FNB Inflation, plenty second round effects

16 May.

FNB Comment: Plenty second round effects.

The SARB uses certain terminology in unpacking inflation and its prospects. This needs perhaps to be unpacked further in order to fully appreciate where we are.

SARB distinguishes between demand side and supply side inflation pressures.

Demand pressure starts to become a feature where available production capacity has been taken up, with extra demand on top increasing the temptation for businesses to increase profit margins and labour to demand shortage premiums (both essentially rationing responses), accelerating (upping) the inflation pressure.

Supply side cost pressure are international commodity prices (oil, food) surging higher, unions politically wanting to “close the wage gap”, Eskom winning high price increases because of earlier planning mistakes and having to obtain a structural improvement in its cash flow to pay for ambitious expansion plans.

SARB contends there is no significant evidence of demand-pull inflation at present, apparently relying primarily on the presence of much resource slack and a lingering output gap for this finding.

SARB also contends that it is closely monitoring the progress of many first-round inflation shocks for evidence of second-round responses, thus broadening into a generalized accelerating inflation.

SARB claims currently not to see much of such second-round effects, allowing its monetary policy to remain on hold for the time being.

But SARB does claim being vigilantly on the lookout for such second-round effects, for this would be the signal to start raising interest rates.

Absorbing this analysis and message, one wonders whether we are all examining the same tealeaves and coming to similar or quite different conclusions.

The rising of global oil prices has a strong demand underpinning but there is still plenty of oil supply, so price surges are mainly responses to feared oil supply tightening in the future.

Similarly, increased global food demand by expanding middle classes is phenomenal, as is energy substitution demands, but there were major supply disruptions this past year, given rise to fearful supply responses (export bans) in turn giving rise to fearful demand responses (import hoarding).

Any way, whether it is globally coming from the demand or the supply side doesn’t really matter, because to us these are external forces, imposed on us from the supply side rather than generated by our own economic agents.

These external supply cost pressures have been fearful in recent months. Add the domestic structural changes in supply costs (Eskom’s approved tariff catch-up to fund its capital needs, unions politically working overtime on closing the wage gap) and one has momentous serialized first-round supply-side cost shocks buffeting the South African economy.

And the main question apparently facing the SARB is whether, like in the hugely underperforming US economy, these price shocks are being “absorbed” by economic agents (businesses, labour) or whether these shocks are giving rise to second-round price surges as they are being passed on to other agents (the mentality of inflation compensation prevailing), thus broadening into an accelerating, generalized inflation.

The SARB so far claims not to be seeing much such second-round effects. Its projected higher inflation rate, from a low of 3.2% last October to 6.3% by 1Q2012 is apparently a mere stacking of serial supply price shocks into the future.

During 2012-2013 the serial supply price shocks apparently remain plentiful to keep inflation near 6%, just within the target band.

So overall (headline) CPI inflation going from near 3% to over 6% in 18 months is apparently not seen as a broadening into generalized inflation (yet).

Something extra is needed (second round effects) to make it so.

But are there really no second-round effects yet?

Listening in on the many wage negotiations going on in the country at present, with CPI inflation at 4.1% but demands varying from 10% in the public sector, 16% in mining and 20% in the metal sector, what else do we hear besides the political supply-side manifesto of closing the wage gap?

Let’s hear it from Vusi Mabho, Numsa engineering sector coordinator (as reported by Engineering News Online 13 May 2011). The union is demanding a 20% increase.

“The wage demand is primarily driven by, amongst other things, an increased cost of living factored on higher petrol, electricity and food prices”.

Only then is the aim of closing the income disparities between races and classes of workers mentioned.

Cost-of-living increases? These are second-round inflation effects, embedding the original first-round price surges in inflation longer-term.

In its application for higher tariffs, Eskom didn’t only plead cash flow shortcomings for capital expenditures. It graphically described how it needed relief from steeply rising costs and on top of that it needs to generate more cash flow to pay for its new investments.

Compensation for rising costs? Those are second-round inflation effects.

Any more evidence?

BER business opinion surveys in the retail, wholesale and motor trades and in manufacturing in recent quarters (!) show evidence of rising liveliness among input costs and prices charged.

The fact of the matter is that the South-African economy clearly remains a cost-plus reality. Except for sectors deeply in recession (such as the building trades and construction where margins are still under pressure), the ruling mentality is to pass on input cost increases, with a margin tacked on.

Most of our economic agents in the formal economy, whether businesses or labour, have this negotiating power and expectation (though at present in the process worsening structural unemployment on the margin).

When price increases are handed out in the services sectors, in too many instances these aren’t 4%. Be lucky to be given 6.5% or 7.5%. It is more likely to be rounded up towards 8% or 10% as a matter of course.

And higher when involving public sector entities.

Happily the cost of housing accommodation is a large item in CPI inflation. With property cyclically out for the count due to changes in credit culture, housing oversupply and stagnating house prices this creates a major natural depressant on CPI inflation at present.

There do remain pockets in the economy benefiting from declining import prices (reflecting limited overseas inflation, strong trade competition and a firm Rand) and import competition constraining domestic players.

Also, some businesses do generate good productivity gains, allowing them to contain their wage bills and cost increases and the price increases they in turn levy on their client bases.

So core inflation is still only about 3.4%, but it is also projected to rise in coming months to above 5%.

Second-round price effects?

The economy is riddled with them. It isn’t only serial first-round supply-side cost shocks that will be doubling inflation this year.

It is primarily the inflation compensation syndromes, cost-plus, rounding-off and cost-of-living approaches, that ensure that a low inflation rate is steadily pushed higher by external cost-push factors AND THEN KEPT ELEVATED AS A GENERALISED HIGHER INFLATION.

Perhaps it just doesn’t quite suit yet to increase interest rates.

There remain major pockets of weakness, thinking property and the building trades.

The job losses and lack of new job gains have a lot to do with the high real wage demands but also with the fact that the economy is still growing only modestly. One would like to see improvement there.

And not everyone can afford to annoy their clients with above-inflation price increases, even if enough do.

Still, the SARB likes to see clear evidence overall that second-round effects are operational, presumably in core inflation turning up, before starting to tighten policy.

And SARB also likes to moderate cyclical volatility in the economy, smoothing the interest rate cycle in such a way that it gives the spiky inflation surges and trough declines a miss, not matching the inflation rate changes kneejerk for kneejerk.

But as to second-round evidence, it presumably won’t have to wait long. The serial cost-push shocks have set everything in motion, and inflation compensation, cost-of-living, rounding-off and cost-price-plus is apparently fully operational in many sectors of the economy.

The table is laid for a return to 5%-7% inflation, which many would describe as still our ‘natural’ inflation rate (though there is nothing ‘natural’ about such habitual mindsets, but it would reflect realism about our lingering structural rigidities, market imperfections, political fisticuffs and habitual mindsets).

It also suggests that our 30-year low interest rate levels are coming to an end soon. When it suits.

Probably a matter of time.

Cees Bruggemans, Chief Economist, FNB

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