Issued by Mr T T Mboweni, Governor of the South African Reserve Bank
The South African economy is continuing to show signs of robust growth and inflation has remained at low levels. Since the last meeting of the MPC, international oil prices have risen to new highs, the rand exchange rate has appreciated moderately and domestic expenditure has remained strong. Oil price increases could be a major source of inflation pressure and pose the greatest risk to future inflation outcomes.
Improved international perceptions of South Africa have been reflected in developments during the past two months. The recent ratings upgrade by Standard and Poor’s of South Africa’s external debt rating to BBB+, the completion of the purchase by Barclays Bank plc of a controlling share in Absa Bank and the recent successful conclusion by the SA Reserve Bank with 33 banks of a $1.5 billion dual-term syndicated loan facility at far more favourable margins reflect the growing positive sentiment towards South Africa by international investors. In conjunction with the higher level of foreign exchange reserves, such developments can be expected to underpin a greater degree of stability of the macroeconomic environment.
Recent inflation developments
Inflation as measured by the consumer price index for metropolitan and other urban areas excluding the interest cost on mortgage bonds (CPIX) has remained within the inflation target range of 3-6 per cent for the past 22 months. For the past three months, CPIX inflation has been below the market consensus forecasts. In June, CPIX inflation was 3,5 per cent, down from the 3,9 per cent measured the previous month. The lower inflation has become increasingly broad-based, and a significantly larger number of categories of goods and services are now within the inflation target range. Prices have continued to decline in a number of categories, including clothing and footwear, furniture and equipment and some food items such as vegetables and grain.
Although services inflation has been declining in recent months there is still a significant difference between goods inflation and services inflation. In June, for example, services inflation measured 6,1 per cent compared to 2 per cent for goods inflation. Although the decline in services inflation has been slow, it nevertheless compares favourably with the 7,0 per cent measured in June 2004. Part of the sluggishness of services inflation can be attributed to the behaviour of administered prices excluding petrol. Although administered price inflation declined significantly from the middle of 2003, since mid-2004 it has remained relatively unchanged. In May and June 2005, administered price inflation excluding petrol measured 7,0 and 6,9 per cent respectively.
Production price inflation has also remained subdued. In June 2005, the percentage change over twelve months was 2,3 per cent, compared to 2,4 per cent the previous month. Although imported goods prices showed an increase from 1,8 per cent to 3,4 per cent from May to June, prices of goods produced domestically rose at a year-on-year rate of 1,9 per cent, down from 2,6 per cent the previous month. This decline was mainly a result of falling prices in the agricultural sector.
The outlook for inflation
The central outlook for inflation remains generally favourable and CPIX inflation is expected to remain within the 3 to 6 per cent target range for the forecast period to the end of 2007. Although the inflation rate over the past few months has been below 4 per cent, it is expected to increase over the next few months, partly as a result of the higher petrol prices. According to our central forecast, CPIX inflation will begin to rise moderately and peak in the first quarter of 2006 marginally below 5,5 per cent, whereafter it is expected to decline moderately. This is marginally higher than the previous forecast and reflects changes in oil price and exchange rate assumptions.
The favourable inflation outlook is underpinned by a number of factors which have improved since the previous meeting. These include the low food price and producer price inflation, and the lower than expected inflation outcomes referred to above.
Since the last MPC meeting there has been a moderate appreciation of the exchange rate of the rand. At the time of the June meeting the rand was trading at a level of around R6,80 to the US dollar. Since then the dollar has weakened against the euro. Having reached a level below US$1,19 to the euro, the dollar is currently trading at levels of around US$1,24. This development explains in part the strengthening of the rand exchange rate to current levels of around R6,37. A further factor that contributed to the strengthening of the rand was the ratings upgrade from Standard and Poor’s. On a trade-weighted basis, the rand appreciated by 6,8 per cent in the period following the last MPC meeting, although it has depreciated by 6,1 per cent since the beginning of the year. The rand will continue to be influenced mainly by dollar developments, which remain uncertain.
The trend of wage settlements and unit labour costs are closely watched by the MPC. At the April meeting we commented on the divergence between wage settlement trends and unit labour cost trends. Although we would not expect these two measures to coincide exactly, they should move in broadly the same direction. Since then there has been greater consistency in the two measures. In the first quarter of 2005, unit labour costs in the non-agricultural sectors increased by 5,9 per cent, compared to the first quarter of 2004. This was a decline from the revised figure of 9,8 per cent measured in the fourth quarter of 2004. Average wage settlements, as surveyed by Andrew Levy Employment Publications, were 6 per cent for the first half of 2005, compared to 6,8 per cent in 2004 as a whole. Although it is too early to tell if this lower trend will continue, it is a positive development from an inflation perspective. However, much will depend on the outcome of the current round of wage negotiations that are taking place in a number of sectors.
Fiscal policy continues to be supportive of monetary policy. Despite the mildly expansionary budget tabled in February this year, the tax revenues in the current fiscal year have to date significantly exceeded budgeted revenues, primarily as a result of higher-than-expected corporate taxes. Expenditure is broadly in line with budget. Given the volatility of expenditures and revenues, it is probably premature to draw firm conclusions about the likely fiscal outcome for the year, but it appears unlikely that the budgeted deficit will be exceeded.
International developments remain broadly supportive of a favourable inflation environment. Although there are some signs of inflation pressures in a number of countries related to oil price increases, the longer term outlook remains benign. Interest rate trends have varied, and in general, interest rates in fast-growing countries such as the United States have been increasing, while those in the slower-growing economies have either remained unchanged, as in the euro area, or have recently declined, as in the United Kingdom and Sweden.
There are however a number of threats to the inflation outlook. The most significant emanates from the international oil prices which have reached new record highs in recent days. The monthly average spot price of Brent crude oil increased from US$53,86 per barrel in June to US$57,49 in July. Since then prices have breached the US$64 per barrel level, and prices for future delivery over the next three months are currently above this level as well. These price increases have occurred despite several increases since 2004 in the official production quotas of the Organization of the Petroleum Exporting Countries (OPEC). The full impact of these developments are yet to be reflected in the inflation numbers. In July and August the petrol price increased by a total of almost 60 cents per litre, and the current underrecovery points to a further possible increase in September. The recent strengthening of the rand against the dollar has, however, helped to mitigate the impact of the rise in international crude oil prices on domestic petrol prices.
Although GDP growth figures for the second quarter of the year are not yet available, indications are that the real economy has continued to grow at a robust pace. The composite leading business cycle indicator has increased significantly since March of this year and initial indications are that this indicator will increase further in June. Manufacturing production appears to have recovered from the slowdown experienced at the end of 2004. Manufacturing production increased by 3,2 per cent in the second quarter of 2005, following a contraction of 1,9 per cent in the first quarter. The Investec/BER Purchasing Managers Index (PMI), which reached its highest level ever in June, indicates that this recovery is expected to remain intact. The various business confidence and trade activity indices also show that expectations are strongly positive. Mining production has also remained strong, with the seasonally adjusted physical volume of total mining production for the three months to May 2005 reflecting a 4,1 per cent increase compared to the preceding three months.
According to surveys, consumer confidence is also still at a high level, and consumption expenditure appears to be continuing at a strong pace. New vehicle sales peaked at record levels of 31 per cent year-on-year growth in June, although this rate of increase declined to 19,4 per cent July. Retail sales grew in real terms by 4,8 per cent in May 2005 compared with May 2004. The housing market, although still strong, has shown signs of moderation. House prices increased at an annual rate of 21,4 per cent in July of this year having peaked at an annual rate of increase of over 35 per cent in September 2004. The month-on-month increase is now less than one per cent, down from 3 per cent in January 2004.
The continued high levels of expenditure are still being reflected in the rates of growth in money supply and credit extension. The twelve-month growth in M3 accelerated from 15 per cent in April 2005 to 17,1 per cent in June. Growth in total loans and advances to the private sector increased from 19,7 per in April to 22,1 per cent in June, driven primarily by an increase in asset-backed credit, in particular mortgage advances, which grew at an annual rate of 26,6 per cent in June.
The robust expenditure has been reflected in part in increases in imports. However because the increase in the value of merchandise exports exceeded that of merchandise imports, the trade deficit in the second quarter of 2005 narrowed, and the current account deficit, which measured 3,8 per cent of GDP in the first quarter, is expected to contract moderately as well. Non-resident net purchases of bonds and equities have amounted to almost R40 billion in the year to date. Capital inflows increased in the second quarter compared to the first quarter, implying that the current account deficit was comfortably financed, and allowed for further reserve accumulation. At the end of July, gross reserves in the balance sheet of SA Reserve Bank had increased to US$18,9 billion, and the international liquidity position to US$15,4 billion.
Monetary policy stance
Although the outlook for inflation is generally favourable as described above, the Monetary Policy Committee has decided that it would be inappropriate at this stage to change the monetary policy stance in view of the risks to the inflation outlook. The repo rate therefore remains unchanged at 7 per cent per annum. The MPC will continue as usual to monitor closely all the developments in the economy and the factors influencing inflation, and will stand ready to adjust the stance in either direction if necessary, depending on the outlook for inflation.
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