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Good Reasons for a Rate Hike
From FNB
1 September 2006
Seasonally adjusted and annualised real GDP rose 4.9% in the second quarter of 2006, up from 4.0% in the first. Driving this outcome was faster growth in mining, manufacturing, wholesale/retail trade and transport. While the headline number is no doubt impressive, some perspective is nevertheless required.
Even though real GDP growth accelerated to 4.9% in the second quarter, measured over a 12-month period, activity continued to slow down. Following year-on-year rates of 4.6% in the third quarter of 2005, growth eased to 4.2% and 4.1% in the first and second quarters of this year. The slowdown is due mainly to agriculture, but also because of mining output which is still 2.6% lower than at the same time last year.
Various factors look set to influence growth in 2006 and 2007. Although still relatively low, rising inflation and interest rates should curb consumer spending in the second half of the year and beyond. There will be knock-on effects of this on wholesale/retail trade as well as on finance and real estate. Also having a dampening affect on activity this year and next ought to be a US-led slowdown in global demand (with concomitant downside risks for international commodity prices).
Weighed against these negative factors are the positive influences expected to result from a weaker rand, along with the direct (and indirect) effects of higher government infrastructure spending, as well as likely ongoing strength in corporate fixed investment. Moreover, there is the prospect of a better agricultural crop in 2007, as farmers raise plantings in response to higher prices this year. On balance (and considering last year's high base), real GDP growth should ease from 4.9% in 2005 to a little above 4.0% this year and in 2007.
With growth expected to slow, the gap between the actual growth rate and the Reserve Bank's estimate of "potential growth" will narrow (or perhaps even disappear). The difference between actual and potential growth (or the "output gap") is used by the Bank as one indicator of likely future inflationary pressures. With the prospect of this gap narrowing or even closing, does it mean we have reached the end of the interest rate hiking cycle? We think not, for the following reasons:
Firstly within the framework of inflation targeting, maintaining price stability is the Reserve Bank's single most important objective. Growth is secondary, or at least a longer-term goal. Also, since underlying growth momentum appears such that the economy should expand at a rate in line with potential growth of around 4.0%, the MPC is probably of the view that it can raise interest rates further without causing undue damage.
Secondly, while inflation should ultimately follow growth lower, for the moment, evidence of price pressure is mounting. Data for compensation of employees showed a 9.2% year-on-year increase in the second quarter of 2006. Although unchanged from the quarter before, it is still higher than the 8.3% recorded early last year. Anxious about the impact of wages on inflation, the MPC is likely to remain cautious on inflation prospects.
And so it should, considering other developments at the producer level. In July, PPI inflation rose to 8.1% year-on-year, up from 7.5% in June and 5.9% in May. Momentum indicators are equally disconcerting: on a quarter-on-quarter seasonally adjusted and annualised basis, PPI inflation is running at 15.0%. Although there is only limited evidence of increased PPI inflation feeding into higher retail prices up to now, inflation risks are clearly skewed to the upside.
Thirdly following the struggle of the past two years, the improved performances from mining and manufacturing of late, must be welcomed. That said, the strong recent acceleration in consumer spending (and to a lesser extent fixed investment) point to little (if any) improvement in the gap between demand and supply. Although we expect higher borrowing costs to eventually contribute to a more balanced growth dynamic, in the interim the MPC is unlikely to rest easy given the dangers posed by the significant current account deficit to the rand and inflation outlook.
Original articles published at www.fnb.co.za.
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