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Inflation Vigilantes
By Dr Cees Bruggemans, FNB Chief Economist
13 October 2005
Although the MPC’s decision today to keep the repo rate unchanged (at 7.0%) was widely expected, the tone of the statement was hawkish. This reinforces the cautious note which the Governor struck at the Fedusa conference four weeks ago (see our September Monthlyfor more details). The MPC is clearly concerned about inflation prospects. At the same time, they are decidedly upbeat about the economy.
Despite the possible impact of slower global growth, the MPC comes across as relaxed: activity in most sectors of the economy (including manufacturing) remains “buoyant”, while the composite leading business cycle indicator “shows a favourable outlook”. The MPC went on to say that “domestic demand shows few signs of significant moderation and all components of final demand grew at a healthy rate in the second quarter”. Taken together, this reflects an economy that “continues to perform at a robust rate”.
With the economy in the good shape that it is, it is no surprise that the MPC - as had been the case in August - refrained from expressing their earlier desire for a more competitive rand exchange rate. In the context of rising inflation and rapid growth in final domestic expenditure – much of it financed by increased borrowing - the last thing the MPC now wants is risking a further depreciation of the rand. This is especially the case given the uncertain outlook for oil.
Even though the price of Brent crude has fallen back from its recent highs (and the petrol price looks set to come down as a result), the MPC is not convinced that this is the beginning of a trend, stating that “volatility of international oil prices means that significant upside risk remains”. The MPC’s increased concern about inflation is reflected in their new central projection: instead of their August estimate of a 1Q06 peak of around 5.5%, the Bank now sees CPIX peaking “at a level just below 6.0%” in 1H06, whereafter it is expected to decline moderately.
While the SARB has no control over the direct impact of high oil/petrol prices, they do have leverage over the “ripple-effect” high energy costs might bring about. Although there are currently no clear signs of this, the MPC warned that “the longer the upward trend and volatility of oil prices persist, the more likely the price increases will continue to impact on expectations and feed through to other prices”.
In coming months we expect the MPC to maintain their hawkish tone, stressing that they will not tolerate secondary effects stemming from high petrol and diesel prices. That being said, we doubt if the Bank will act if the status quo prevails: for the moment, non-petrol inflation remains well behaved (at 3.6% y/y in August), while growth in unit labour costs averaged 5.0% in 1H06 - well down from increases seen in previous years. Also, while inflation expectations have deteriorated, they have not done so to the point where the MPC’s credibility as an inflation fighter is in question.
Overall, the October statement indicates the increased concern of the MPC about the inflation outlook. It seems as though the Bank’s central projection is for CPIX to remain above 5.0% over the medium-term. This, combined with the economy growing at (if not slightly above) trend, and credit demand remaining buoyant, does not leave much room for error. We have recently highlighted the risk of a tightening in monetary policy. Although we are not yet at the point of making this our official view, the risk of an early rate hike has increased sharply.
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