Inflation and Rates
food prices have soared
Three powerful exogenous factors affecting the supply and demand of food items across the world are at play:
Despite all this, commodity prices, both soft and hard,
can’t keep increasing forever. At some stage, global commodity price
inflation will moderate, although the risk is that the peak will come
far later and be much higher than expected
SA food inflation is problematic…
In South Africa, a strong driver of food inflation in 2007 was the surge in the maize price thanks to one of the worst droughts in twenty years. Luckily, good rains in late-2007 helped stabilise domestic maize prices and they have since steadied. For 2008, the culprit of food inflation has so far been the domestic price of wheat. In March 2008, spot international wheat prices were up 93% YoY and, because South Africa is a net importer of wheat, this puts pressure on staple food items such as the price of bread.
But, as mentioned, the saving grace for domestic food inflation is the
stabilisation of maize prices. Thanks to maize making up 50% of livestock
feed, meat and dairy products will benefit. And because these two components
have a higher weighting in the overall CPIX basket than wheat-rich components
like bread, we expect food inflation to slow in the coming months, ending
the year in single-digits.
…but overall inflation
is also ticking up
The price of petrol has increased 25.6% YoY on average over the past 6 months. It is therefore no surprise that the transport category increased by an average of 8.8% YoY for the same period. In February 2008, thanks to a 17 cents/litre rise in the petrol price, the growth in the transport category hit double-digits at 13.2% YoY (see figure 2). Add to this diesel prices rising by 46.8% YoY in March (and potential shortages looming in the face of load-shedding) placed further pressure on consumer pockets. If oil prices remain at elevated levels, we can expect transport costs to remain problematic and look for an average increase of 20% YoY for 2008.
Increases in food and transport prices have a disproportionately negative impact on low income groups. These two categories make up more than 50% of the low income consumption basket. As a result, inflation for this group was up 11.9% YoY in February, well above the average 9.4%YoY increase (see figure 3). Therefore, despite nominal wage increases averaging 9% in 2007, an average inflation rate of 6.5% last year means that real wage growth in the public sector slowed to 2.8% YoY.
Ultimately, this means that inflation continues to eat away at consumer’s
pockets across income groups, leaving overall spending slowing substantially.
For 2008, we look for consumer spending to average 3.0% YoY (down from
an average 7.0% in 2007).
Interest rates will remain
high for a long time
If electricity prices rise by 30% in June, we expect this to add about 1.3ppt to the annual CPIX average. At the same time, oil prices may rise further, pushing up petrol prices. Therefore, the upside risk to the inflation outlook for 2008 lies in electricity and transport costs. If electricity prices increase by more than 30% and the petrol price rises further, the year-on-year growth in CPIX would move into double-digits.
In an effort to combat higher consumer inflation, the SA Reserve Bank
has increased interest rates by 450 basis points since mid-2006. Though
inflation is being driven by exogenous factors – mainly food and
petrol, the SA Reserve Bank maintains a strict inflation-targeting policy
with a target range of 3% - 6%. The behaviour of the Monetary Policy Committee
over the past two years suggests that until inflation peaks, the Bank
will remain on watch. Because both the BER 1Q08 survey of inflation expectations
(Figure 1) and the inflation forecast of the SA Reserve Bank deteriorated
significantly in the first quarter of 2008, one last hike in April was
not surprising. And since inflation will take a long time to move back
into the target range, the chance of a cut in interest rates before late
2009 looks slim.
With the US prepared to do whatever it takes to avoid a deep economic recession, the Fed Funds rate looks likely to decline further. This would expand the interest rate differential between South Africa and the rest of the world even more (Figure 5). Under normal circumstances, this would cause the rand to strengthen, as carry trade inflows are attracted by the higher yield in South Africa. However two factors make the carry trade in South Africa less than attractive. Firstly, the real interest rate differential is far less attractive, as Figure 6 shows. Secondly, the uncertain political climate, coupled with doubtful economic conditions and electricity supply constraints all contribute to a negative sentiment in South Africa which makes the rand less than attractive.
Two variables that could significantly change the rate
outlook are rand and oil prices. Our understanding is that when the SA
Reserve Bank updates its inflation forecasting model, they tend to factor
in something close to spot rand and oil prices and then hold these constant
for the duration of the forecast horizon.
However, if the rand continues to weaken further or oil prices go even higher, then a real risk of another rate hike exists.
Our base case is for the rand to stabilise at current levels (ending
the year at ZAR7.90/USD) and we have factored in quite stable oil prices
- though Macquarie’s official view is for prices to fall a bit in
the coming months. Added to this we expect the prolonged rand weakness
and slowdown in consumer spending to result in an improvement in the current
account deficit. We look for an average rate of -5.9% as a ratio of GDP
for 2008. Therefore we see rates on hold for the foreseeable future.
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