back of an expected increase in private investment due to improved business and consumer confidence. The RMB/BER Business Confidence Index increased 11 points in the first quarter of 2018 to a reading of 45 points, reaching the highest level in three years. Nonetheless, the marked improvement in sentiment in the wake of positive political developments was unable to lift the index to net positive territory (above a reading of 50).
Key factors in favour of keeping rates stable for longer
1. Tax increases to put pressure on prices
In the annual Fiscal Budget speech, then-Finance Minister Malusi Gigaba announced an increase of one percentage point in value-added tax (VAT) to 15% from April. This will influence the prices of the majority of goods measured by the consumer price index (CPI). Fuel, tobacco and alcoholic beverages, which account for over 10% of the consumer basket, will see further tax hikes. Furthermore, the health promotion levy (“sugar tax”) could add around 10% to the price of sugar-sweetened beverages.
As these tax increases take effect from April, consumers will feel the burden of a jump in prices of various goods and services, which will feed through to higher inflationary outcomes in coming months. The MPC is expected to comment on the expected impact of these tax adjustments on inflation results.
2. Credit rating downgrade still looms
In January, the SARB lowered its inflation projections to 5.2% and 5.5% for 2018 and 2019 respectively, while identifying key upside risks to these projections. The largest risk factor remained the prospect of further sovereign ratings downgrades, which would result in an outflow of capital from the domestic bond market and an accompanied weakening in the rand exchange rate. If Moody’s Investors Service were to downgrade South Africa’s sovereign debt to below investment grade, the volatility for local bonds and the rand would likely disperse hopes of an interest rate cut. Ratings agency Moody’s, the last major agency to hold South African debt at investment grade, is expected to make its latest announcement by Friday, 23 March.
3. Federal Reserve rate decision
The Federal Open Market Committee (FOMC) of the US Federal Reserve is expected to raise interest rates by 25 basis points at the conclusion of its policy meeting on Wednesday, 21 March. The Fed’s interest rate statement will be closely watched for any signs as to the pace of US monetary policy tightening for the remainder of the year. At the close of 2017, the Fed indicated three rate hikes for 2018, but a positive assessment of the economy by new Chair Jerome Powell fuelled speculation about a faster-than-anticipated pace of US monetary policy tightening.
Rapid monetary policy tightening in developed markets can lead to a reallocation of international capital out of emerging markets like South Africa to higher yielding and lower-risk developed markets. The concomitant weakening in the exchange rate raises the risk of imported inflation and would cause the SARB to lean towards a more conservative monetary policy stance.
The balance of risk
In January, policymakers decided to keep rates on hold, with only one out of six MPC members favouring a 25 basis point reduction. The MPC has previously warned that the central bank’s internal modelling guidelines point to at least two interest rate hikes before the end of 2019. Since the January decision, the upside risk to inflation has again become apparent, linked to the increase in VAT and other taxes. Much will hinge on the Moody’s credit rating decision pending towards the end of the week, which will be a factor the MPC will debate at its policy meeting next week. This month’s interest rate decision is scheduled for Wednesday, 28 March.
Maura Feddersen is the Economist at PwC.