3 August 2006
Domestic inflation is on an upward trend, with food price inflation adding
to the pressures emanating from persistent petrol price increases. Household
consumption spending has continued to grow at a strong pace and consumer
confidence remains high. This has been reflected in strong credit extension and
preliminary indications are that the deficit on the current account of the
balance of payments might have remained high in the second quarter. These
factors, combined with a general depreciation of the rand, have resulted in a
further deterioration in the inflation outlook.
In the recent past there has been considerable volatility in international
financial markets in general, and in emerging markets in particular. These
developments have cantered around the uncertainty about the future path of
interest rates globally. However, the latest developments appear to suggest
that some calm may be returning to the financial markets, as evidenced by the
narrowing spreads on emerging market debt.
Recent inflation developments
Inflation as measured by the consumer price index for metropolitan and other
urban areas excluding the interest cost on mortgage bonds (CPIX) increased at a
year-on-year rate of 4,8 percent in June, compared to 3,7 percent in April and
4,2 percent in May. This upward trend is not only attributable to petrol price
increases. If petrol prices were excluded, CPIX would have measured 3,5 percent
and 3,8 percent in May and June respectively. This latter figure is the highest
rate of increase of this measure since June 2004. Food price inflation has also
made a significant contribution to this upward trend.
Prices of petrol and diesel increased at year-on-year rates of 13,2 percent
and 22,7 percent in May and June respectively. Food price inflation has been
increasing steadily since late 2005. In November last year, year-on-year food
price increases measured 2,0 percent. In each subsequent month food price
inflation increased, and measured 7,2 percent in June. Significant increases in
the prices of meat, fish and vegetables have been the major contributors to
this trend. Grain product prices have not fully responded to the sizable
increase in maize prices since the latter part of last year although some
upward pressure is evident. In June, the grain products inflation component of
CPIX measured 3,8 percent compared to 0,2 percent in January 2006.
Most of the other CPIX categories continue to exhibit low rates of price
increases, while the categories of clothing and footwear and furniture and
equipment have shown persistent price declines. Services price inflation has
declined continuously in the past few months and measured 3,3 percent
year-on-year in June 2006. Administered prices excluding petrol are
predominantly services and therefore have exhibited a similar trend but at
marginally lower rates of increase.
Indications of possible consumer price pressures come from production price
inflation which increased at a year-on-year rate of 7,6 percent in June,
compared to 5,5 percent and 6,3 percent in April and May respectively. Although
food and energy were important drivers of these increases, the pressure was
more broad-based. If food and energy were excluded, production price inflation
would have measured 4,5 percent in June, compared to 2,9 percent in April, and
3,6 percent in May of this year. Some of the upward pressure in June can be
attributed to the change to winter electricity tariffs.
The outlook for inflation
Since the previous meeting of the Monetary Policy Committee (MPC), the
inflation forecast of the bank has deteriorated moderately. The most recent
central forecast of the bank projects inflation to peak above the six percent
level and to remain outside the target range for the first two quarters of
2007. Thereafter, based on the current assumptions, CPIX inflation is projected
to decline slowly to reach a level marginally above five percent by the end of
2008.
It seems to us that the use of the forecast in monetary policy decisions
needs to be further explained. The MPC does not use the forecast in a
mechanical way as the basis for policymaking. The forecast provides a broad
guide to possible inflation outcomes, but the Committee relies on its judgement
about possible future developments. No model can adequately capture all the
relevant dynamic processes in any economy. It is worth emphasising that the
model outcomes are also dependent on the assumptions that are fed into it.
Furthermore, the MPC takes a view of the risks to the forecast.
The exchange rate has exhibited considerable volatility, and fluctuated
between levels of around R6,70 and R7,50 to the United State (US) dollar since
the June MPC meeting. The behaviour of the rand was initially related to
increased global risk aversion, combined with concerns relating to domestic
balance of payments imbalances. More recently, expectations that the monetary
policy tightening cycle globally may be at or near its peak have prompted an
appreciation of the rand to current levels of around R6,90. On a trade-weighted
basis, the rand has depreciated by about 14 percent since the beginning of the
year, and by 2,5 percent since the previous MPC meeting. Some pass-through from
the exchange rate to prices can be expected, particularly to domestic petrol
prices, which have increased by a cumulative R0,56 in July and August. Exchange
rate movements accounted for about R0,44 of this adjustment. The prospects for
the rand going forward, and the associated risks to inflation, depend to some
extent on the global interest rate trend.
In previous statements the MPC expressed concerns about the expanding
deficit on the current account of the balance of payments. Current account
deficits are a reflection of higher domestic expenditure and are not in
themselves inflationary. There is however a possible risk to the exchange rate
if the deficits are perceived to be unsustainable, particularly if the deficits
are reflecting higher consumption expenditure.
The recent exchange rate reaction to the higher deficit is indicative of
this, but it is also part of the macroeconomic adjustment process. In order for
the exchange rate to play its part in this process, it is important that the
exchange rate changes are not simply offset by higher inflation.
The current account deficit is expected to be adequately financed through
capital inflows, although the focus of non-residents has shifted from the
equity market towards the domestic bond market. In July, non-residents became
net sellers of shares to the value of R2 billion, whilst non-resident net bond
purchases totalled R11,8 billion in the same month, compared to net sales of
R1,3 billion in June.
Household consumption expenditure, which grew at an annualised rate of 7
percent in the first quarter of this year, shows few signs of abating. The
First National Bank (FNB)/ Bureau for Economic Research (BER) Consumer
Confidence Index declined marginally in the second quarter of 2006, but
nevertheless remain close to historically high levels. Motor vehicle sales
continue to exhibit strong growth. New vehicle sales grew by 20,8 percent in
the year to July.
This higher consumer demand has been underpinned by low nominal interest
rates, rising real incomes, and wealth effects arising from strong asset price
growth. The residential property market remains buoyant, although the rate of
increase in house prices has declined somewhat during 2006. According to the
ABSA house price index, house prices recorded year-on-year increases of 13,6
percent in June. Prices on the Johannesburg Stork Exchange Securities Exchange
have been somewhat volatile with the ALSI fluctuating between 18380 and a high
of 21592.
Growth in credit extension to the private sector reflects the growth in
consumer expenditure and higher property prices. Growth over twelve months in
total loans and advances accelerated from 22,5 percent in May 2006 to 23,2
percent in June. Asset backed credit growth, which accounts for a significant
part of the increase in total loans and advances, has remained around 27
percent since February 2006.
Until recently wage developments presented a benign picture. During 2005,
unit labour cost in the formal non-agricultural sector increased by 3,4
percent, providing further evidence that wage pressures were well contained.
However in the first quarter of 2006, nominal unit labour cost increased by 7,6
percent compared to the same quarter of the previous year, and up from an
increase of 2,6 percent in the fourth quarter of 2005. This development is
attributed in part to a decline in labour productivity in the first quarter of
2006 compared to the first quarter last year, as employment outpaced output
growth.
It is too early to tell if this represents a reversal of the previous trend,
but as a significant number of wage negotiations are concluded in the third
quarter, these developments will be closely monitored. Wage settlements surveys
conducted by Andrew Levy Employment Publications show that settlements have
averaged 6,2 percent in the first half of 2006, compared to 6,3 percent in 2005
as a whole.
Preliminary indications are that economic growth, although still robust,
continues to show some moderation compared to the 4,9 percent achieved in 2005,
and consequently poses little threat to the inflation outlook. The Rand
Merchant Bank (RMB)/BER Business Confidence Index declined in the second
quarter, although it remains at a high level. Manufacturing output growth has
shown some signs of sustaining the first quarter recovery after the subdued
levels in the second half of 2005. The physical volume of manufacturing
production increased by 4,4 percent on a year-on-year basis in May, while the
Investec/BER Purchasing Managers Index has increased for six consecutive
months, with the measure for July indicating a strongly positive outlook for
the sector. Mining production, however, remains under pressure. Total mining
production decreased by 6,8 percent year-on-year in May although in the past
three months mining production increased by 5,4 percent compared to the
previous three months, mainly as a result of increased platinum group metals
production.
International factors also pose a risk to the inflation and interest rate
outlook. International oil price developments remain a significant source of
concern. In mid-June the price of Brent crude oil had declined to levels of
around US$66 per barrel as a result of higher reported inventories. However by
the end of June, oil prices had risen to levels of around US$75 per barrel as a
result of strong demand pressures, supply constraints and rising geopolitical
tensions. In July the price of Brent crude oil averaged almost US$74 per
barrel, compared to US$68 per barrel in June.
Despite the relatively subdued global inflation environment, inflationary
pressures have begun to emerge in a number of countries. This has prompted
further tightening of monetary policy by several central banks in the past few
months.
Monetary policy stance
The MPC remains concerned about the longer term threats to the inflation
outlook and has therefore decided that a further adjustment to the repo rate
would be prudent. Accordingly, the repo rate is increased by 50 basis points to
8,0 percent per annum with immediate effect. The Monetary Policy Committee
will, as is always the case, remain vigilant in order to ensure that CPIX
inflation stays within the inflation target range.
Enquires:
Cathy Powers
Tel: (012) 313 4420
E-mail: Cathy.Powers@resbank.co.za
Issued by: South African Reserve Bank
3 August 2006
Source: South African Reserve Bank (http://www.reservebank.co.za)
