MPC Preview – May 2021: Watching for nuances

The MPC is widely expected to leave the repo rate unchanged at 3.5% for the fifth successive time. In March, all five members of the MPC were in favour of keeping the rates unchanged. The May MPC meeting is expected to play out along similar lines but the post-MPC statement and Q&A session could reveal a nuanced discussion.
Key focus points:  The key focus areas of the meeting will be the tone of the statement and the assessment of the balance of risks to inflation.  The tone of the March MPC meeting was in our view neutral-cautious. The risks to inflation were deemed to be balanced. We think the balance of risks to inflation could remain neutral - with higher global inflation drivers countered by the stronger rand and contained nontrade able inflation – but volatility risk has probably increased in view of rising domestic input prices in some sub-components of producer price inflation. 

What has changed since the March MPC meeting

We think that developments in the global economy could lead to upward revisions to the SARB’s global inflation assumptions. Commodity prices have accelerated in Q2, particularly the prices of iron ore (+32%), coal (+15.1%), (copper (+13.9%), and aluminum (+14.4%) since the end of February. There has been a notable increase in global PMI prices and delivery times due to the mismatch between a robust demand recovery and supply-side disruptions caused by mobility restrictions. While global inflation was widely expected to rise in Q2 21 owing to energy-related base effects, the increase in global producer price inflation and US CPI inflation in April (from 2.6% to 4.2% and above market expectations of 3.6%), has raised concerns that the increase in inflation could be more persistent than transitory, as expected by G3 Central Banks.

The IIF notes that the severity of supply chain disruptions has led to mark-ups charged by US manufacturing firms on output over input prices rising sharply, which is correlated with the rise in supplier delivery delays using March data. This trend has broadened globally in April: “This raises the risk of supply chain disruptions and their knock-on effect for inflation being a medium-term shock, as opposed to a short-term one that is quickly forgotten. As vaccination spreads globally, it is likely that delivery delays will remain cute from some time, making this a medium-term shock that may complicate life for the world’s central banks.” The direction of core CPI inflation and inflation expectations will be key dynamics in the coming months.

Watching the Fed’s new reactive function
The Fed’s reaction function is another dynamic that emerging markets have to contend with as there are implications for (1) foreign capital flows to EMEs and the (2) term premium embedded in US Treasury yields.  The Fed’s new average inflation targeting framework is uncertain since the response function has become reactive as opposed to proactive and outcome based. The acceleration in April’s CPI inflation rate, which overlapped with a disappointing outcome of growth in the labour market, has led to a debate of the timing of the commencement of tapering (which has kept US 10-year Treasury yields range bound but with a compositional change as breakeven inflation expectations have increased). The implied Fed Funds future rates for 2020 and 2021 continue to be biased towards the commencement of a tightening in monetary policy from 2022 compared to the Fed’s forecast in 2023. The IMF noted in a recent blog (How rising interest rates could affect emerging markets) “that the situation is therefore fragile….The Federal Reserve’s guidance about its preconditions for a rise in policy rates is a good example. As the recovery continues, further guidance on possible future scenarios would be useful, given that the Federal Reserve’s new monetary policy framework is untested and market participants are uncertain about the pace of future asset purchases.”  We do not expect the FOMC meeting minutes, to be published on Wednesday, to provide clarity on the matter as the acceleration in April CPI inflation came as a surprise.

Inflation forecast and negative real interest rates
Our analysis suggests that the SARB’s inflation forecast could be revised marginally higher in 2021 from 4.3% but remains at around the mid-point of the target band in 2021 and 2022. However, the MPC is likely to continue to tolerate higher negative real rates, reflected in a neutral-cautious tone in the statement. In the Q&A session at the March MPC meeting, Deputy Governor Rashad Cassim elaborated on the MPC’s assessment of a negative real rate, which is influenced by (1) slack in the economy and (2) the output gap. An accommodative monetary policy is warranted at present in view of the lack of demand-pull pressures and a negative output gap (forecast at -3.5% in 2021 and -2.0% in 2022). A negative real policy rate will become of more concern when the economy starts to accelerate at a faster pace, leading to an earlier narrowing of the output gap. With EMEs lagging the AEs’ vaccine rollout programmes, South Africa’s Phase 2 has commenced this week with daily Covid-19 infections and the risk of some mobility restrictions rising.