Rate hike could come sooner than expected

Gareth Stokes, FAnews Online Editor

The latest consumer price inflation (CPI) number came in worse than expected for May 2011. According to Statistics South Africa the cost of local goods and services surged by 4.6% year-on-year (y/y) May versus 4.2% registered in April. “This was higher th

Lings observes: The main reason for the higher than expected inflation reading was a jump in food prices. Food inflation rose by 1.7% month-on-month (m/m) May, which contributed 0.3 percentage points to the monthly change in CPI, while fuel (petrol) prices increased by 2.9% m/m, taking the annual rate of petrol inflation to 17.7%! Food prices are clearly on the charge. Statistics SA reported increases in the price of bread and cereals (+2.9% m/m), oils and fats (+3.0% m/m), vegetables (+4.3% m/m) and sugar and sweets (+2.1% m/m). Dairy prices were also on the rise, resulting in food inflation of 6.3% y/y, the highest annual inflation number for the sub-category since July 2009. The bad news, says Lings, is food inflation will be higher in coming months.

Why should we care about inflation?

Everything in economics is connected. South Africa’s central bank, the SA Reserve Bank, has built inflation targeting into its monetary policy stance. What this means is that the bank watches levels of price increases very carefully. They want SA CPI to float within a 3% to 6% band. And one of their primary weapons against rising inflation is interest rates. Although economists can spend hours debating whether interest rate hikes are appropriate measures against supply side inflation the reality is the bank will act, with an inflation increase, when local inflation pushes through (or even threatens to push through) the 6% level. And if you’re paying an interest rate-linked mortgage bond or hire purchase instalment any upward move in interest rates hits you in the pocket – hard!

At the moment prime interest rates are pegged at a very low (historically) 9%. To find out what might happen to rates over the next 12 to 24 months we need to consider the outlook for inflation. Once again, Lings helps out. “Looking ahead, there are a number of clear upside risks to SA inflation,” he says. “These include higher food inflation and higher energy prices.” Lings believes that the extent to which these price pressures will impact on inflation will be heavily influenced by the rand exchange rate. Through 2010 local consumers were saved from inflation by an incredibly strong local currency. The rand effectively cushioned us from potentially damaging price pressure. Today, we’re facing higher local prices for two reasons. The first is that the rand is likely to lose some of its value, particularly against the US dollar, through the remainder of 2011. And the second results from further electricity price hikes coupled with other service costs and administered price rises, as well as the concerning increase in wage demands could also push domestic inflation higher.

Can we expect a rate hike by Christmas?

The economists we’ve spoken to through the first half of 2011 were divided on whether we’d see an interest rate hike late this year or early 2012. The majority believe the Reserve Bank will hold off for as long as possible; but they are now divided on how long that might be. It seems the chances of a Q4 2011 hike are now more than 50:50! “We expect CPI inflation to continue on the upwards trajectory for the remainder of the year, reflective of steep price increases for food and administered prices such as electricity, petrol, rates and taxes,” said Investec economist Kgotso Radira, as reported by Reuters on Fin24.co.za. “Steep wage increases also pose upside risks to the inflation outlook – so we maintain our view of a 50 basis point interest rate hike in Q4 2011.” The central bank’s main problem is that South Africa’s economic recovery remains fragile. So they could delay the decision despite expecting inflation to breach 6% early next year.

Central banks face inflation conundrum in the developed world too

Their’s is not a unique dilemma. Inflation is building in developed economies too, forcing central bankers in the US and UK to choose between targeting inflation (by hiking rates) or affording business more time to recover (keeping rates pegged). Uncertainty is growing following the most recent Bank of England (BoE) interest rate meeting. Members of the rate-setting committee felt that the economic outlook had weakened and that further quantitative easing steps might be necessary. Quantitative easing involves the ‘injection’ by government of additional ‘cash’ into an economy, something most Western governments did to keep their economies afloat through recession.

But this excess liquidity is having serious side-effects. First – inflation pressures are building up despite the bombed out economy. And second, the excess liquidity is finding its way to stock markets and underpinning share prices at artificially high levels. Ironically, in trying to tackle the financial contagion following a US house price bubble, the world is creating an equity bubble of similar magnitude. At this state it seems certain the BoE will keep UK rates pegged at the record low 0.5%. And its US counterpart should do the same, thereby creating an environment for the South African rand to remain stronger for longer.

Editor’s thoughts: Will we see an interest rate hike before Christmas 2011. Economists are divided on the question… As far as we are concerned we don’t expect a hike this year UNLESS the rand slips significantly between now and mid-November. Do you expect a rate hike before year-end 2011 – and how far will the next interest rate hiking cycle take us? Please add your comment below, or send it to gareth@fanews.co.za