Inflation - and interest rates - will things get worse before they get better?

There is worse to come for embattled consumers facing inflation that spiked at 7.4% year on year this week causing the South African Reserve Bank to respond by hiking interest rates by an unusually large 0.75%. File Image: IOL

There is worse to come for embattled consumers facing inflation that spiked at 7.4% year on year this week causing the South African Reserve Bank to respond by hiking interest rates by an unusually large 0.75%. File Image: IOL

Published Jul 26, 2022

Share

By Laura du Preez

There is worse to come for embattled consumers facing inflation that spiked at 7.4% year on year this week causing the South African Reserve Bank (SARB) to respond by hiking interest rates by an unusually large 0.75%.

On top of shocking fuel price, grocery and other increases, you should expect inflation to get worse and more big rate hikes.

Zisanda Gila, senior portfolio manager in fixed income at Momentum speaking at an Actuarial Society of South Africa investment conference this week, revealed that Momentum was expecting further large rate hikes this year and following the SARB interest rate hike, Momentum updated its forecast to a further 0.75% percent increase in September and another 0.5% in November.

Melanie Stockigt, portfolio manager at Laurium, speaking at the same conference said inflation would probably reach 8% this quarter before it peaked.

Stockigt says the spike in the inflation rate was a result of the increases in food and fuel prices on the back of the Russian invasion of the Ukraine.

These countries are important suppliers of oil, wheat and fertiliser, which is required to produce much of the food we eat.

Food and transport make up 25% of the basket of goods and services that is tracked to measure inflationary increases in prices.

Gila and Stockigt shared a platform with Sanisha Packirisamy, economist at Momentum. All three agreed that the SARB was managing interest rates well and that the short-term pain rising rates delivers to consumers with debt is worth it.

The three investment specialists explained how the SARB needs to act swiftly to contain inflation expectations and curb further increases.

Curbing inflation expectations

Central banks like the SARB have to consider what expectations role players in the economy will have about inflation, Stockigt said.

The Reserve Bank needs to stop those playing a role in the economy from thinking that current high inflation is a permanent feature and hiking the costs of goods and services they provide accordingly, she says.

Before Covid it was widely accepted that the inflation rate in South Africa was 6%, prices were regularly increased by 6% or more and wage and salary earners demanded 6% increases.

The Reserve Bank worked very hard to combat this view and to bring inflation expectations down to 4.5% - the mid-point of its inflation target of 3% to 6%.

In order to do so, the local central bank ran interest rates quite high relative to what many people thought interest rates should be since South Africa needs to spur economic growth, Stockigt says.

But the SARB’s work paid off as inflation expectations then came down to 4.5%.

Stockigt says now that inflation has spiked at 7.4% and is likely to reach 8% before it peaks, it is important for the SARB to act quickly by hiking interest rates to contain inflation and the belief that it can manage the situation.

Price stability

Packirisamy says the main role of a central bank is price stability and to try to contain costs and protect consumer’s purchasing power.

She says a prime example of a central bank gone wrong was in Turkey where the bank was not independent and took instructions from Prime Minister Recep Tayyip Erdoğan. The official inflation rate there now is 74% and estimates are that the real inflation rate is closer to 160%, she says.

The Turkish lira has devalued massively as a result, Packirisamy says.

Avoiding the US situation

Gila says it is fair to say the SARB is doing a great job to contain inflation. It wants to avoid the ending up in a situation like that in the US where inflation is now running at 9.1% as its central bank, the Federal Reserve, initially under-reacted to increases in inflation.

It is now being forced to catch up with interest rate increases in larger increments, she says.

Packirisamy says it was ironic that US inflation was now so high just a few years after concerns about inflation there slowing.

Inflation in the US – as is the case for many countries around the world - was affected by a shortage of manufactured goods after lockdowns in the early stages of the Covid-19 pandemic disrupted production supply chains.

During the pandemic, the government there and in some other countries, provided relief to businesses and consumers, so that when lockdowns were eased, cash-flush consumers had a demand for goods that were in short supply. This resulted in demand-led inflation on top of the cost-push inflation, Packirisamy says.

US inflation was then further impacted by the Russian invasion as well as another round of Covid cases in China. Strict lockdowns in China exacerbated supply chain problems, Packirisamy says.

Slamming on brakes

Stockigt says normally equities are a good hedge for inflation – if inflation rises, so do equity returns.

But inflation isn’t normally as bad as it is now and that is a reason why global equity returns are down year to date, she says.

Instead of gently tapping the interest rate brakes to slow inflation, the Federal Reserve reacted belatedly but it is now slamming on the brakes at the risk of a recession in the US economy.

This affects equity valuations as future company earnings need to be discounted, Stockigt says.

In addition, the Federal Reserve is no longer in a position where it can spend to support the economy should a recession arise because unemployment is low and inflation is high, she says.

Inflation in the US may have peaked and oil prices may come down, but because inflation has spread into the broader market it is likely to remain higher for longer, she says.

Bond markets have also changed rapidly. The change in interest rates as well as the fact that Federal Reserve is now selling bonds – including corporate bonds - instead of buying them, has made US bond yields turn negative, she says.

Look long term

Packirisamy says investors get very worried about their portfolios when there are market dips like the current one for global equities. But you do not have to react to every dip – focus on the long term as over longer periods equities can give you quite a decent returns, she says.

Local bonds are very different to global ones, Stockigt says, and if you focus long term and believe in the Reserve Bank’s ability to bring average inflation down to around 5%, this can help you to make investment decisions.

Longer-dated bonds are currently yielding 12%, partly as a result of investors globally selling off emerging market bonds, including ours, she says.

This means you can get a real (after inflation) return from local bonds of 7%, she says.

This article was originally published on SmartAboutMoney.co.za, an initiative by the Association for Savings and Investment South Africa (ASISA)

BUSINESS REPORT