The domestic economy has shown signs of moderate improvement since the previous meeting of the Monetary Policy Committee. Inflation expectations have moderated. Inflation has returned to within the target range and is expected to remain there for the remainder of the forecast period. The risks to the inflation outlook have declined somewhat as a result of the continued appreciation of the exchange rate of the rand and greater certainty with respect to future electricity tariff increases. Household consumption expenditure is growing at positive, albeit low rates, but growth in private sector fixed capital formation remains negative.
2. Recent developments in inflation
The year-on-year inflation rate as measured by the consumer price index (CPI) for all urban areas returned to within the inflation target range sooner than expected, in February 2010, when it measured 5,7 per cent. The moderation in inflation was fairly broad-based. The main contributors to the inflation outcome were the categories of housing and utilities and miscellaneous goods and services. The former category was driven mainly by electricity price increases of 26,8 per cent, while the latter category was driven by insurance costs relating to housing, health and transport. Food price inflation declined to 1,0 per cent, while communication costs declined by 22,0 per cent. Administered prices excluding petrol and paraffin increased by 10,8 per cent.
Producer price inflation increased to 3,5 per cent in February 2010, compared with 2,7 per cent in the previous month. Food price inflation at the producer level remained well contained. Agricultural food prices declined at a year-on-year rate of 13,5 per cent, while manufactured food prices declined by 1,2 per cent.
3. The outlook for inflation
The CPI forecast of the South African Reserve Bank (the Bank) indicates an improved inflation outlook during 2010 and a relatively unchanged outlook for 2011. Inflation is expected to average 5,3 per cent and 5,4 per cent in 2010 and 2011 respectively, and to reach a low point at an average of 4,9 per cent during the third quarter of 2010. There is now greater certainty with respect to electricity tariff increases following the decision by the National Energy Regulator of South Africa (Nersa) to grant price increases to Eskom in the order of 25 per cent per annum, which was in line with the Bank’s previous assumptions. However, because lower increases were granted to municipalities, the current forecast makes provision for electricity tariff increases of 20 per cent during the third quarters of 2010 and 2011. Other factors contributing to the improved expected inflation trajectory include favourable food price developments as well as lower-than-expected inflation outcomes.
The Survey of Inflation Expectations published by the Bureau for Economic Research (BER) at Stellenbosch University shows a significant improvement in the first quarter of 2010, although expectations remain on average above the upper end of the target range. Average headline CPI inflation expectations in respect of 2010 declined from 7,7 per cent during the final quarter of 2009 to 6,5 per cent during the first quarter of 2010. Inflation expectations in respect of 2011 declined from 7,7 per cent to 6,7 per cent, and the expectation for 2012 is 6,8 per cent. The improved outlook was mainly due to the favourable change in the expectations of business sector and labour union respondents. The expectations of analysts remained more or less unchanged.
Inflation expectations in the financial markets also reflected a more favourable inflation outlook. The Reuters survey of financial analysts shows some improvement relative to the previous month. Inflation expectations as measured by the yield differential between conventional government bonds and inflation-linked bonds across all maturities declined since January and reflect expectations within the target range over longer maturities.
Growth in domestic expenditure appears to be recovering at a modest pace but does not currently pose an upside risk to the inflation outlook. Following five consecutive quarters of negative growth, real household consumption expenditure increased at an annualised rate of 1,4 per cent in the fourth quarter of 2009. While expenditure growth on non-durable and semi-durable goods contracted, expenditure on durable goods, particularly motor vehicles, increased. Wholesale and retail trade sales in January appear to confirm this trend as positive month-on-month growth was experienced. Consumer confidence, as reflected in the FNB/BER Consumer Confidence Index, showed a significant recovery.
The turnaround in household consumption expenditure is expected to continue at a slow pace. The improvements in the domestic equity markets appear to have reversed the negative wealth effects on consumption. Nevertheless the recovery in household consumption expenditure is expected to be constrained by the levels of household indebtedness, which increased to 79,8 per cent of disposable income of households in the fourth quarter of 2009. Other constraining factors include the strict credit criteria applied by banks, and persistently high levels of unemployment.
Growth in total loans and advances to the private sector has been negative since September 2009, and declined further at a twelve-month rate of 1,2 per cent in January. Mortgage credit extension was again the only category that showed positive growth, while loans to companies declined further. The subdued credit extension data are a function of both demand and supply side effects. The strict credit criteria applied by banks have been partly a result of the rising levels of impaired advances which now appear to be leveling off. In January 2010, impaired advances as a percentage of total gross loans and advances declined slightly to 5,9 per cent. A significant proportion of these impairments relate to retail loans, reflecting continued pressure on the consumer.
There are indications that the decline in employment in the formal non-agricultural sector appears to have slowed. According to the Quarterly Employment Survey, 18,000 jobs were created in the final quarter of 2009. However, on a seasonally adjusted basis, employment declined by 0,7 per cent, following the 5,1 per cent decline in the previous quarter. Cyclical employment trends tend to lag the upturn in the economy, and the impact of the recession on employment will take some time to be reversed.
A countercyclical fiscal policy stance has been maintained. The national government deficit is projected to equal 7,2 per cent of GDP in the 2009/10 fiscal year and then to narrow over the next three years as the economy recovers, and to measure 4,7 per cent in the 2012/13 fiscal year. The public sector borrowing requirement is expected to reach 11,8 per cent of GDP, and the overall government debt to GDP ratio is expected to peak at 43 per cent in the medium term. Should this fiscal trajectory be maintained, the MPC does not foresee a possible conflict with monetary policy objectives.
The economic growth outlook has improved somewhat over the past few months, although the output gap is expected to remain positive for some time. The 3,2 per cent annualised growth rate recorded in the fourth quarter of 2009 confirmed that the economy has emerged from the recession, and the latest forecast of the Bank is that growth is likely to average 2,6 per cent in the current year. Although this compares favourably with the growth experienced in 2009, it is nevertheless still low.
The manufacturing sector in particular grew relatively strongly in the last two quarters of 2009, although off a low base, following four consecutive quarters of negative growth. The Kagiso/BER Purchasing Managers Index indicates that this trend is likely to continue. Business confidence, as measured by the RMB/BER Business Confidence Index also showed an improvement but remains negative.
The sustainability of the recovery in domestic growth will be influenced to a significant degree by the global growth trends. The pattern of the global economic recovery has remained unchanged with strong growth being recorded in Asia in particular, and more moderate growth in a number of countries in Latin America and Africa. The outlook for the United States and Europe is less positive with increased concerns about the sustainability of burgeoning fiscal deficits and government debt ratios. In the United States, the weak housing market also remains a constraint on household consumption expenditure. Although a number of countries have begun to normalise their policy rates, monetary and fiscal stimuli still remain in place in most industrialised economies, and indications are that there will not be an early reversal of these accommodative policies. Against this backdrop, the benign global inflation environment is expected to persist, and the risk of imported inflation is relatively low.
While an appreciated rand exchange rate is a positive factor in the inflation outlook, an excessively strong exchange rate is a cause for concern from the perspective of overall macroeconomic balance. It is difficult to determine with precision an appropriate level of the exchange rate, but at recent levels the exchange rate may contribute to constraints in the recovery of export and import-competing sectors of the economy.
Since the previous meeting of the MPC, the rand has appreciated from levels of around R7,60 against the US dollar to current levels of around R7,35. On a trade-weighted basis, the rand has appreciated by about 6 per cent since the previous meeting and by 3 per cent since the beginning of the year. The trade-weighted exchange rate was also influenced by the recent weakness in the euro and pound sterling against the US dollar. Since the previous meeting, the rand has appreciated by about 8 per cent and 11 per cent against the euro and pound sterling respectively.
A number of factors continue to impact on the exchange rate of the rand. These include the sustained capital inflows into emerging markets in general in response to abnormally low interest rates in advanced economies, investor sentiment, and the recovery in commodity prices. The latter contributed to the narrowing of the deficit on the current account of the balance of payments in the final quarter of 2009 to 2,8 per cent of GDP.
Other supply side or exogenous factors are not expected to impart a significant upside risk to the inflation forecast. International oil prices have remained relatively stable in the US$70-US$80 dollar range, and moderate increases over the forecast period have been incorporated into the inflation forecast. Nevertheless an increase in the order of 50 cents per litre has been assumed for April, about half of which is due to increased fuel levies announced in the budget.
Domestic food prices, which for most of last year were one of the main sources of upside risk to the inflation outlook, have recently contributed favourably to the inflation outlook. In the past few weeks, maize prices have declined significantly, despite an upward trend in other food prices globally. While it is not clear at this stage to what extent these price declines will be passed on to the consumer, these developments should at least constrain food price increases for some time.
Wage settlements continue to indicate some moderation but remain positive in real terms. The ratio of total compensation of employees to real GDP declined from 10,1 per cent in the year to the third quarter of 2009 to 9,2 per cent in the year to the fourth quarter. Nominal unit labour costs increased from 5,7 per cent in the third quarter to 8,8 per cent in the fourth quarter of 2009, but this figure was distorted by significant once-off adjustments to some public sector pay scales.
Despite the reduced uncertainty associated with the electricity tariff increases, electricity and other administered price increases remain a threat to the inflation outlook. Of concern is the apparent trend towards greater reliance on high tariff increases to finance long term infrastructural expenditure projects. These increases are in effect relative price changes or implicit tax increases. However they contribute to the general inflation environment and remain a challenge for monetary policy.
4. Monetary policy stance
The assessment of the Monetary Policy Committee is that despite clear signs that the economy has emerged from the recession, the pace of recovery is expected to remain slow. The improved inflation environment has provided some space for an additional monetary stimulus to reinforce the sustainability of the upswing without jeopardising the achievement of the inflation target. The MPC has therefore decided to reduce the repurchase rate by 50 basis points to 6,5 per cent per annum with effect from 26 March 2010. The MPC will continue to assess developments, and will adjust the monetary policy stance when necessary in order to achieve the inflation target.
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