It is unlikely the Reserve Bank will hike interest rates at its MPC meeting, says Annabel Bishop.
Johannesburg - After the 0.5 percent rise in the repo rate in January, the SA Reserve Bank (SARB) governor said future interest rate hikes would be measured, a word which usually means considered, careful and calculated. Furthermore, the governor said the future trajectory of interest rates would prove to be data dependent.
Since the January monetary policy committee (MPC) meeting, the rand has strengthened to a best point of R10.61 a dollar, R14.65 a euro and R17.76 a pound, from R11.29 a dollar, R15.41 a euro and R18.69 a pound, as the Budget on February 26 showed strong measures on all fronts to ensure fiscal consolidation, and so was viewed as credit neutral to positive by the rating agencies.
We continue to believe that the SARB is over-estimating consumer price index (CPI) inflation for this year. With exogenous pressures on the targeted measure of inflation lessening as the rand has retraced, future domestic grain prices have fallen as the drought has been broken and a petrol price cut (albeit small) is priced in, the impetus for an interest rate hike this month has lessened.
This is reflected partially by the forward rate agreement (FRA) curve, however, which is still pricing in the greater chance of a 50 basis point hike rather than no change. For this reason the SARB has likely increased its guidance of a modest, measured higher interest rate trajectory, versus the market expectation of an immediate 50 basis point rise and a further 100 basis point by year end.
We continue to believe that the likelihood of the SARB pausing, and not hiking the repo rate on Thursday, is higher than the likelihood of a second 50 basis point hike this quarter. The economic data since the January MPC meeting shows confidence continues to deteriorate (move deeper into negative territory) in the business sector (Rand Merchant Bank/BER business confidence index, or BCI), with 60 percent of respondents stating that operating conditions are wholly unsatisfactory.
The release says that its “BCI has been a good early indicator of turning points in the business cycle”, and business confidence has been in negative territory for over a year, which is concerning as it indicates that the underlying momentum in the economy is slowing.
The SARB leading indicator is also signalling likely future economic weakness (potentially from mid-year) as it dropped lower over the past three consecutive months’ readings.
Furthermore, the business activity index in the Kasigo purchasing managers’ index (PMI) – a survey of manufacturing activity – has remained below the contractionary mark (50) for three months, while the overall PMI reading has climbed above 50 on the sharp rise in its constituent price index following rand weakness.
With 59 percent of household debt comprised of mortgages the January interest rate hike has had a direct and immediate impact on household finances (the leasing and instalment category that vehicle finance falls into accounts for a further 17 percent of household debt). The slowdown in growth in car finance began last year as real disposable income growth slowed and household consumption expenditure (HCE) growth along with it.
Growth in mortgage advances has dropped from above 30 percent year on year in 2008 to around 2.5 percent as the 2009 recession saw house prices fall and provision of credit tighten. Mortgage advances as a percentage of total credit extended to the private sector has declined materially, but the SARB should not mistake this as an indication that household finances are strong enough to withstand a series of interest rate hikes.
Instead, the retreat in growth in mortgage advances has occurred from the unsustainable pace reached in 2008 when the housing market approached bubble territory. Households’ usage of overdrafts make up only 3 percent of debt and credit cards 7 percent, with the remaining 14 percent other loans and advances. Unsecured credit extended to households is estimated at 24 percent of total household credit, up from 15 percent in 2009, although the pace of growth has slowed to 8.9 percent year on year from above 30 percent in 2012.
Indeed, growth in overall private sector credit extension to households has declined to a low 5.6 percent year on year, from 10 percent at the start of last year, and from 25 percent in 2008. Averaging 6 percent in the fourth quarter of last year, well below the nominal gross domestic product (GDP) growth rate of 7.7 percent, growth in credit extended to households is definitely not inflationary and so the data does not indicate the need for higher interest rates.
With real disposable income growth slowing and impairments and delinquencies rising (now 50 percent and 60 percent respectively), the financial health of households has deteriorated markedly, and with it tolerance to higher interest rates. Interest rate hikes this year will slow growth in credit provided to households, inhibiting household spending and domestic demand.
Growth in private sector fixed investment is also expected to remain modest (as the impetus to expand capacity, including increasing employment, is poor on moderating demand).
Furthermore, household debt as a percentage of disposable income is most recently reported at 74.3 percent (for the fourth quarter of last year), down from 75 percent in the third quarter and 83 percent in 2009, but well above the 50 percent to 60 percent of disposable income recorded in the late 1990s and early 2000s, when the prime lending interest rate averaged 16 percent.
With household debt levels 20 percent higher as a percentage of disposable incomes, households will be more sensitive to interest rate hikes (and high interest rate levels), and consequently monetary tightening can be modest this year, but still have a substantial impact on demand-led inflation. Households were in a process of financial consolidation before January’s interest rate hike, and were not in a position to absorb the additional 1.5 percent expected in the markets (over and above the 50 basis point hike in January) without cutting back on expenditure.
The FRA curve is showing interest rates up by 2.5 percent by the end of next year (up 1.5 percent this year), which would translate into a repo rate of 8 percent and a prime lending rate of 11.5 percent by the end of next year, if the SARB followed suit, which we do not expect. The SARB has also signalled this is unlikely. Should such hikes materialise GDP growth would fall below 1 percent this year and next year, and below 2 percent in 2016.
In January, the FRA curve indicated a 50 basis point hike and this is what transpired at the MPC meeting with no prior SARB commentary to the contrary. The FRA curve again predicts a 50 basis point hike at the next MPC meeting, but the SARB has said repeatedly that the current hike scenario of the FRA curve is overdone, the pace of interest rate increases is likely to be (more) measured, and monetary tightening will be highly data dependent.
This would seem to imply that the MPC will leave the repo rate unchanged, given the marked SARB communication ahead of the meeting and lack of such communication in January.
The guidance from the Reserve Bank is not clear cut as it indicates that should circumstances warrant it, it will hike. But the latest data on household demand, incomes, debt, financial health and jobs to date do not include the impact of the January interest rate hike, but already clearly show that another interest rate hike is not warranted this quarter as demand is slowing noticeably.
The output gap is negative as GDP growth is closer to 2 percent than the potential growth rate of 3.5 percent, which argues against a hike.
CPI inflation rose to 5.8 percent in January from 5.4 percent, partly a function of a higher petrol price and partly due to the start of the year price rises in reaction to the marked rand weakness last year. CPI inflation ticked up slightly last month, to 5.9 percent, just below the 6 percent year-on-year upper limit of the 3 percent to 6 percent inflation target range, on the usual annual rise in medical aid costs. But there was clear evidence of the waning impact of previous rand depreciation.
CPI inflation this month is likely to drop towards 5.6 percent, if not actually come out at 5.5 percent as the petrol price increase of 81c/litre in March last year created a high base, and petrol prices only rose by 36c/litre in this month. An 11c/litre petrol price cut is likely for next month due to the rand’s retracement from previous depreciation early this year, and should a petrol price cut occur then CPI inflation could remain around the 5.5 percent mark next month, which would further reduce the need for another interest rate hike in the first half of this year.
Local unit to firm
* We continue to believe that the SARB is over-estimating CPI inflation for this year. If surveyed CPI inflation (the BER inflation survey) shows no deterioration in the forecasts in a 12-to-18-month target period then it is unlikely the SARB will hike interest rates at its MPC meeting.
* The Reuters consensus shows CPI inflation expectations for next year have fallen to 5.6 percent from 5.7 percent in the latest survey, and are unchanged at 5.5 percent for 2016. This implies that there is no onus to raise interest rates as a consequence of the Reuters EconoMeter survey. Indeed CPI inflation is expected by the consensus to be lower than previously believed over the majority of the SARB’s inflation target period.
* In January, the SARB revised its forecast for this year up sharply to 6.3 percent from the 5.7 percent previously forecast. The MPC’s CPI inflation forecast for next year rose to 6 percent from 5.4 percent. Both its CPI inflation forecasts for this year and next are well above those of the latest Reuters EconoMeter survey.
* Given the recent retracement in the rand, we expect no further deterioration in the SARB inflation forecasts.
* We expect a moderation of 0.2 percent in the SARB’s CPI inflation forecast this year on the recent plunge in maize future prices given prolonged, widespread rains that broke the drought and made a bumper grain crop likely, the retracement in the rand and potential petrol price cut. This CPI and food price data also imply no repo rate increase is needed this month.
* The Budget gave no reason to instigate a credit rating downgrade, and the rand consequently firmed. As domestic monetary policy ceases to be accommodative and the normalisation of interest rates occurs (initially on concerns of somewhat higher domestic inflation following rand depreciation after quantitative easing (QE) tapering began), so the fiscal policy will need to move toward neutrality over the next couple of years.
* A small tightening in domestic monetary policy is likely, as the US potentially hikes interest rates by 4 percent by 2018, and South Africa maintains its interest rate differential.
* A future tighter monetary space (higher domestic interest rates) means government must get its finances in order to reduce upward pressure on inflation (particularly above inflation salary and wage increase of civil servants), and so not counteract monetary policy.
* Furthermore, avoiding a rating downgrade via fiscal rectitude reduces pressure on the rand, and so assists in moderating inflation. Fiscal policy will need to become neutral and cease being counter-cyclical.
* SARB has said achieving the midpoint of the inflation target range will require a strong monetary policy response. This implies CPI inflation will likely be tolerated at the upper end of the 3 percent to 6 percent band (but not outside on a sustained basis) this year and next, as long the output gap remains negative.
* Future grain prices have plummeted on good rainfalls and food prices should benefit later in the year, particularly meat prices as recent good rains mean the quality and quantity of grazing and winter fodder will improve. Future maize prices have come off substantially on the rains, with lower white maize prices positive for food price inflation and hence the CPI, and lower yellow maize prices will also lower the future cost of poultry.
* Additionally, global food price deflation will also exert some downward price pressure in the first half of this year. CPI inflation excluding state administered prices (“demand-led” inflation) moved up to 5 percent in January, from 4.8 percent in December, on higher food price inflation (maize recorded a record price high) at that time exogenously led by rand weakness and poor (drought) weather conditions.
* This highlights the difficulty in obtaining a true measure of demand-led inflation, one that excludes both state administered prices, the direct impact of rand weakness on US dollar-based commodity prices (which includes agricultural food) and the impact of the weather on food.
* The current account deficit has narrowed on a moderation in the trade deficit in the fourth quarter of last year, but this is likely a temporary reprieve and will widen in the first quarter of this year not on consumer imports, but rather capital equipment for the public sector, oil and inputs for domestic production as evidenced by the January trade deficit of minus R17.1 billion.
* Interest rate hikes will not narrow the current account deficit meaningfully as over half of it is consistently composed of the services and income account, mainly coupon and dividend payments to foreigners (3.1 percent of GDP for the fourth quarter of last year with the current account running at 5.1 percent of GDP) and Southern Africa Customs Union payment transfers (minus 0.7 percent of GDP).
* The smaller remaining part of the current account is the trade deficit (minus 1.3 percent of GDP in the fourth quarter of last year), and the bulk of the trade deficit is oil and capital equipment, with consumer goods in third place. Foreigners sold R20bn of bonds net of purchases, and R26bn net of purchases in the first quarter.
* The announcement in the middle of last year of the advent of future QE tapering precipitated the rand’s weakness, with the domestic unit weakening much less in comparison when actual QE tapering began in December.
The new Federal Reserve Bank chairwoman, Janet Yellen, will preside over the third Federal Open Market Committee meeting since QE tapering began and is expected to stick to the path established by her predecessor.
* The deterioration in growth in production in China, in particular, has led commodity prices lower, with the rand additionally weakening on the negativity afflicting emerging markets as the tide flows out with QE tapering and those emerging markets with fundamental economic and political problems become exposed.
* We continue to believe that the rand will strengthen back to its purchasing power parity value by 2016.
* Annabel Bishop is Investec Group economist.