Will the Reserve Bank increase interest rates?

Some emerging market economies are at risk to the (eventual) unwinding of quantitative easing (QE) in developed economies and any unexpected increases in global risk-free interest rates. This includes South Africa, which is running twin deficits (a govern

These developments beg the question: "Will the Reserve Bank need to raise interest rates?" Much will depend on the behaviour of the Rand in the months ahead, which plays an important role in domestic inflation in the near term. And inflation remains the key consideration for the Bank.

We cannot predict near term currency movements. Over the long run, however, we expect changes in the Rand to reflect inflation differentials between South Africa and its trading partners. Viewed from this perspective it seems reasonable to argue the Rand is now materially undervalued. Indeed, our estimate of the fair value of the Rand (that is its purchasing power parity level as determined by inflation differentials) is ZAR/US$ 8.85. Hence, we would expect the Rand to eventually strengthen, although we cannot be certain when this will happen. For purposes of our inflation forecast we assume tthe Rand appreciates towards ZAR/US$ 9 by the end of 2013.

Our inflation forecast shows headline CPI increasing to around 6 ½% to 7% by July 2013, before receding to just below 6% by year end. If we are right, the Bank’s policy rate is unlikely to increase this year. Sanlam Business Market, Economic Overview : July 2013

Source: I Net

Needless to say, however, the longer the Rand remains undervalued, the more it poses upside risk to inflation forecasts, while further sharp falls from its level at the time of writing (close to ZARUS$ 10) would ostensibly prompt the Reserve Bank to act.

At least, the rise in global real risk-free rates should be contained. Given sustained high government debt levels policymakers in developed economies have a strong incentive to maintain a relatively low level of real interest rates. In any event, growth in these economies is anything but robust and inflation remains low, which suggests central banks are likely to be wary of raising interest rates. That should provide emerging market economies with some breathing space, although some remain vulnerable to slower capital inflows, including South Africa.

In summary, given our forecasts for below trend GDP growth and long-term inflation below 6% we expect the Bank to hold off on interest rates this year. However, the environment has become more challenging for domestic businesses.

The benchmark small to mid-cap universe on the JSE is a heterogeneous group of companies. Currency weakness affects companies differently. But, broadly speaking, small businesses tend to fair better when domestic demand accelerates. Alas, the weakness of the Rand reflects a lack of foreign capital inflows, which implies domestic saving should increase (that is consumption growth should slow), or domestic investment growth should weaken, or both.