South Africa: Inflation Set to Fall Further
[Perhaps we have some good news for SA miners coming up. Mish]
Riccardo Barbieri (London)
In a world characterised by extremely accommodative monetary policies, it is heartening to see a central bank that keeps a close eye on consumer spending and asset price inflation, as the South African Reserve Bank (SARB) has been doing of late. However, we believe that the inflation picture is improving to such an extent that a rate cut at one of the next two MPC meetings is very likely. In fact, our forecast of a total of 100 basis points of rate cuts in the first half of this year is no longer looking outlandish, we feel.
We are cutting again our inflation forecast. The December CPIX reading, at 4.3% year-on-year, was well below our projection and the consensus (4.6%). We have been expecting a drop in inflation in the first two months of the year. But with the weakness in food prices revealed by the December CPIX data, and a further fall in maize future prices, we now think that the drop in inflation in the coming months will be greater than on our previous forecast. We see CPIX inflation falling to 3.6% in January and 3.3% in February. Even assuming that petrol prices will rise somewhat in March and possibly in the following months due to the recent bounce-back in crude oil prices, we project that the CPIX inflation rate will rise only moderately from March onwards, ending the year at 4.0%.
The rand and food prices are the key factors, but wages and regulated prices will also help. The strength of the rand exchange rate and the drop in food prices (which is due in part to favourable weather conditions) are clearly the key drivers of disinflation. However, we also expect that wages and regulated prices will show increased moderation in 2005. Wage contracts likely will envisage lower increases than in 2004 in response to the decline in CPIX inflation and to the government’s commitment to a more forward-looking approach guided by the inflation target. Administered and regulated prices, while still probably rising at a higher rate than the inflation target, will also decelerate, in our view. The recent announcement by Transnet concerning railway and port tariffs supports this expectation.
Monetary policy easing looks likely. A reading of 3.3% would be way below the midpoint of the target range for the SARB, which is 3% to 6%. If by the time of the February 9–10 MPC the SARB research department comes up with an inflation forecast not too distant from our scenario, and if the MPC is comfortable that alternative assumptions on energy prices, the dollar, and other external variables would not yield substantially higher inflation projections, then a cut in the repo rate would be highly likely, in our view. Our forecast that the repo rate will be cut by a total of 100 basis points in the first half of this year due to the strength of the rand and to falling inflation is now looking less outlandish.
The CPIX data surprised us on the downside in December. We and the consensus correctly anticipated that vehicle running costs and other energy-related components of the CPIX would decline in lagged response to the drop in crude oil prices in October and November. Food prices, however, surprised us on the downside. While we had been looking for stability or at most a slight increase at the retail level, food prices were down 0.5% month-on-month, as meat prices fell by 1.7%, reversing strong increases in previous months. Other goods prices also showed declines, due most probably to the strength of the rand exchange rate in 4Q. Clothing and footwear declined by 0.3% on the month, furniture and equipment by 0.2%, and vehicles also by 0.2%. Medical and health care edged down by 0.1%, thanks to lower prices of imported inputs or competing services.
The December PPI was also below expectations. The index fell by 0.5% on the month, and, as a result, the year-on-year growth rate declined to 1.9% from 2.5% in November. We had been looking for a much higher reading of 2.6%. Mining prices played a role, as they declined by 3.2% month-on-month. However, there were also two important developments from the standpoint of final goods prices. First, agricultural prices declined for the second consecutive month, suggesting that the fall in food prices observed at the retail level could continue in the early months of the year. Secondly, manufacturing prices fell by 0.4%, the first decline in five months. As was also suggested by the December manufacturing PMI, the upward trend in prices has been reversed. While this could be due in part to the easing in certain commodity prices, the strengthening of the rand trade-weighted index between September and December appears to be the main factor.
We reckon that real GDP growth slowed markedly in 4Q. Based on the production data for October and November, and on the December PMI, we estimate that output declined in the fourth quarter both in manufacturing and in mining. Even assuming a continuation of buoyant growth in construction and services (particularly retail trade), we estimate that quarter-on-quarter annualised real GDP growth slowed to 3.5% in 4Q, from a peak of 5.6% in 3Q. We expect the first quarter to see a further slight deceleration in real GDP growth to 3.2% before the economy regains momentum thanks to some monetary stimulus (which in our baseline scenario would be caused by lower interest rates and, in due course, a weaker exchange rate).
Risks to our 4.0% real GDP forecast for 2005 are skewed on the downside, we feel. If we had to characterise the risks to our forecast under unchanged monetary conditions, we would view them as being skewed on the downside. Indeed, while a stronger outcome cannot be ruled out, we believe that the effects of the 2003–04 monetary and fiscal easing will gradually taper off. Granted, business and consumer confidence are at historical highs, and the government is making strides on structural policies. However, the strong rand is hurting the export sector, as was highlighted by a special BER survey released in late November. Durable consumption growth will probably slow once the stock of vehicles, household appliances, and the like approaches the desired level. The mining companies are reporting reduced profits and have scaled down capital expenditure plans. It seems to us that a policy of external stimulus would be needed to keep GDP growth at 4% or above.
The SARB is likely to remain concerned about demand and credit growth. The dichotomy between the supply and the demand sides of the economy is well known. The consensus view remains that the economy is overheating on the demand side, and this may ultimately cause inflation pressures. In fact, the latest retail sales data showed a further acceleration in October (to 12.8% year-on-year in real terms), and auto sales grew by fully 38.5% year-on-year in December. The SARB is also focusing on bank lending growth, which reached 10.5% year-on-year in November, with the mortgage component up 22.7%. House prices rose by 32.1% in 2004, the highest rate in 13 years. While the growth rate declined in the final months of the year and the rise in house prices affects the CPIX only indirectly, the SARB is right in monitoring house prices as one of the factors influencing its policy decisions.
We believe that the improving inflation outlook will be the key factor shaping monetary policy. However, we believe that the December CPIX and PPI figures were also a positive surprise for the SARB. Moreover, we expect that when the MPC meets on February 9–10, not only will the inflation forecasts be more positive than at the previous meeting, but the (undisclosed) economic growth forecast will also be lowered. The buoyancy of the demand side of the economy notwithstanding, we believe that the lack of meaningful near-term inflation risks will swing the pendulum in favour of a rate cut. We still expect a 50-basis-point cut, although a smaller cut of 25 basis points is not out of question. While several permutations of policy changes are conceivable for the subsequent MPC meetings, our baseline scenario assumes no policy change in April and then a final rate cut at the June MPC meeting. A key prediction supporting this call is that the rand will remain strong throughout the first half of the year. On our forecast, the repo rate would trough at 6.5%, down from 7.5% currently. |
