On July 16-18, the South African Reserve Bank’s (SARB) monetary policy committee (MPC) will meet for the fourth time this year to debate whether any change in monetary policy should be implemented. Consensus expectations among analysts as well as the rate guidance provided by financial markets suggest that there is a strong probability that the repo rate will be lowered by 25bps to 6.50% when the SARB delivers its verdict on interest rates on Thursday, July 18th.
Since the previous MPC meeting in May
Since the SARB’s previous meeting in May, the stars across global markets have aligned to create room for the MPC to reduce interest rates.
Various major global central banks have indicated that they would need to turn more accommodative in their respective policy stances going forward, while some (the Reserve Bank of Australia, for example) have already started easing policy through interest rate reductions. The most noteworthy shift has been from the U.S. Federal Reserve Bank, which has rapidly turned dovish (i.e. favouring looser monetary policy through interest rate reductions) and indicated that interest rates may be lowered as soon as later this month.
The rationale for the dovish shift in rhetoric is twofold. Firstly, the global growth outlook has gradually deteriorated as the global business cycle matures and the ongoing trade wars have compounded the risks to growth over the medium term. Secondly, inflation risks remain muted and in countries such as the U.S., inflationary pressures have stayed benign regardless of an ongoing decline in the unemployment rate. These developments are crucial for emerging market economies which are highly exposed to the changes in global economic dynamics and central bank policy.
Internal dynamics naturally play a pivotal part in the SARB’s decision-making process as well and factors such as currency fluctuations, domestic inflation risks, underlying growth momentum, and so on, are considered when a decision is taken on domestic interest rates.
Inflation plays a key part in this decision-making process given the Reserve Bank’s primary mandate to “achieve and maintain price stability in the interest of balanced and sustainable economic growth in South Africa”.
Impact of rising non-discretionary prices
A noteworthy trend observed in recent quarters is how rising costs of non-discretionary prices have squeezed household budgets rather than pushing up overall inflation.
These non-discretionary goods include regulated price inflation, including electricity and water, which has consistently trended well above headline CPI for several years. Tax hikes are yet another example of how regulated prices are being forced onto households, eroding the real disposable income that is available for spending on discretionary / luxury goods.
In an environment where costs are rising and the labour market is under significant strain, businesses have been forced to squeeze margins to protect sales volumes. The overall growth environment, meanwhile, remains particularly weak, as was evident in the collapse in GDP in the first quarter of this year.
Inflationary pressures anchored below SARB’s mid-point target
Against this weak domestic growth and sluggish aggregate demand backdrop, underlying inflationary pressures have consistently stayed well anchored below the SARB’s mid-point target of 4.5% for at least the past eighteen months.
At the same time, the SARB has sent a strong message to the market that it is committed to engineering an environment in which price stability features prominently and the policy committee has targeted an inflation rate of 4.5% – which marks the mid-point of the 3%-6% inflation target band.
Subdued inflation has meanwhile helped anchor medium-term inflation expectations from analysts, business people and trade union officials, as reflected in the Bureau of Economic Research’s inflation expectations survey.
Market inflation expectations have also softened and are currently at their lowest levels in around four and a half years. Given the SARB’s primary mandate of achieving price stability, the current and expected inflation dynamics in conjunction with the muted domestic growth backdrop suggests that the bank indeed has room to lower interest rates.
The SARB’s Quarterly Projection Model
The SARB introduced a Quarterly Projection Model a couple of quarters ago and has since communicated an implied path of policy rates generated by this model. While the SARB has emphasized on numerous occasions that the implied path is merely a broad policy guide and therefore does not dictate to the SARB the timing and direction of changes in interest rates, the guidance offered by the model is nevertheless very closely monitored by the market.
Therefore, the significant change at the May MPC meeting did not go unnoticed. Specifically, the QPM’s implied policy path suggested that interest rates would be reduced by 25bps by the end of Q1 2020, which compares to the March path of one 25bps rate increase by the end of 2019.
In conclusion, internal and external dynamics are conducive to a reduction in interest rates at the July MPC meeting, especially as the SARB has already offered a more dovish tone at their May meeting.
Factors such as a strong ZAR performance and subdued oil prices further corroborates this view.
Whether a marginal interest rate reduction of 25bps would provide any stimulus to the domestic economy is up for debate, however, given that the factors that are crippling economic growth are very structural in nature.
AUTHOR: JANA VAN DEVENTER, ETM ANALYTICS