FNB Timing any changes in policy stance

11 May.

FNB: Timing any changes in policy stance.

With inflation steadily creeping higher (CPI now at 4.1% but likely to rise quickly in coming months towards 6% by year end), yet with formal employment persistently stuck at 9.2 million and total employment at 13.1 million (well off peak levels), the monetary policy stance may not stay unchanged indefinitely.

Yet any chance is unlikely to be abrupt, given inflation within or near the target zone, the output gap only gradually narrowing and credit growth tepid.

Financial markets discount a 50/50 chance of the first rate hike of 0.5% occurring in September, and are only fully discounting this first hike by November 2011.

If SARB follows through, we should end the year at prime 9.5% compared to 9% now, with further hikes in 2012 taking prime to 11% or thereabouts.

Beyond these initial rate increases things become vague, for will upward pressures on our inflation taper off, with growth in the economy only gradually inching higher and not fully taking up available slack? If so, that might not warrant further tightening beyond the initial instalments.

There are other scenarios.

One sees further increases in oil and food costs, and a weakening of the Rand, together with domestic price pressures pushing inflation yet higher and demanding further rate increases beyond next year, prime advancing towards 12%-13% beyond 2012.

Another sees import commodity prices advancing less aggressively, yet with the Rand staying firm (or even still gaining), subduing the external forces on inflation, allowing it to settle near the upper boundary of the SARB target.

With growth remaining modest in 3%-4% territory, resource slack isn’t fully taken up. It may make the SARB inclined to move even more gradually than now expected, prime settling in 10%-11% territory.

These various views sketch a likely prime target of 10% to 13% these next three years, not excessively high given past cyclical upswings which in recent decades tended to see much bigger upward rate advances on the back of vigorous inflation increases.

Much will depend on domestic events, whether nominal labour demands will remain excessive. Public sector demands are for 10%, mining 16%.

Can employers weather such demands, either through cost reduction (parts of manufacturing, various trades, financial services) or politically absorb such increases (affecting public sector borrowing) or because export commodity earnings keep rising generously (affecting mining, but also impacting many non-mining suppliers).

External events will also have a major bearing on our fortunes.

Will import commodity prices and the Rand keep firming rapidly, or do we need to assume differently?

Global growth of 4% to 5% will likely push oil demand higher by 2mbd annually while oil supply will increase only by 1mbd annually for the foreseeable future. Thus the oil balance should keep tightening, maintaining upward pressure on oil prices.

Then there are the political price premiums regarding oil supply security. With Middle East political prospects in flux, this will for some time remain an area of great uncertainty, imparting volatility to oil prices.

Food prices are similarly determined by global demand and supply. Many agricultural prices have risen steeply over the past year. With inventories in many instances low, much depends on new growing seasons to augment supply.

Meanwhile the growing global middle class and energy substitutes keep putting greater demands on agricultural commodity supplies, providing upward bias to prices.

Aside of short-term price corrections, as seen recently, the trend remains supportive for high commodity prices.

So far we have seen the Rand strengthen considerably, absorbing some of these higher import commodity price pressures, and putting domestic producers generally under pressure to contain their domestic price trends.

But will these conditions continue?

In favour of a yet higher Rand this year (and even next) are debt problems in Europe having a favourable impact on precious metal prices, and especially the Fed delaying its exit from a supportive monetary stance, allowing the Dollar to ease and fanning unease about future US inflation, in addition to an uncertain debt outlook.

Against such an outlook, assuming an early high water mark for Rand and precious metals, and thereafter a cyclical weakening, is the view that the US expansion is now self-sustaining, US employment growth will gradually reduce its unemployment and US core inflation is gradually lifting.

This may induce the Fed to end QE2 after June (as intended) and thereafter start with a gradual shrinking of its balance sheet, in the process tightening its policy stance. US rate increases may follow, starting from as early as 2012 or as late as 2013 (after the next Presidential election).

Either US growth and Dollar are going to disappoint for longer, or there will be an early change in fortune. As the Fed shifts its policy stance, it will likely provide headwind to commodity prices (especially precious metals) and EM currencies.

It would seem that the next 18 months have considerable scope for surprise, as much US performance and Fed timing, as event risk out of Europe and the Middle East (and possibly China), all impacting on our export prices, import prices and the Rand, and by implication on our inflation, growth and interest rates.

This prospect is by its very nature uncertain. Much will happen. But what, and when, precisely?

SARB has the luxury of being able to await events before acting. The next two years especially it is likely to do so.

Cees Bruggemans, Chief Economist, FNB

Register for free e-mail articles www.fnb.co.za/economics