Stagflation puts Reserve Bank in difficult position

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No central banker, especially one who has inflation targeting as its main objective, ever likes to hear the word stagflation. This is unfortunately the harsh reality facing the South African economy.

The latest consumer price index inflation release is above the 6 percent target limit, and the most recent gross domestic product (GDP) data has shown that the economy contracted by 0.6 percent in the first quarter. This is the worst position for any central banker, as raising interest rates should successfully contain inflation but at the cost of potentially throwing the economy into a recession.

On the other hand, by cutting interest rates and stimulating the fragile consumer, the Reserve Bank should succeed in reviving the growth outlook, but at the even greater cost of letting inflation spiral out of control.

It should, therefore, come as no surprise that the central bank has decided not to adjust the repo rate at its last two meetings.

So what happened in January, one might rightfully ask? Why did the bank opt to hike the repo rate by 50 basis points to 5.5 percent? One could argue that the international landscape at the time looked somewhat different to what it is now.

The rand had depreciated to R11.30 to the dollar, foreigners were large net sellers of local bonds and other emerging markets were hiking their policy rates to remain attractive to foreign investors.

All these factors left South Africa somewhat vulnerable, and probably forced the bank’s hand in raising rates, although it justified this action by projecting much higher inflation expectations. Add to this the “twin” deficits, which rely on foreign currency inflows for funding, and you get a deadly cocktail if interest rates are not raised. So, the hike steadied the ship again and bought the country some time.

Luckily, the international landscape has changed from January and it seems as if the global hunt for yield is back in play.

How long this situation will last is a difficult question to answer. As long as global liquidity remains elevated, GDP growth continues to recover fairly slowly and global inflation and volatility remain low, this trend can last for a few months longer, but certainly not forever.

Although the Reserve Bank kept rates unchanged at its last two meetings, it has continuously cautioned the market that in terms of monetary policy, the economy is in the middle of a rate-hiking cycle.

Why then, given that growth is so weak, would governor Gill Marcus warn us of this? The large current account deficit is probably one reason. The depreciation in the rand exchange rate should have made our exports more competitive relative to our imports, reducing the deficit. So far, this has not happened and the trade balance has been slow to adjust (not helped by the mining strikes), and it will take higher interest rates to stave off imports that have largely been driven by consumer spending.

Furthermore, with the repo rate currently at 5.5 percent and inflation above 6 percent, the country is one of only a few emerging markets with negative real rates. To be more competitive in the hunt for foreign capital, South Africa will need to offer higher real yields to attract foreign investors. Not being able to fund our deficits through foreign investments will add further pressure to the currency, which in turn will push inflation even higher.

How high can the repo rate go? Current market expectations are for the repo rate to rise to between 6.5 percent and 7.5 percent in two years’ time. Previous hiking cycles have typically been between 400 and 500 basis points (9.5 percent to 13.5 percent in 2002 and 7 percent to 12 percent in 2007/8).

We expect that this time around the cycle might be relatively shallower than these previous ranges.

There is a widely held view that the neutral federal (fed) funds rate has established a much lower range than the prior 4 percent level before the global financial crisis. Market expectations for the fed funds rate are at less than 2 percent in two years’ time, confirming the perception that the normalisation process will take time.

Likewise, taking the lacklustre growth situation in South Africa into account, it could easily be argued that a repo rate closer to 6.5 percent to 7 percent would be considered as neutral in this hiking cycle. The lower neutral repo rate could also have an impact on the 10-year bond yield.

The extract below from the latest Reserve Bank bi-annual monetary policy review best describes its current stance:

“The world economy is back in the start phase of what has been a stop-start recovery, as the Federal Reserve has started tapering its extraordinary stimulus measures. As a consequence, international capital flows have become… erratic, creating new pressures on emerging markets.

“Monetary policy is in a rising interest rate cycle and will align to the speed of global policy normalisation. It will do so, however, within a flexible inflation targeting framework that allows monetary policy committee decisions to remain sensitive to changing data and the fragility of the domestic recovery.”

Globally, economists are optimistic on the outlook for US growth, and inflation appears to have bottomed. The US quantitative easing stimulus programme should end in October if the Fed continues to taper at the current pace of $10 billion (about R108bn) per meeting. This reduction in liquidity will not be positive for emerging market interest rates, and should place pressure on real rates in these countries. Other countries, like Europe and Japan, are still stimulating their economies as they continue to battle deflationary or growth fears.

It is for this reason that US 10-year rates have remained lower than expected in recent months, but this pressure should abate as the US economy and inflation rates start to normalise in the second half.

We continue to remain underweight fixed income as an asset class and will begin to reduce our underweight position as 10-year bond yields rise to our fair value forecast of about 8.75 percent. Further supporting our underweight position is the subdued total return expectation of 4 percent to 6 percent from this asset class over the next 12 months. However, given the expectation that the interest rate hiking cycle may be shallower than previous hiking cycles, we warn against being too pessimistic on this asset class over the medium term.

* Nico Els is the head of fixed income at Ashburton Investments, the asset management arm of FirstRand Group.


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