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Economic comment - MPC interest rate decision
Inflation Expectations Survey indicates thatDomestic demand is recovering, albeit at a modest pace, with credit demand still subduedThe high level of household indebtedness, equivalent to 79,8% of household income, highThere is no risk of demand inflation, with the main threat to the inflation outlook posed byThe government's expansionary stance does not pose a significant threat toThe global environment of a moderate rebound and a benign inflation environment isOther contributors to the improved inflation outlook were food prices and lower-thanexpectedMarket inflations expectations, as indicated by both the Reuters survey and the break-evenWage settlements remain concerning, with nominal unit labour costs rising significantly inThe rand has firmed noticeably since the January meeting, gaining 6% on a tradeweighted
Latest
Repo rate: 6,5% effective 26 March (previously 7%, effective 14 August 2009)
Prime rate: 10% effective 26 March (previously 10,5%, effective 14 August 2009)
Comment
The Monetary Policy Committee (MPC) reduced the repo rate by 50 basis points, taking the prime
rate to 10%, its lowest level since January 1981. Data released since the last meeting in January
2010 pointed towards a moderate improvement in economic activity, inflation has dropped to
within the target band and is projected to remain within the target band until the end of 2011, and
inflation expectations have moderated.
The MPC's inflation outlook has improved somewhat mainly due to the certainty relating to
electricity tariffs. Although Eskom has been granted increases of around 25% per annum for the
next three years, municipalities have been granted lower increases. The Bank's model therefore
assumes tariff increases of 20% during each of the third quarters of 2010 and 2011. CPI is
therefore projected to remain within the target band until the end of 2011 after falling below 6% in
February. The Bank projects CPI to average 5,3% this year and 5,4% in 2011, touching a low
point of 4,9% in the third quarter of this year.
The Bureau for Economic Research's first quarter
inflation expectations have moderated slightly, although inflation is still expected to remain
outside the target band. Inflation is now expected to average 6,5% in 2010, 6,7% in 2011 and
6,8% in 2012, with the figures for 2010 and 2011 slightly down on the 7,5% and 7,7% expected in
the previous survey. Analysts remained the most optimistic about the inflation trajectory,
expecting CPI to average 5,5%, 5,9% and 6,0% in 2010, 2011 and 2012, respectively. Business
people were the more pessimistic as they expect CPI to remain well above the 6% level over the
period, averaging 7,1%, 7,2% and 7,3%.
Other key developments highlighted by the MPC were:
unemployment, and strict credit criteria are likely to inhibit a strong recovery in household
demand
high increases in administered prices
macroeconomic stability
supportive of the domestic inflation trajectory
inflation outcomes
inflation rate, show an improvement in inflation expectations since the previous MPC
meeting
the fourth quarter, although this was partly because of once-off public sector adjustments
basis; this is positive for inflation, but poses a risk to the recovery of export and
import-substituting sectors
Implications
The MPC's decision was in our view always going to be tricky. Although we thought that the
committee would hold interest rates unchanged given recent decisions under similar
circumstances, we thought that there was still a significant risk of a last cut in this cycle (of around
45%). Ultimately the MPC's decision was probably taken on the basis of a cut doing no harm in
the current depressed credit environment. However, there will also be considerable speculation
as to how much the finance minister's clarification of mandate letter played a part in the MPC's
decision.
In our view this is the right decision at the wrong time. There was plenty of scope for further cuts
in interest rates in the second half of last year but, despite severe economic conditions, the MPC
was guided by concerns about cost-push inflation. The risk is that further easing now could hurt
credibility in the medium term leading to higher inflation expectations. This is probably unlikely but
future signals will be closely watched by the markets.
The question is whether the committee will be tempted to cut once more in this cycle and whether
the current change will influence the timing of the turning point in the cycle. Inflation is likely to dip
towards the 5% level by the time of the May meeting, but the economy will have probably gained
further momentum by then, helped by the approaching 2010 FIFA World Cup. On balance, we
think that the Reserve Bank will keep interest rates unchanged until well into 2011, raising rates
in the third quarter.
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