8 June 2006
The risks to the previously benign inflation outlook in South Africa have
increased over the past few weeks. Uncertainties relating to the future
movements of United States (US) interest rates have had reverberations in
international financial markets, with negative consequences for a number of
emerging markets in particular. This has put some downward pressure on
commodity prices and has contributed to a marked depreciation of the rand since
the last meeting of the Monetary Policy Committee. These events have occurred
at a time of continued geopolitical tensions which have driven international
oil prices to new record highs.
Domestically consumer demand has remained robust and there are few signs of
moderation. Growth in credit extension has continued at a brisk pace and house
hold debt has continued to rise, while the current account deficit of the
balance of payments has widened further. Domestic output growth in the first
quarter of 2006 returned to a level more in line with potential output
following the improved performance of the manufacturing sector in the first
quarter of 2006.
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 by
3,7 percent year on year rate in April having measured 3,8 percent and 4,5
percent in the previous two months respectively. Petrol price movements
continue to account for much of the volatility in CPIX inflation. If petrol
prices were excluded CPIX inflation would have fluctuated within a band of 3,0
percent and 3,7 percent since July 2004 and would have averaged 3,3 percent in
April 2006. Motor vehicle running costs declined to year on year rates of
increase of 13,7 percent and 9,5 percent in March and April. This can be
compared to respective increases of 21,5 percent and 24,6 percent in the
previous two months.
Goods price inflation declined to 4,1 percent and 3,9 percent in March and
April respectively compared to 4,8 percent in February. The lower trend of
goods price inflation was influenced by the lower rates of increase in vehicle
running costs and the continued decline in the prices of clothing and footwear,
furniture and equipment and motor vehicles. Food price inflation increased
further, measuring 5,5 percent and 6,2 percent in March and April respectively.
The main categories contributing to the higher food price inflation were meat,
fish and vegetables. Although grain price increases remained relatively low
there were signs of acceleration in this category as the impact of the higher
maize prices began to be felt at the consumer level. Grain product prices
increased by 3,9 percent in April compared to a modest fall in prices in
January. Services price inflation remained below that of goods inflation and
measured 3,5 percent in both March and April of this year. Administered prices
increased at a year on year rate of 5,2 percent in April while administered
prices excluding petrol increased by 3,3 percent.
Production price inflation has remained relatively stable at around 5,5
percent for the first four months of 2006. Imported goods prices increased by
6,7 percent and 6,1 percent in March and April respectively, while prices of
domestically produced goods increased by 5,0 percent and 5,5 percent in these
months respectively.
The outlook for inflation
Compared to the previous forecast of the bank, the latest forecast shows a
marked deterioration in the inflation outlook particularly in the short term.
Whereas the previous forecast projected CPIX inflation to peak at a level just
below five percent in the first quarter of 2007, it is now expected to breach
the upper end of the target range and to peak at a level of 6,2 percent at that
time. CPIX inflation is then expected to fall back below the upper end of the
target by the next quarter and by the third quarter it is projected to decline
further to 5,2 percent. Inflation is then expected to continue to moderate
gradually to reach 4,8 percent by the end of 2008. The main reason for the
deteriorating outlook is a significant upward revision of the international oil
price assumptions.
The most recent inflation expectations survey of the bank conducted by the
Bureau for Economic Research at the University of Stellenbosch shows that
expectations for 2006 have remained more or less unchanged, although there has
been a slight deterioration in expectations for 2007 and 2008. The revisions
were mainly a result of an upward adjustment of expectations of trade unionists
and this brought them in line with the expectations of analysts and business
executives. Inflation is now expected to average 4,9 percent in both 2007 and
2008 compared to expectations in the first quarter of 2006 of 4,6 percent and
4,8 percent for these two years respectively. These expectations are in line
with the inflation expectations as indicated in the long term break even
inflation rate, measured as the yield differential between conventional bonds
and inflation linked bonds which measured 4,8 percent at the end of May
2006.
Favourable factors to the inflation outlook include the continued fiscal
discipline, the moderate trend in unit labour costs and the benign world
inflation. The International Monetary Fund (IMF) expects world inflation to
decline from a projected 3,8 percent in 2006 to 3,5 percent next year despite
higher international oil prices.
South Africaâs growth performance improved during the first quarter of 2006
to a rate of 4,2 percent compared to the revised 3,2 percent growth in the
fourth quarter of last year. The improved performance occurred despite
contractions in both agriculture and mining. The manufacturing sector made a
good recovery and grew by 4,3 percent following a mild contraction in the final
quarter of 2005. The latest Investec/BER Purchasing Managerâs Index indicates
that this improved performance may continue in the second quarter, despite the
downturn recorded in April. Overall growth in 2006 is expected to remain more
or less in line with potential output.
Although inflation is expected to remain within the target range for most of
the forecast period the risks are still seen to be on the upside. Household
real consumption expenditure increased in the first quarter of 2006 at a rate
roughly the same as that in the previous quarter and in line with the 6,9
percent increase in 2005. Motor vehicle sales remain at a high level although
on a month on month basis a 4,1 percent decrease was recorded in May of this
year.
These developments continue to be reflected in the growth of credit
extension. A 12 months growth in bank loans and advances extended to the
private sector measured 23,1 percent in April compared to 24,3 percent in
March, while asset backed credit extended to the private sector continued to
grow strongly at a year on year rate of 27,2 percent in April reflecting strong
growth in mortgage advances. This has resulted in a further increase in
consumer indebtedness. In the first quarter of 2006, the ratio of household
debt to Gross Domestic Product (GDP) had risen to approximately 68 percent
compared to 65½ percent the previous quarter. The cost of servicing the debt
has remained fairly stable at around seven percent.
High levels of expenditure contributed to the continued widening in the
deficit on the current account of the balance of payments in the first quarter
of 2006. This has arisen in part as a result of weak export volume growth and
higher volumes and values of crude oil imports, particularly in January and
February, when significantly large trade deficits were recorded. The widening
deficit has nevertheless been more than financed by capital inflows. These
inflows enabled the Bank to further increase its holdings of foreign exchange
reserves. By the end of May, official gross gold and other foreign exchange
reserves had increased to US$24,1 billion, while the international liquidity
position had increased to US$20,4 billion.
The international environment has posed increased risks to the inflation
outlook. Since the last meeting of the Monetary Policy Committee (MPC) the
exchange rate of the rand has come under pressure as a result of developments
in international financial and commodity markets. Previously the relative
exchange rate stability had contributed to the positive inflation outlook. In
the past weeks the rand has depreciated against all the major currencies at a
time when the US dollar has been weakening against other major currencies. The
decline in commodity prices and the re-rating of emerging market risk
contributed to the depreciation of the Rand from around R6,12 to the US dollar
at the time of the last MPC meeting to current levels of around R6,80 and from
R7,42 to the Euro to current levels of around R8,65. On a trade weighted basis,
the Rand has depreciated by approximately 13 percent since the last MPC
meeting.
The continued uncertainties on the international financial and commodities
markets add to inflation risk but may be a part of the adjustment to changing
risk perceptions of emerging markets. Of significance is the fact that South
Africaâs spreads have not widened by as much as those of a number of other
emerging markets and there does not appear to be a strong exodus by
non-residents from the domestic bond and capital markets. In fact over the past
few weeks, non-residents have remained net buyers of South African bonds and
equities. However, in line with a number of other markets internationally,
share prices on the Johannesburg Stock Exchange (JSE) securities exchange have
come under pressure and the all share index has retreated from a recent all
time high of just over 2 2000 in May to current levels just below 20 000.
According to the IMF, world growth is expected to average a robust 4,9
percent this year compared to the previous forecast of 4,3 percent and 4,7
percent next year. Uncertainties arise however in the interpretation of recent
events in the international markets. It is unclear at this stage whether they
are simply a reflection of a temporary correction in the markets or a more
sustained period of volatility which could undermine world growth in general
and in emerging markets in particular.
Adding to the uncertainty is the continued risk posed by international oil
prices. Since the last meeting of the MPC the price of Brent Crude has averaged
around US$70 per barrel and fluctuated between a new record high of just below
US$75 per barrel in the third week of April and the current level around US$68.
These developments have been a result of tight supply and demand conditions as
well as continued geopolitical tensions which have kept the oil price at a high
level. These higher oil prices have been felt domestically in the pump price of
petrol. The R0,22 per litre increase in April was followed by increases R0,39
per litre and R0,36 per litre in May and June respectively. Approximately R0,14
of the most recent increase is a result of exchange rate movements.
Monetary Policy stance
On the basis of the detailed analysis of the economy which is summarised
above, the MPC has decided that a moderate adjustment in the repo rate is
warranted at present. Accordingly the repo rate is increased by 50 basis points
to 7,5 percent per annum with immediate effect. The MPC will continue to
monitor economic developments and all the relevant risks which might have a
bearing on the continued attainment of the inflation target.
Contact:
Cathy Powers
Tel: (012) 313 4420
E-mail: Cathy.Powers@resbank.co.za
Issued by: South African Reserve Bank
8 June 2006
Source: South African Reserve Bank (http://www.reservebank.co.za/)
