Since the July meeting of the Monetary Policy Committee, domestic inflation has moderated to lower-than-expected levels, and it is anticipated that it will remain within the target range for the rest of the forecast period. Contributing to this development were the further appreciation of the rand exchange rate, and the relatively weak domestic demand conditions. The output gap has remained negative, and economic growth in the second quarter of 2010 was lower than market expectations. Growth is expected to remain below potential for some time, against the backdrop of a fragile global economy.
2. Recent developments in inflation
The year-on-year inflation rate as measured by the consumer price index (CPI) for all urban areas declined to 3,7 per cent in July 2010, compared with 4,6 per cent in May. Goods price inflation measured 2,1 per cent in July, while services inflation, which had been relatively sticky, declined to below the upper level of the target range and measured 5,4 per cent.
The categories of housing and utilities (mainly electricity) and miscellaneous goods and services (predominantly insurance costs) together contributed 2,2 percentage points of the 3,7 per cent inflation outcome. However, electricity price increases were lower than expected. There was also a quick reversal of the influence of the Fifa World Cup on some categories. This was particularly noticeable in the category of hotels which experienced a month-on-month price decline of 11,2 per cent. CPI excluding administered prices measured 2,9 per cent ie below the lower limit of the inflation target band.
The recent upward trend in producer price inflation was reversed in July when it measured 7,7 per cent, having peaked at 9,4 per cent in June. Food price inflation remained benign, with agricultural prices increasing by 0,2 per cent on a year-on-year basis, while manufactured food prices declined by 1,0 per cent over the same period. This suggests that food prices at the consumer level are likely to remain contained for some time, notwithstanding higher global food prices.
3. The outlook for inflation
Partly as a result of the recent lower-than-expected inflation outcomes, the inflation forecast of the Bank was revised downwards, particularly in the short to medium term. Targeted CPI inflation is expected to reach a low point of 3,7 per cent on average in the third quarter of 2010. Inflation is expected to average 4,8 per cent in 2011 and to measure 5,1 per cent in the final quarter of 2012.
The lower inflation trend has had a favourable impact on inflation expectations in the financial markets. Break-even inflation rates, as measured by the yield differential between conventional government bonds and inflation-linked bonds, declined across all maturities since the previous meeting of the MPC and remain below the 6 per cent level. The Reuters survey of analysts published in September also shows an improvement of expectations and inflation is expected to average 4,6 per cent and 5,2 per cent in 2010 and 2011 respectively.
The global economic outlook continues to be characterised by heightened uncertainty. Although fears of a reversion to recession in the advanced economies have diminished somewhat, the downside risks remain high. During the course of the year, forecasts of global growth have generally been downgraded in the wake of the European sovereign debt crisis, high rates of unemployment in the US and the euro area, and weak demand in many of the advanced economies. The US economy is expected to experience below-trend growth for some time, and doubts remain about the sustainability of the fiscal austerity programmes in some of the southern European economies. A number of Latin American and Asian economies, apart from Japan, have maintained their strong growth performances, but China has experienced a moderate policy-induced slowdown.
While the low-growth global outlook poses a downside risk to prospects for domestic economic growth, inflationary pressures emanating from the advanced economies are likely to remain benign. The hesitant global recovery has also helped to maintain international oil prices in a relatively stable range of between US$70-US$80 for some time.
These international developments also imply that policy rates are likely to remain abnormally low for an extended period of time in a number of the advanced economies. The resultant search for yield by foreign fund managers has had implications for the rand exchange rate, which remains the main downside risk to the inflation outlook. Since the previous meeting of the MPC, the rand has appreciated by about 4,6 per cent against the US dollar and by 5,6 per cent against the euro. On a trade weighted basis, the rand has appreciated by 4,0 per cent since the July meeting and by 5,7 per cent since January 2010.
Since the beginning of the year, non-residents have been net buyers of equities and bonds to the value of R100 billion, of which R75 billion were bond purchases. This compares with net purchases of bonds totaling R15,5 billion in 2009 as a whole. Whereas in previous years bond flows appeared to be mainly speculative in nature, the recent developments suggest that there could have been a fundamental shift in these flows. There are indications that a significant proportion of these flows are more long term in nature as foreign pension funds and other fund managers take advantage of higher yields in emerging market economies. The higher levels of bond market inflows are not unique to South Africa. It is estimated that emerging-market bond funds have recorded year-to-date inflows of US$32 billion, compared with the previous full-year high of US$9,7 billion in 2005.
The appreciating trend of the rand exchange rate has been sustained despite further accumulation of foreign exchange reserves by the Reserve Bank. The Bank does not target a level for the exchange rate, but takes advantage of prevailing conditions to continue to build reserves. However, this is a costly exercise, and in order to sterilise the impact on the money market, the Bank is now engaged in longer-term foreign exchange swap transactions. This in effect results in an overbought foreign exchange position, and adds to the international liquidity position, but not to the gross reserves. Gross reserves will only be affected if and when these swaps are not rolled over and the Bank takes delivery of the dollars. Any profits or losses will be borne by the National Treasury in keeping with its stated commitment to support the Bank in its reserves accumulation efforts.
Domestic economic growth declined in the second quarter of 2010, to a quarter-on-quarter annualised rate of 3,2 per cent, following a growth rate of 4,6 per cent in the previous quarter. The slower growth was due mainly to the 20,8 per cent contraction in the mining sector in this quarter. Growth in the manufacturing sector moderated to 6,9 per cent from 8,4 per cent in the first quarter, while the tertiary sector grew at a rate of 4,0 per cent.
Growth in the second half of 2010 is expected to moderate further. The composite leading business cycle indicator of the Bank declined in May and June, suggesting a slowdown in the pace of recovery in the coming months. Although the RMB/BER Business Confidence Index rebounded markedly in the third quarter following the second quarter decline, the overall index remains below the 50 level, and confidence has remained particularly weak in the manufacturing and construction sectors.
The Kagiso/BER purchasing managers index increased slightly in August, but it nevertheless points to a deceleration of the growth momentum in the sector. At the same time, manufacturing capacity utilisation, which increased moderately in the second quarter, remains below the long term average. The construction sector also continues to be under pressure, as evidenced in the low growth in building plans passed, while private sector gross fixed capital formation is expected to remain subdued. The Bank’s forecast of GDP growth has declined moderately since the previous meeting of the MPC, with growth now expected to average 2,8 per cent in 2010 and 3,2 per cent in 2011.
Household consumption expenditure has shown some signs of recovery following the contraction during 2009. Growth in real final consumption expenditure by households moderated to an annualised rate of 4,8 per cent in the second quarter of 2010 compared with growth of 5,7 per cent in the first quarter. The impact of the World Cup on expenditure is unclear at this stage, but some moderation can be expected in coming months. Motor vehicle sales have shown a particularly strong year-on-year recovery, although off a low base. Preemptive buying ahead of the introduction of the carbon emissions tax may have contributed to this outcome.
The outlook for household consumption expenditure continues to be affected by contradictory forces. The main negative factors include low levels of credit extension, high levels of household indebtedness, high levels of unemployment and continued job losses.
Underlying credit extension remains weak but there has been some improvement in the past months. Growth over twelve months in banks’ total loans and advances to the private sector measured 1,7 per cent in July, its highest level in over a year. Growth in mortgage advances, which measured 4,0 per cent, was the main driver of this growth. Instalment sale and leasing finance, as well as other loans and advances, continued to contract but at a slower rate. Within the latter category, general loans exhibited positive year-on-year growth of 2,1 per cent. Growth in the retail portfolios of banks remained weak, and the ratio of impaired advances to gross loans and advances amounted to 5,9 per cent in June, relatively unchanged from the previous quarter. Although banks appear to have relaxed their credit criteria somewhat, they remain relatively cautious, and their pricing for risk still appears to be higher than was the case before the crisis.
Consumers are also constrained by high levels of debt, although the cost of servicing the debt has declined in line with lower interest rates. Household debt as a ratio to disposable income has moderated very slowly from its peak of over 80 per cent.
Household consumption expenditure is also expected to be constrained by the continued unemployment trends. According to the Quarterly Labour Force Survey of Statistics South Africa, the unemployment rate increased marginally in the second quarter of 2010 to 25,3 per cent. In the two years to the second quarter of 2010, one million jobs were lost, while the number of discouraged workers increased by 900,000. Consistent with the slowdown in manufacturing and construction, job shedding was most marked in these sectors.
Factors that could provide a positive impetus to household consumption expenditure include lower nominal interest rates, lower inflation, positive wealth effects arising from improving house prices and equity market developments, and high levels of real wage increases for those in employment.
Wealth effects over the past year have been positive, with house prices increasing at year-on-year rates of over 10 per cent. However in July the rate of increase declined moderately according to both the ABSA and FNB house price indices. The bond market rally has continued, and equity prices have recovered significantly from their lows in the first quarter of 2009, although they remain below pre-crisis levels.
Wage settlements in excess of inflation, while providing a positive impetus to consumption, are also the main upside risk to the inflation outlook. Some wage demands and a number of settlements have been made without regard to the lower inflation outcomes and the improved inflation outlook. Unless accompanied by higher productivity, such settlements could put pressure on domestic prices and impact negatively on our international competitiveness. Such settlements are also likely to have a negative impact on employment trends.
Risks from cost push pressures are relatively unchanged. Administered price increases remain on average at elevated levels, and therefore place upside pressures on the inflation outlook. Potential risks emanate from food price increases at the global level, particularly related to wheat prices. However the impact domestically is expected to be constrained by the relatively strong exchange rate and the recent domestic bumper maize crop.
4. Monetary policy stance
The assessment of the Monetary Policy Committee is that the improved inflation outlook creates sufficient room for monetary policy to provide additional stimulus to the somewhat fragile recovery of the domestic economy which remains vulnerable to the uncertain global environment.
The MPC has decided to reduce the repurchase rate by 50 basis points to 6,0 per cent per annum with effect from 10 September 2010. The MPC views this action to be consistent with the continued attainment of the inflation target, having given due regard to the risks to the outlook. The scope for further downward movement is seen to be limited, but this will be assessed on an ongoing basis. Our approach remains forward-looking and is informed by close examination of the data and future developments.
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