What the rate cut means

In a move that surprised most analysts the MPC[1] cut the repo rate[2] by 50 basis points which brings it to 5.00 % and the prime overdraft rate to 8.5 %, the lowest it has been since 1974. We look at the implications as well as the reason for the decisio

When the Monetary Policy Committee released its statement it was clear that the Reserve Bank is concerned about contagion from the global economic downturn negatively affecting the South African economy and was therefore acting to minimise the impact.

Growth prospects

The growth outlook for the Eurozone remains negative and, despite the fiscal austerity measures taken so far, the situation seems set to continue for a long while. This means that the contagion to South Africa might become worse before it gets better as our economy is fragile, further exacerbating the situation.

Consumer spending: Although retail sales data for May 2012 increased at a rate of 6.4% year on year, a significant improvement from 1.1% recorded for April, this has been driven in part by an increase in unsecured lending rather than improving household income. Clearly the current spending trend cannot be sustained; while overall inflation has reverted back to target and is expected to remain so for the rest of the year, there are pressures from within the inflation basket from high administered prices and other necessities. These include higher prices for energy, transport, education, medical services and water.

The higher expenditure on these items will mean that consumers would have to cut back on other retail items and already on a month to month basis, retail sales fell in May. A significant reduction in retail sales will have a negative impact on GDP growth because consumption expenditure by the household sector is about 60% of total expenditure, so the state of consumer finances matter.

Falling confidence: Both business and consumer confidence are on the decline. Consumers are not confident about their financial position (and hence spending) going forward while business is hesitating to spend on infrastructure projects. During Q1 2012 private business increased fixed investment or infrastructure expenditure by just 1.8%. This happens at a time where corporate deposits are sitting at R1 594 billion, so it’s not a matter of funding but confidence.

Inflation outlook

The bank was able to cut rates to support growth as the inflation outlook is benign. Inflation is within target and the bank’s latest forecast has been revised downwards in the latest MPC meeting. CPI inflation declined from 5.7% in May year-on-year to 5.5% in June.

The inflation rate is now expected to continue to slow over the next quarters, culminating at a low of 4.9% in the second quarter of 2013. Inflation is then expected to remain fairly stable around the 5% to the end of 2014.

Food inflation: Lower inflation can partly be attributed to a very welcome slowdown in food inflation and a reduction in petrol inflation which declined by 4.6% on a month-to-month basis. There is a potential upside risk for food inflation going forward as maize prices have spiked due to fears that the drought in the US might lead to crop failure and there always remain some upside risks to overall CPI inflation from administered prices like electricity and water.

Will the rate cut work?

It is important to ask whether a 50 basis point cut in interest rate is sufficient to support or even boost growth. The immediate impact will be to boost consumer confidence rather than to turn around the economy. Turning the economy around takes time and the actions of the central bank alone are not sufficient to change the growth trajectory. There needs to be a carefully coordinated policy response between the bank and government over a sustained period to turn around the economy.

More cuts: The bank has created expectations for rate cuts to support growth so they should not stop at just one, because for the measure to have real impact the cumulative cuts should be at least 150 basis points. This will be difficult for the bank to do because they need to balance supporting growth with a need to attract foreign investment into the country. If the returns are too low it might not sufficiently compensate them for the risk of investing in an emerging market.

The cut is good news for consumers who will get some relief from high administered prices which are still above the overall inflation rate. Hopefully part of the extra cash freed up will be used to pay off debt and even for saving.

References:

[[1]] The Monetary Policy Committee
[2] The repo rate (repurchase rate) is the interest rate at which commercial banks can borrow money from the Reserve Bank