Correct measure of inflation key

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The calculation of consumer price index (CPI) inflation is of crucial importance for South Africans, as it determinates the outcome of inflation and so the decision to change interest rates at the Reserve Bank.

CPI inflation is the measure targeted by the Reserve Bank, and as such it is the survey method, choice of items included and weighting of the prices consumers face at the tills that count.

Administered price inflation, or state controlled inflation, has seen a heady increase of 64.6 percent since the start of 2009 compared to the 29.5 percent increase in the overall CPI inflation rate in the same period. State controlled prices include electricity tariffs, water tariffs, property rates and taxes, petrol and diesel prices and the cost of public transport.

Indeed, according to the publication “2013 State of City Finances” households living in properties of over R1 million in value in major metropolitan areas have seen the cost of their municipal services rise by 37 percent in real terms (over and above inflation) between 2009 and 2012. This implies close to an 80 percent increase in the combined cost of water, electricity, sanitation, refuse removal, property rates and taxes etc between 2009 and 2012.

Statistics SA data shows that the cost of electricity has risen by 103 percent since 2009 and the cost of water by close to 70 percent on average, which has driven administered price inflation higher.

In its monetary policy deliberations the Reserve Bank pays close attention to what is deemed the core rate of inflation, namely CPI excluding the prices of food, petrol, electricity and non-alcoholic beverages.

This is because core inflation provides a better estimation of the underlying trend of inflationary pressures driven by demand. Food (and non-alcoholic beverage) prices can be affected by drought, rand volatility or global supply issues, while the petrol price is determined by the dollar price of international petroleum products, and electricity prices are set by the public authorities.

The latest data shows this measure of core inflation was running at 5.3 percent year-on-year in December last year, but the question is whether it is indeed the most appropriate measure given that it does not exclude all state administered prices.

CPI inflation excluding all administered prices was 4.8 percent year-on-year in December, and is clearly a better measure of demand pressures in the economy as both electricity and water tariffs are rising due to the expansion of infrastructure.

Even using a core inflation rate excluding the cost of water, as well as the prices of food, petrol, electricity and non-alcoholic beverages, would provide a better measure of demand driven inflation pressures.

The reason this is key is that the Reserve Bank hikes interest rates in order to attempt to quell future increases in inflation, that is to attempt to keep CPI inflation running between 3 percent and 6 percent. Specifically, if the monetary authorities think that CPI inflation will exceed the 3 percent to 6 percent target band for a sustained period over the next six months to two years they will likely increase the repo rate.

However, if it is state administered prices that are driving CPI inflation toward the 6 percent mark, as can be seen by the difference between CPI inflation excluding administered prices which is 4.8 percent year-on-year and the CPI inflation rate which is 5.4 percent year-on-year, then increasing interest rates to bring down mainly the state controlled inflationary pressures in CPI inflation makes less sense.

Administered price inflation is high, at 7.8 percent year-on-year, well above the CPI inflation rate targeted by the Reserve Bank. CPI inflation excluding administered prices had fallen to 4.8 percent year-on-year by the end of last year, from 5.3 percent year-on-year in August and this decline in demand led inflation shows that individuals are already tightening their belts due to slowing real growth in disposable incomes, high debt levels, rising delinquencies (60 percent of credit active individuals are 30 days or more in areas in repayment of a debt) and rising impairments (50 percent of credit active individuals are 90 or more days in areas of repayment of a debt or have a listing or judgment against their name).

The Reserve Bank said recently that “should the interest rate cycle turn, at the current elevated debt levels, the household sector and related credit providers exposed to this sector could be very vulnerable”.

Growth in consumer spending has been weakening significantly due also to deteriorating sentiment about the future as employment conditions in the private sector remained weak, and a tightening in lending criteria. With consumers already showing self-limiting behaviour in demand for goods and services, with many consuming less as evidenced by lower reported volumes by many retailers, it would appear the Reserve Bank does not need to tighten interest rates materially, unless this nascent trend of falling demand led inflation reverses. However, rand weakness has had a negative impact on sentiment, with many now of the view that interest rates will rise further this year.

Given that the true measure of core inflation, CPI less administered prices is falling, such interest rate hikes would be in response to the rand weakness, not demand levels in the South African economy which are proving to be relatively muted, demonstrated also by the fact that there has so far been no pass through or second round effects from the rand’s depreciation on CPI inflation.

The effective rand has weakened by 19 percent year-on-year, namely against the currencies of key trading partners, and this weakness has caused concern that it could lead to higher inflation expectations this year, and higher future CPI inflation.

The effective rand depreciated by 18 percent year-on-year last year and this depreciation was not translated through into higher CPI inflation, with CPI inflation falling instead from 6.4 percent year on year to 5.4 percent year on year.

 

Annabel Bishop is Investec Group economist



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