While we expect a 25 basis point hike at the July monetary policy committee meeting this Thursday on the back of the Reserve Bank’s hawkish communication, we do not recommend one.
Consumer and business confidence are suppressed, the industrial sector is at risk of mild recession and the price pressures pushing up consumer price index inflation (CPI) in the targeting period (which is 2016) are either exogenous, statistical base effects or state administered prices (and so cannot be influenced by higher interest rates).
The central bank does not need to hike interest rates to contain inflation from a demand-led point of view, as demand-led inflation pressures are modest, and are likely to remain so over 2016, indicating no need for an interest rate hike.
State administered prices (electricity and water tariff increases, property rates and taxes); exogenous price pressures (rand depreciation and drought induced costs of higher maize prices) and statistical base effects are the key reasons for the higher forecast inflation in 2016 (around 6 percent year on year).
Hiking interest rates in July will not change these exogenous effects, statistical base effects or above inflation target state administered price increases, and so will not alter the inflation outcome in 2016. Furthermore, inflation expectations for 2016 have lifted due to these exogenous effects, statistical base effects and state administered price effects. Hiking interest rates will not change inflation expectations of higher supply-side price pressures for next year, and these increases are already in the pipeline.
However, higher interest rates will quell consumer and business confidence further, negatively affecting the private sector’s will to expand fixed investment and employment, adding to the weakness of economic growth. South Africa has seen economic growth slow steadily from 3.2 percent year on year in 2011 to 1.3 percent quarter on quarter, seasonally adjusted and annualised in the first quarter. This year will battle to make the 2 percent year on year expected economic growth target, with the industrial sector likely to experience a shallow recession and the interest rate sensitive services sector becoming the main growth engine.
Weak economy
The recent International Monetary Fund (IMF) country review of the US recommends that nation delay its interest rate increases until 2016. The US is not expected to hike interest rates before September, with markets expecting the hike to be delayed until December.
From this perspective, there is no need to worry about maintaining South Africa’s interest rate differential with the US in July, as the US is not likely to lift its interest rates. Furthermore, South Africa’s interest rate differential with the repo rate and CPI inflation is positive, and much closer to neutral levels than last year, also signalling no need for a July interest rate hike – given the natural normalisation of interest rates that has occurred.
Indeed, South Africa should not be attempting normalisation of interest rates while the economy is so weak, as this will mean a move away from accommodative to neutral monetary policy. Given the lower actual and potential economic growth that has become the norm, in the face of rising unemployment South Africa needs accommodative monetary policy to support the single cylinder the economy is firing on – the interest rate sensitive services sector.
The economy is not overheating nor causing demand-led inflation pressure to rise. Indeed, it is at risk of seeing economic growth for 2015 slowing to 2014’s strike induced outcome of 1.5 percent year on year, given also the negative impact of the drought on domestic maize, along with the negative impact of low commodity prices and weak global trade volumes on exports, and the effect of electricity supply constraints. An interest rate cut may have limited ability to stimulate growth, but an interest rate hike will potentially slow economic growth given the fragility of domestic demand and confidence.
Hiking interest rates will subdue economic growth further, as South Africa’s interest rate sensitive services sector is the only real engine of economic growth, fuelled by corporate and consumer spending.
* This is an abridged version of a research note put out by Investec Group economist Annabel Bishop ahead of this week’s meeting by the Reserve Bank’s monetary policy committee.
Business Report