South African Inflation and Rates
by
Nazmeera Moola and Gina Schoeman

Global food prices have soared
A booming global economy has driven up the prices of commodities worldwide – even staples such as wheat, maize and soya are at all-time highs. Global food prices have more than doubled in the past three years. In March 2008, international food prices were up 56.9% YoY. The run in global commodity prices can be seen in the graph below; after lagging metals for years, agricultural commodities have caught up rapidly (see figure 1).

Three powerful exogenous factors affecting the supply and demand of food items across the world are at play:

  • Poor weather conditions in recent years;
  • Growing income levels in countries such as China has led to a stronger demand for meat;
  • Surging oil prices have boosted the need for alternative energy sources such as biofuels, which in turn consume large amounts of corn, soya and sugar.

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…
After bottoming in March 2005 at a low of 3.6%YoY, consumer price inflation in South Africa (as measured by CPIX) has risen markedly. The latest reading, in February 2008, was 9.4% YoY. One of the main drivers of this upsurge has been food inflation which has, since the start of 2006, increased by an averaged of 8.7% YoY (14.6% YoY in February 2008) (see figure 2). If the soaring food prices were excluded, CPIX would have increased at a much slower average rate of 4.7% YoY since 2006.

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
Soft commodities are only a piece of the inflation puzzle. Overall, consumer price inflation has been ticking up for quite sometime. And despite food inflation contributing a large part of this incessant increase, other factors are also at play.

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
Going forward, we expect that consumer inflation peaked in March 2008 at around 9.5% YoY. Thereafter, the slowdown will be very gradual, with the CPIX only dropping below the 6% target ceiling towards the end of 2009. Part of the reason for this gradual deceleration in inflation is that where food inflation is set to ease, household electricity tariffs are set to surge from mid-2008 onwards. Eskom has asked for a 60% increase to be implemented in June 2008, and for prices to double by 2010.

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.
If the rand were to strengthen significantly over the next few months, there could be a small chance of a rate cut later this year. Similarly if oil prices were to fall sharply – to say USD80/barrel, the inflation outlook would be markedly improved, opening the door for a rate cut within the next twelve months.

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.

Nazreem Moola Nazmeera.Moola@macquarie.com
Gina Schoeman Gina.Schoeman@macquarie.com
Tel +27 11 343 2200  

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