African Reserve Bank Governor, Mr TT Mboweni
7 June 2007
Introduction
CPIX inflation breached the upper end of the inflation target range in April
2007 for the first time since August 2003. The year-on-year increase of 6,3
percent was higher than that expected by the bank and most forecasters. The
petrol price had increased by R0,69 per litre in April and this was expected to
contribute to an increase in the inflation rate. This was compounded by strong
increases in food prices as well as generalised increases in some other
categories.
The breach of the target is in the past and there is nothing that monetary
policy can do about past inflation. Nevertheless the Monetary Policy Committee
(MPC) cannot ignore the possible impact of this breach on inflation
expectations and the public's understanding of the monetary policy process.
Monetary policy acts with a lag and the focus of the Monetary Policy Committee
will remain, as always, on the medium-term inflation outlook which is the
period over which monetary policy can be effective.
Recent developments in inflation
Year-on-year 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 6,3 percent in April 2007
compared to 4,9 percent in February and 5,5 percent in March. Food and petrol
price increases accounted for most of the increase, but more broad-based
pressures are also becoming evident. If food and energy were excluded, CPIX
inflation would have measured 4,6 percent in April compared to 3,9 percent in
January. Although this measure is still well within the target range, the
recent strong upward trend is indicative of more broadly-based price
pressures.
The biggest impetus to the increase in the inflation rate in April came from
the petrol price. Petrol prices increased at a year-on-year rate of 15,5
percent in April compared to 7,9 percent in March 2007. Food price inflation
also continued its upward trend measuring 7,8 percent and 8,6 percent in March
and April respectively. The higher food price inflation in April was driven
mainly by grain product and meat price increases. Grain product prices
increased at a year-on-year rate of 10,6 percent compared to meat price
increases of 10,8 percent. The latter, although still high, are significantly
lower than the peak increases of almost 20 percent in October and November last
year. Prices of household consumables increased by eight percent in April,
compared to 6,1 percent in February.
Services price inflation has also been increasing steadily, having measured
5,5 per cent on a year-on-year basis in April, compared to 4,6 percent in
January. Certain components of housing services made a significant contribution
to this upward trend. Pressures on inflation continue to be moderated by price
declines in clothing, footwear, furniture and recreation and entertainment.
Production price inflation increased at a year-on-year rate of 11,1 percent in
April, compared to 9,5 percent and 10,3 percent in February and March
respectively. These developments point to further pressures on CPIX inflation
in the coming months. The April increase was the highest since December 2002.
Apart from textiles, clothing and footwear, the increases were across a wide
spectrum. Prices of domestically produced goods increased by 11,2 percent in
April compared to 10,5 percent for imported goods.
The outlook for inflation
The most recent central forecast of the bank's models indicates a further
deterioration in the inflation outlook compared to the previous forecast. The
forecast, which takes account of the petrol price increases of May and June,
projects that CPIX inflation will remain marginally above the upper level of
the inflation target range in the second quarter of 2007. After a technical
decline in the third quarter, CPIX inflation is expected to marginally exceed
six percent in the subsequent two quarters, peaking at an average of 6,3 in the
first quarter of 2008. Thereafter, CPIX inflation is projected to follow a
downward trajectory and to average 5,3 percent in the fourth quarter of 2008.
The higher trend of the forecast in the near term compared to the previous
forecast is a result of a slightly higher oil price assumption. The committee
continues to view the risks to the outlook to be strongly on the upside.
Inflation expectations are an important indicator of possible future
inflation trends because of their impact on wage and price setting processes.
According to the most recent inflation expectations survey conducted in May on
behalf of the Bank by the Bureau for Economic Research at the University of
Stellenbosch, there had been some deterioration in inflation expectations which
had moved back to the levels of the fourth quarter of 2006. Nevertheless
inflation expectations still remained within the inflation target range.
Respondents expected CPIX inflation to average 5,5 percent this year and to
moderate to 5,3 percent and 5,2 percent respectively in the coming two years.
Expectations of trade unionists increased the most since the previous survey.
Labour and business expectations were then significantly higher than those of
analysts, but all groups were within the target range for all three survey
years.
The bond markets have also shown evidence of some deterioration in
expectations. In reaction to the April inflation data, long-term bond yields
increased further and the yield curve shifted upwards, although it remained
inverted. The break-even inflation rate, which is the difference between the
yield on conventional bonds and the yield on inflation-linked bonds, increased
by about 50 basis points to around 5,6 percent since the end of May. The MPC
identified a number of upside risks to the outlook. These include food and oil
prices and continued high rates of household consumption expenditure. The
assessment of most of the other variables was relatively unchanged since the
previous meeting.
Oil remains an upside risk to the inflation outlook. The price of North Sea
Brent crude oil has averaged US$68 per barrel since the previous MPC meeting
and is currently trading above US$72 per barrel. International prices remain
dominated by geopolitical tensions, fluctuating inventory levels and supply
disruptions in a number of oil-producing countries. Futures prices suggest that
upward pressure on oil prices is expected to persist in the near future. The
domestic petrol price was increased by R0,34 and R0,23 per litre in May and
June respectively. These increases, which were due to international product
price increases, were cushioned to some extent by the behaviour of the exchange
rate.
Pressure on inflation emanating from food price increases is expected to
persist for some time. This may be attributed to international food price
developments which have seen the diversion of grain products to biofuel
production and increased food demands as a result of higher global real
incomes.
Household consumption expenditure has remained strong although preliminary
estimates suggest that there has been a slight moderation in the first quarter.
Growth in new passenger motor vehicle sales has been declining since late last
year, but the most recent trend has been distorted by problems related to the
teething challenges during the introduction of the new electronic licensing
system. Sales of commercial and heavy vehicles remain strong, reflecting the
strong state of the economy. Growth in retail sales declined to a year-on-year
rate of 8,0 percent in February compared to 9,9 percent the previous month, but
growth accelerated to a year-on-year rate of 10,1 percent in March.
The continued underlying strength in household consumption expenditure is
reflected in the high rates of domestic credit extended to the private sector.
Twelve-month growth in banks, loans and advances extended to the private sector
measured 26,2 percent in March before increasing to 27,4 percent in April.
Adjusted for the cumulative effect of securitisation transactions, growth has
remained around 29 percent. Growth in mortgage advances, which had previously
exhibited a slight declining trend, increased at a year-on-year rate of 27,6
percent in April. In line with declining trend in passenger motor vehicle
sales, instalment sale and leasing finance increased by 17,2 percent and 16,9
percent in March and April respectively. Consistent with the growth in fixed
capital formation, advances to the corporate sector accounted for the strongest
increases in bank lending.
The sustained strength in consumer demand has been underpinned by higher
levels of employment, higher real incomes and improved household balance
sheets. Higher equity and house prices contributed to this positive wealth
effect. The All-share index on the Johannesburg Securities Exchange (JSE)
Limited reached new heights in the past weeks, in tandem with strong equity
market performances in a number of countries. According to the Absa and
Standard Bank house price indices, house prices continue to increase although
at moderately slower rates.
South Africa's economic growth rate declined moderately in the first quarter
of 2007 to an annualised quarter-on-quarter rate of 4,7 percent. The decline is
attributable mainly to a contraction in the mining sector and slower
manufacturing sector growth. The construction sector grew at over 21 percent
mainly as a result of non-residential construction and civil engineering
projects. This strong performance is indicative of the continuing domestic
investment boom which has been given further impetus by the investment
activities of public corporations.
The economy is still growing at a rate around estimated potential and the
higher rate of fixed capital formation, which is now in excess of 20 percent of
Gross Domestic Product (GDP), is expected to sustain economic growth going
forward as well as increase the growth potential of the economy. The
utilisation of production capacity in manufacturing increased by a further 0,3
percentage points in the first quarter of 2007 to 86,5 percent. However, growth
in the manufacturing sector appears to have moderated somewhat. Manufacturing
output declined between March and April of this year and the most recent
Investec Purchasing Managers Index (PMI) also indicates a slowdown of the
manufacturing sector's growth momentum.
According to the most recent Wage Settlement Survey by Andrew Levy
Employment Publications, wage settlements averaged 6,5 percent in 2006 and
remained at this rate in the first quarter of 2007. These increases are
consistent with the inflation target if account is taken of positive changes in
labour productivity.
The exchange rate of the rand is trading at levels similar to those
prevailing at the time of the previous MPC meeting. The volatility observed
since the last meeting can be attributed mainly to movements of the United
States dollar against other currencies.
The deficit on the trade account of the balance of payments narrowed as a
result of an expected decline in the volume of imported oil. Preliminary data
suggest that the deficit on the current account of the balance of payments in
the first quarter was narrower than that experienced in the final quarter of
2006. As before, this deficit was comfortably financed by net financial
inflows. In the year to date, non-resident net purchases of bonds and equities
have totalled around R45 billion. The bulk of this has been equity investments,
reflecting continued confidence in South Africa's macroeconomic policy
framework and the related growth prospects.
This is also illustrated further by the revision of the outlook from stable
to positive of South Africa's external sovereign debt rating by Moody's rating
agency. Further progress was also made with international reserve accumulation.
At the end of May, official gross gold and other foreign exchange reserves had
increased to US$ 27,9 billion, while the international liquidity position had
risen to US$ 25,5 billion.
Aside from oil and food price developments, the international economic
environment remains relatively favourable. World growth is expected to remain
strong although slightly lower than that achieved last year. The main risk to
growth is seen to emanate from the housing market in the United States,
although this risk appears to have dissipated somewhat. In general,
international interest rates are not expected to decline in the near future,
while further increases may still occur in some regions. The generally tighter
monetary policy stance is expected to keep inflation contained despite
pressures from rising oil and food prices. Growth prospects in the Common
Monetary Area (CMA) region remain positive, although member countries are also
experiencing inflation pressures from food and oil prices.
Monetary policy stance
The Monetary Policy Committee has decided that in view of the further
deterioration in the inflation outlook, the monetary policy stance needs to be
adjusted to ensure that CPIX inflation returns to within the inflation target
range over time. Accordingly, the repo rate will be increased by 50 basis
points to 9,5 percent per annum with effect from Friday, 8 June 2007. The MPC
will continue to monitor developments which have a bearing on inflation
outcomes and will not hesitate to adjust the policy stance as may be
appropriate.
Contact person:
Thandi Moya
Tel: 012 313 3027
E-mail: Thandi.Moya@resbank.co.za
Issued by: South African Reserve Bank
7 June 2007
