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February 2006 MPC Meeting
Dr Cees Bruggemans, Chief Economist, First National Bank
3 February 2006
The February 2 meeting was the second consecutive one at which the MPC had lowered its inflation forecast. Whereas CPIX was previously expected to end 2007 at 5.0%, the Bank now sees it at 4.7%. At this level, inflation would be barely above the midpoint of the inflation target range. That interest rates were left unchanged notwithstanding, suggests that the MPC currently sees the risks to its inflation forecast as titled to the upside. The essence of the statement is captured in the last paragraph: "There are significant risk factors to the inflation outlook that the Monetary Policy Committee is mindful of. Nevertheless, the Committee has decided for now to leave the repo rate unchanged".
So why the cautious stance when some weakness has emerged in the manufacturing sector, world inflation is under control and growth in wage settlements is decelerating? While these factors may have played a role in deriving the new CPIX forecast, we get the impression that the main reason was that the Bank raised its rand forecast. If this is correct, the MPC would also have accepted along with the revised rand assumption, the negative impact currency strength is likely to have on economic growth. In other words, indications of "a general slackening in manufacturing growth", is not an overriding concern at this stage.
In addition, the MPC identified three main risk factors namely: domestic demand, oil and food prices. Most attention was given to the current strength of domestic expenditure. Although not posing an immediate inflationary threat, it would do so if it "were to accelerate unchecked". The committee went on to describe the recent buoyancy in consumer confidence, retail sales, as well as credit extension, where they highlighted the particularly strong increase in asset backed credit.
It was significant that the MPC related the strength in domestic demand to the wealth effects emanating from sharp increases in property and share prices. This is not to say that the Bank now also targets asset prices, but it does show that the MPC is concerned (as are other central banks) about rising asset prices triggering excessive household borrowing which, in turn, could ultimately be a threat to price stability. While this is not spelt out, it may also be that the MPC is concerned that rising asset prices make people feel wealthier and less inclined to save, thereby boosting spending. Much of the increase in domestic expenditure has also found its way into higher imports, which has contributed to a widening current account deficit.
Over and above the risk that domestic demand poses to the inflation outlook, oil and food prices were also highlighted as concerns. The MPC noted that since the previous meeting (December 8), the price of Brent crude oil has risen from $55 per barrel to $65 per barrel. "Apart from continued strong demand for oil, upward pressure on prices has emanated from supply related geo political concerns." Neither of these two reasons for higher oil prices is likely to disappear any time soon.
Higher meat prices were solely responsible for the jump in December's CPIX food component. Recent strong growth in household incomes (together with demographic changes) has increased the demand for meat, placing upward pressure on prices. To this extent, food prices cannot be regarded as an exogenous factor, but as a result of the strength of domestic expenditure. While food price inflation has historically been driven by cost push factors, recent trends suggest that more concerning demand pull factors are involved.
Things can of course still pan out differently from the MPC's base case assumption. However, given how the Bank currently sees the risk distribution around its central inflation forecast, we are now more comfortable than before with our "no change" interest rate outlook for this year.
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