The South African Reserve Bank raised its policy rate 25 basis points (bps) to 5.75 percent at its Monetary Policy Committee (MPC) meeting this week.
This was in line with HSBC expectations but consensus was mixed.
It was the first 25bps move since the fourth quarter (Q4) in 2000.
Six of the MPC members voted to hike rates, against one for a hold.
Key forecasts for this year deteriorated, with consumer price index inflation projected to average 6.3 percent (from 6.2 percent) and peak at 6.6 percent in Q4, and gross domestic product growth lowered to 1.7 percent (from 2.1 percent).
Concern over a potential wage-price spiral, the risk that inflation expectations become dislodged, and a decoupling of foreign exchange moves from emerging markets peers seemed key to the decision.
We expect a 25bps hike in September.
Facts
The policy rate was hiked 25bps to 5.75 percent. Six MPC members voted for a rise, with one voting for 50bps, while just one voted for a hold.
The 25bps move was in line with a recent communication from the bank, which had highlighted the efficacy of 25bps changes in the policy rate when it was at low levels.
Market expectations for a change in rates was divided, with 15 of 30 economists expecting rates to be held at 5.50 percent, seven expecting a 25bps hike, and eight expecting a 50bps hike.
The bank raised its inflation forecast for the year to 6.3 percent (from 6.2 percent at the May MPC meeting), with inflation peaking at 6.6 percent in Q4 (previously 6.5 percent).
Inflation is expected to return to the 3 percent to 6 percent target range in Q2 next year, and average 5.9 percent in the year (5.8 percent previously), 5.6 percent in 2016 (previously 5.5 percent), ending the year at 5.5 percent.
The core inflation forecast was unchanged at 5.6 percent this year and 5.7 percent next year, and 5.5 percent in 2016.
The lagged impact of foreign exchange pass-through, rather than demand pressures, are seen as fuelling higher core inflation.
The bank lowered its gross domestic product growth forecast for the year to 1.7 percent (from 2.1 percent in May), 2.9 percent next year (from 3.1 percent), and 3.2 percent in 2016 (from 3.4 percent).
Risks to these forecasts remain skewed to the downside and they assume a speedy resolution of the metal workers’ strike.
The bank expects Q2 growth to be positive but subdued, given the prolonged strike in the platinum sector and its impact on the manufacturing sector, and expects the current strike in the metals and engineering sector to weigh on Q3 growth.
The improvement in the current account balance was welcomed but falling platinum output is expected to put pressure on the current account deficit in Q2.
The MPC statement reiterated that monetary policy decisions would be data dependent and that it believed South Africa was at the start of a policy tightening cycle.
Implications
In keeping with a familiar pattern of recent MPC statements, it outlined the upside risks to inflation, downside risks to growth, and movements in the exchange rate.
The bank’s inflation and growth forecasts worsened, with growth forecasts now closely aligned with HSBC’s views for gross domestic product growth of 1.7 percent this year and 2.7 percent next year.
Yet perhaps the biggest surprises in the statement were some of the messaging around inflation risks and the currency.
With consumer price index inflation accelerating to 6.6 percent in May (and expected to rise further in June), the bank was keen to outline its discomfort with inflation at the current elevated levels. Food prices and currency pass-through are seen as a principal risks to the inflation trajectory.
While the inflation outlook was little changed for the next 12 months, the bank repeated that inflation remained “uncomfortably close to the upper end of the target range when it does eventually return within the target”.
Upside risk factors also make the inflation trajectory vulnerable to any changes in inflation pressures.
In particular, more of the statement was devoted to wage trends and the risks they pose to the inflation outlook.
Indeed, the bank expects these pressures to intensify in the current difficult labour relations environment.
The MPC expressed concern that mine settlements may set a precedent for higher wage deals across the economy and could generate a wage-price spiral, unless accompanied with productivity gains.
The bank also said there needed to be a focus on executive remuneration.
The inflation outlook for next year is subject to additional upside risks potentially emanating from an adjustment to the electricity tariff following Nersa’s review of Eskom’s costs and revenues during the second multi-year price determination.
The MPC statement took comfort in inflation expectations remaining stable and close to the upper target band, but expressed concern that there may be some deterioration in the coming months.
On the currency, the MPC said that since early last month, the rand had decoupled from emerging market peers as it reacted to deteriorating fundamentals, including the Q1 gross domestic product contraction, ratings downgrade and revisions, and protracted strikes.
The bank repeatedly highlighted the role of the strikes in restraining South Africa’s economic outlook and expressed concerns about “weak growth, widening output gap and the negative employment outlook”.
But it reiterated that this was not something monetary policy could ameliorate.
Indeed, the bank said in the statement that “monetary policy should not be seen as the growth engine of the economy”, highlighting the importance of a more conducive labour relations environment and structural reforms, such as those set out in the National Development Plan, to stimulate higher and more inclusive growth.
In summary, the growth-inflation dilemma facing the bank has become more challenging, but the dangers of a wage-price spiral, deteriorating inflation expectations, and unfavourable exchange rate developments within the context of worsening macroeconomic dynamics have prompted a monetary response given the bank’s core mandate of price stability.
We expect consumer price index inflation to rise again in June and average 6.4 percent in the second half of the year, keeping pressure on the real policy rate and pushing inflation expectations of price setters in the economy – business and labour – higher. Based on these factors, we expect another 25bps rise in September.
David Faulkner is an economist at HSBC.