22 Nov 2017

MPC update: SARB "prudently” keeps the repo rate unchanged at 6.75% ahead of significant event risks

Annabel Bishop

Chief Economic

With upside risks to the inflation outlook still prevailing, the SARB MPC unanimously “decided that it would be prudent to maintain the current stance of monetary policy at this stage.”

Figure 1: SA Consumer Inflation: history and forecasts
  • With upside risks to the inflation outlook still prevailing, the SARB MPC unanimously “decided that it would be prudent to maintain the current stance of monetary policy at this stage.” The repo rate was therefore left unchanged at 6.75%, in line with market and consensus expectations.
  • The SARB reiterated that the rand is a prominent upside risk to the inflation profile. The currency remains vulnerable, heading in year-end and 2018, to political and policy developments linked to the outcome of the ANC elective conference in December. Critically, there is a heightened possibility of a sovereign credit rating downgrade to non-investment grade post the Medium-Term Budget Policy Statement that showed a retreat from fiscal consolidation.
  • The SARB faces some uncertainty regarding the potential impacts of a credit rating downgrade on the domestic currency and bond markets as these will depend on the extent to which a downgrade is already priced in by the markets and the prevailing global risk appetite at the time of a downgrade.
  • The rand, along with the broader emerging market currency complex, is also vulnerable to a faster than expected pace of monetary policy normalisation by advanced economy central banks, particularly the US Fed, that could trigger a reversal in capital flows to emerging markets (EM).
  • Higher international oil prices as well as a sizeable electricity tariff hike in 2018 were noted as the other key upside risks. The SARB has previously calculated that a 19.9% tariff hike, as requested by Eskom, could raise the inflation profile by as much as 0.3%.
  • The SARB’s Quarterly Projection Model generated modestly higher CPI forecasts (see figure 2) over the medium-term, driven by a weaker rand path in 2018, higher oil prices and higher wage inflation. The SARB projects nominal unit labour to remain above 6% over the medium term.
  • Some of these upward inflationary pressures are expected to be countered by moderating food inflation, on a continued favourable grain supply outlook, as well as a persistent absence of meaningful demand led inflationary pressures.
  • The model also predicts 75bp in rate hikes by 2019. The SARB cautioned that “this does not imply an unconditional commitment to this policy path”. However, it would suggest that in the current environment, rates are more likely to increase over the next year and that the scope for a resumption in policy easing has diminished. Moreover the SARB noted that “the less favourable path of fiscal consolidation could potentially reduce the scope for further monetary accommodation.”
  • Our base case is that SA loses all its investment grade ratings in the next six months and that a strengthening global cycle, a further lift in commodity prices and higher local administered tariffs will see a more elevated inflation profile. As such, we see scope for interest rate increases in 2018 (see figure 3).
Figure 2: SARB CPI inflation forecasts (% y/y) 2017
Figure 3: Economic Scenarios: the risk is currently tilted to the downside
Figure 4: Foreign sector assumptions
Foreign Sector Assumptions
  1. Trading partner GDP growth: is broadly determined via the Global Projection Model “GPM” which is adjusted to aggregate the GDP growth rates of South Africa’s major trading partners on a trade weighted basis. Individual projections are done for the four largest trading partners (euro area, China, United States and Japan), while the remaining trading partners are grouped into three regions: Emerging Asia (excluding China), Latin America and the Rest of Countries bloc. The assumption takes account of country specific “consensus” forecasts as well as regional growth prospects.
  2. Output gap: as with GDP growth the output gap is determined via the GPM and is similarly adjusted. The output gap is driven by a combination of country-specific domestic factors, external factors, and financial-real linkages (beyond interest rate and exchange rate effects). Domestic factors include expectations of future demand and medium-term interest rates. External factors include exchange rate impacts on demand, direct spillovers through trade with trading partner countries, and foreign demand.
  3. International consumer prices: are also broadly determined via the GPM, the index is an aggregate of the consumer price indices of the G3 countries (euro area, United States and Japan) weighted by their relative trade weights. Consumer prices are determined for each region discussed above by accounting for expected future price inflation, demand pressures, and pass-through from changes in the relevant exchange rate. Other institutional forecasts for international consumer prices are also considered.
  4. Commodity price index: is a weighted aggregate price index of the major South African export commodities based on 2010 prices. The composite index represents the total of the individual commodity prices multiplied by their smoothed export weights. Commodity price prospects generally remain commensurate with global liquidity as well as commodity demand/supply pressures as reflected by the pace of growth in the trading partner countries.
  5. Brent crude oil price: is expressed in US Dollars per barrel. The assumption incorporates the analysis of factors of supply, demand (using global growth expectations) and inventories of oil (of all grades), as well as the expectations of the US Energy Information Administration (EIA), OPEC and Reuters.
  6. World food prices: is the composite food price index of the Food and Agriculture Organization of the United Nations (FAO) in US dollars. It is weighted via average export shares, and represents the monthly change in the international prices of a basket of five food commodity price indices (cereals, vegetable oil, dairy, meat and sugar). World food price prospects incorporate selected global institution forecasts for food prices as well as imbalances from the anticipated trend in international food supplies relative to expected food demand pressures.
  7. International policy interest rate: is again broadly determined via the GPM. Interest rates are an aggregate of the policy rates of the G3 countries (euro area, United States and Japan). They are individually determined by a “Taylor-type” monetary policy rule. The communications of the relevant central banks and other institutional forecasts are also considered.
Figure 5: Domestic sector assumptions
Domestic Sector Assumptions
  1. Fuel taxes and levies: are the total domestic taxes and costs included in the price of fuel paid at the pump. They include the Road Accident Fund (RAF), the fuel levy, retail and wholesale margins, slate levy, and other minor levies. The two major taxes, which are set by the Minister of Finance in the annual budget, are the RAF and fuel levy. Income generated by the RAF levy is utilised to compensate third party victims of motor vehicle accidents while the fuel levy is used to provide funding for road infrastructure.
  2. Electricity price: is an administered price measured at the municipal level with a weight of 3.75 per cent in the headline CPI basket. Electricity price adjustments generally take place in the months of July and August of each year, and the assumed pace of increase over the forecast period reflects the multi-year price determination (MYPD) agreement between ESKOM and NERSA with a slight adjustment for measurement at the municipal level.
  3. Potential growth: the pace of potential growth is derived from the SARB’s semi-structural potential output model. The measurement accounts for the impact of the financial cycle on real economic activity and introduces economic structure via the relationship between potential output and capacity utilisation in the manufacturing sector (South African Reserve Bank, Working Paper Series, WP/14/08).
  4. Inflation target midpoint: is the middle of the official target range of 3 to 6 percent.
  5. Neutral real interest rate: The neutral real interest rate is the rate at which inflation is stable at the inflation target midpoint and output is operating at its potential. It is a key variable to determine the appropriate stance of monetary policy.  The neutral real interest rate is a function of the model consistent real interest rate.