SA Consumer Inflation: history and  forecasts

At the last MPC meeting in September the SARB outlined heightened upside risks to the inflation profile over the next 12-18 months that included the rand exchange rate, the pace of global monetary policy normalisation and electricity tariffs. As these risks have not receded, we expect the SARB to keep interest rates on hold at 6.75% at this week’s (21st – 23rd November) MPC meeting.

Since the SARB last met to decide on interest rates, the nominal trade weighted exchange rate has depreciated by 5.2%. US dollar strength over this period weighed on the local currency but much of the weakness has been a function of domestic factors. These pertain to increased political uncertainty and the Medium Term Budget Policy Statement in October, which showed a retreat from fiscal consolidation and therefore exacerbated the possibility of further sovereign credit rating downgrades. Moody’s specifically noted that the MTBPS “signals credit-negative change in policy direction”.

A downgrade of SA’s local currency credit rating to sub-investment grade by Moody’s and S&P would result in exclusion of SA rand-denominated bonds from key global bond indices such as the World Government Bond Index (WGBI). SARB Governor Kganyago recently noted that consequent forced selling by foreigners is being estimated at between R100bn and R180bn. The magnitude of outflows will be a function of the extent to which a downgrade is already priced in by the markets and the prevailing risk appetite in global markets at the time of a downgrade. Based on SA’s credit default swap (CDS) spread the possibility of a ratings downgrade is priced in. Specifically, SA’s CDS spread is trading close to that of Turkey and Brazil, both which are sub-investment grade.

Figure 2: Trade weighted rand versus headline CPI inflation
Figure 3: 5yr credit default swap spreads

As the MTBPS did not deliver on fiscal consolidation it is less likely that downgrades will be avoided at the 24th November scheduled country reviews. However, it may be the case that the rating agencies could first look to the outcome of the ANC elective conference in December which will undoubtedly inform economic and fiscal policy and therefore the 2018 Budget. Indeed, Moody’s implied that its rating decision would hinge on the 2018 Budget by stating that “unless the government presents a credible fiscal consolidation plan in the February 2018 budget, debt sustainability is at risk.” As such, the rand remains vulnerable heading into year-end and into next year and sustained rand weakness would exert upside pressure on the inflation profile.

Global market developments could exacerbate the rand’s vulnerability. Throughout 2016 and so far in 2017, global financial conditions have been supportive of emerging market portfolio inflows. Faster than expected monetary policy normalisation in the US or a rise in global risk aversion could trigger a tightening of global financial conditions and a repricing of risk. In the event, there would likely be reversals in capital flows to emerging markets.

With inflation still broadly benign in advanced economies, aggressive monetary policy normalisation by the major central banks is not expected. In particular, the market-implied interest rate path continues to signal that US policy rates will rise only gradually in the coming years. Moreover, it is expected that the balance sheet unwind and tapering will result in only a gradual change in liquidity conditions.

Figure 4: Portfolio investment inflows to emerging economies
Figure 5: US FOMC projections and Fed fund futures

Aside from the risk of sustained rand depreciation, another key source of potential upside inflationary pressures stem from administered prices pertaining specifically to electricity tariff hikes. Eskom has applied to National Energy Regulatory (Nersa) for a 19.9% increase in tariffs in 2018, which is in excess of the SARB’s 8.0% tariff increase assumption that is also the approved amount under the original Multi-Year Price Determination. The SARB estimates that a 20% tariff increase would add 0.2 – 0.3% to headline inflation and potentially prompt second-round effects. Nersa’s decision on Eskom’s revenue application is scheduled for 7 December 2017.

Although the SARB’s last published forecasts place inflation within the 3 - 6% target range over the forecast horizon, the Governor recently noted that “the expected inflation trajectory is still higher than we would prefer, with the risks tilted to the upside.” Specifically, the SARB projects that CPI inflation will stabilise at 5.3% towards the end of the forecast horizon. Notwithstanding the weak economic growth prospects, for the SARB to substantiate further interest rate cuts, its inflation outlook would need to improve. At this week’s MPC, the SARB is likely to reiterate that the balance of risk to the inflation profile remains to the upside and if anything, could further raise its medium term inflation forecasts further. For 2018 and 2019, we forecast CPI inflation at 5.7% y/y and 5.8% y/y respectively (our expected case is that we lose all our investment grade ratings in the next six months) whilst in September the MPC forecast 5.0% y/y and 5.3% y/y respectively.

Figure 6: Eskom’s average tariff adjustment
Figure 7: Inflation expectations: one year

Moreover, the SARB remains concerned that inflation expectations “remain anchored at the upper end of the target range. This is particularly the case for the price-setters in the economy, i.e. business and labour respondents. We would prefer to see these expectations anchored at the midpoint of the target band.”

In its October Monetary Policy Review, the SARB estimated the neutral real interest rate at 1.5%. Decelerating inflation in 2017 saw the actual real interest rate eventually move above the neutral real interest rate which supported the argument for the interest rate reduction in July 2017. However with CPI inflation forecast to start lifting towards 6.0% y/y by mid-2018, the actual real interest rate would move below the neutral rate which would suggest higher interest rates in 2018.

Higher interest rates would likely be aimed at maintaining a neutral rather than a tight policy stance, as the weak economic growth prospects are taken into consideration. The SARB has already suggested that aggressive policy easing would likely have limited effects on the economy given that growth constraints are of a structural nature. Deputy Governor Mminele recently noted that the “lack of growth resides in a self- reinforcing ‘negative feedback loop’ of policy uncertainties, low private-sector confidence, subdued investment in productive capacities, and poor competitive performance” and is not “the consequence of restrictive financial conditions”. Market expectations, reflected in the forward rate agreements (FRAs), reflect steady interest rates into 2018, with approximately 50bp in rate hikes from mid-2018.

FRA curve