12 October 2006
Recent domestic economic developments indicate that the risks to the
inflation outlook to which the Monetary Policy Committee (MPC) drew attention
in previous statements remain. The domestic economy continues to grow at a
brisk pace while domestic demand growth has sustained its vibrancy, buoyed by
strong credit extension. The deficit on the current account of the balance of
payments continues to be at levels which may strongly influence the exchange
rate outlook. The exchange rate has depreciated further since the last MPC
meeting and broad-based pressure from producer prices has become more
pronounced.
Internationally, oil prices have moderated somewhat, which has allowed for a
reduction in petrol prices in two consecutive months. However, in line with
declining oil prices, commodity prices in general have also declined
recently.
The outlook for the international economy remains positive although there
are still uncertainties relating to the growth outlook in the United States of
America. The latest World Economic Outlook of the International Monetary Fund
(IMF) says that global growth is expected to moderate slightly from 5,1 percent
in 2006 to 4,9 percent in 2007. Against the background of generally tighter
monetary policies globally, world inflation is expected to remain under control
and average 3,7 percent next year, slightly higher than the April projection of
the IMF.
Recent developments in inflation
Inflation has continued to display an upward trend. 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) has increased in each
month since April of this year when it measured 3,7 percent. By August this
year, CPIX inflation had increased to 5,0 percent. Goods prices increased at a
year-on-year rate of 6,0 percent compared to 3,5 percent for services in
August. The main inflation drivers in the goods category were again food and
petrol prices. The prices of a number of food products have been increasing at
high rates, in particular meat prices which increased at year-on-year rates of
15,2 percent in August. Meat has a weight of about 7 percent in the CPIX
basket, and in August its contribution to CPIX inflation was similar to that of
petrol and diesel. Petrol and diesel prices, which have a weight of 5,04
percent in the CPIX basket, increased at year-on-year rates of 22,1 percent. By
contrast, clothing, footwear and furniture and equipment prices continued to
decline, while administered prices excluding energy increased at a year-on-year
rate of 4,2 percent.
Production price inflation increased markedly and across a broad spectrum of
categories. Measured year-on-year, production price inflation had increased to
9,2 percent in August 2006. Of particular concern was the 9,6 percent increase
in domestically produced goods inflation, up from 8,1 percent the previous
month. Imported goods inflation measured 7,8 percent in August compared with
8,2 percent in July. The categories displaying the highest month-on-month
increases were agricultural products, manufactured food and electricity, gas
and water.
The outlook for inflation
In the short term, the increase in CPIX inflation is expected to be
moderated somewhat by the reductions in the domestic petrol price, amounting to
R0,36 and R0,50, which took effect in September and October respectively.
Pressures emanating from production prices, however, indicate that some
countervailing movements can be expected. The outcome of the South African
Reserve Bank's (SARB) forecasting models shows that over the forecast period,
inflation is expected to continue its upward trend towards the upper end of the
target range and remain at levels of around seven percent between the second
and fourth quarters of 2007. Thereafter CPIX inflation is expected to decline
gradually to reach around 5,4 percent by the end of the forecast period in the
fourth quarter of 2008.
Market expectations of inflation, as indicated by the break-even inflation
rates (i.e. the yield differential between inflation-linked bonds and
conventional government bonds); also show an upward trend over the shorter
maturity range. Inflation expectations as reflected in the survey conducted on
behalf of the SARB by the Bureau for Economic Research (BER) have also moved
higher. Compared to the previous quarter, inflation expectations during the
third quarter of this year increased in respect of every forecast year. Average
inflation expectations increased by 0,5 percent for 2006 to 4,9 percent, while
for 2007 they increased by 0,4 percent to 5,3 percent. Inflation is then
expected to decline to 5,0 percent in 2008. Despite this upward movement,
expectations are still within the inflation target range during all the
forecast years. Given the importance of inflation expectations in the price and
wage formation process, it is vital that the MPC remains vigilant to ensure
that expectations stay entrenched within the three to six percent range.
A number of factors have contributed to the adverse inflation outcomes and
outlook, and continue to pose a risk to future outcomes. Domestic expenditure
remained buoyant in the second quarter of this year. Real domestic final demand
increased at an annualised rate of 10 percent in the second quarter, with
strong growth in final consumption expenditure by households and general
government, as well as fixed capital formation.
Strong household consumption expenditure remains one of the primary risk
factors. In the second quarter of this year, household consumption expenditure
increased at an annualised rate of 8 percent, the highest quarter-on-quarter
growth rate since 1995. There are few indications that this trend has been
reversed despite the most recent interest rate changes. However it is
recognised that it is possibly too early to assess fully the impact of monetary
policy actions. One tentative indication of a possible slowdown in demand
growth is seen in motor vehicles sales. In the third quarter of this year,
sales of new motor vehicles declined by 0,3 percent. On a month-on-month basis,
sales in September declined by 3,6 percent.
This strong demand is supported by higher asset prices and increased credit
extension to the private sector. Share prices on the Johannesburg Stork
Exchange (JSE) securities exchange reached new record highs recently while
house prices have continued to increase, albeit at a slower rate. Growth over
twelve months in total loans and advances extended to the private sector grew
at a level of 26,1 percent in August. Mortgage advances continued to be the
largest component of credit extension. This component is likely to react to
interest rate changes with a lag, given the time taken to finalise property
transfers. The higher rates of credit extension have contributed to the further
increase in household indebtedness which in the second quarter of this year
rose to 70 percent of household disposable income.
Growth in money supply (M3) remains brisk. Twelve-month growth in money
supply decelerated from 23,0 percent in June to 21,2 percent in July before
accelerating marginally to 21,4 percent in August. The income velocity of
circulation of M3 declined from 1,43 in the first quarter of 2006 to a low of
1,37 in the second quarter. This is yet another indication of ample liquidity
in the South African economy.
Recent exchange rate developments might pose a risk to the inflation
outlook. Since early May, the rand has depreciated on a trade-weighted basis by
almost 22 percent. At these levels, it is possible that some pass-through to
higher prices might occur. The challenge for monetary policy is to ensure that
this effect is minimised.
A part of the explanation for the recent adjustment in the rand exchange
rate lies in the reaction of the market to the current account deficit, which
has averaged over six percent of Gross Domestic Product (GDP) during the first
half of this year. Other factors influencing the exchange rate include the
lower commodity prices, the re-pricing of risk in a number of emerging markets
and a general tightening of monetary policy globally.
Whilst noting potential risks that may emanate from the relatively high
deficit on the current account of the balance of payments, the MPC noted that
this deficit continues to be reasonably well financed. The overall balance of
payments situation is in surplus and has allowed further improvements in the
external position of the country, with official reserves continuing to improve.
Official gross gold and other foreign exchange reserves stood at US$24,6
billion at the end of September 2006 and net reserves amounted to US$21,2
billion.
Food prices also pose a significant risk to inflation. Food prices in
general have increased by 7,2 percent and agricultural prices at the producer
price level have increased at a year-on-year rate of 20,4 percent. In 2005 food
price inflation averaged 2,1 percent and exerted significant downward pressure
on the overall inflation trend. Higher maize prices are also likely to be
sensitive to exchange rate developments. Maize product inflation in CPIX is on
an upward trend but is still relatively low, having measured 4,7 percent in
August, and further pressure is expected from this source.
There have, however, been some positive developments. In particular, the
threat to inflation posed by the international oil prices has subsided to some
extent. Having reached levels of almost US$80 per barrel in August of 2006, the
price of Brent crude has now fallen to below US$60 per barrel. The timing of
this adjustment has happened by chance or luck, as a high and rising oil price
coupled with a depreciating rand would have had a marked and rapid impact on
inflation. In August and September, the decline in international oil prices
more than offset the upward pressure exerted by the exchange rate on petrol
prices. Despite this positive development, the MPC considers the risk to
inflation from this source still to be on the upside. The tight supply and
demand conditions in the oil markets coupled with the sensitivity of oil prices
to geopolitical tensions mean that oil prices could respond quickly to any new
adverse developments. Furthermore, the decision by Organisation of the
Petroleum Exporting Countries (OPEC) to cut quotas by 1 million barrels per day
could slow the decline in oil prices.
Labour market developments do not appear to pose a threat to the inflation
outlook at present. Having increased by 7,3 percent in the first quarter of
this year, unit labour costs increased by 3,2 percent in the second quarter.
Trends in inflation expectations will be critical in the months ahead. Should
expectations increase significantly above those indicated earlier, this is
likely to be reflected in higher wage demands which may impact on the price
formation process. Although at this stage wage costs do not pose a threat to
inflation, these developments will be closely monitored by the MPC.
The developments outlined above have taken place against the background of a
buoyant economy. In the second quarter of this year, the economy grew by 4,9
percent on an annualised basis, compared to four percent in the previous
quarter. Nevertheless economic growth this year is still expected to be lower
than the 4,9 percent average recorded last year. At these levels, growth is
still in line with, or slightly above, what our studies indicate to be the
potential output of the economy. The Rand Merchant Bank/BER Business Confidence
Indicator is still at a high level, while the Investec/BER Purchasing Manager's
Index (PMI), although lower in October, still reflects a positive outlook for
the manufacturing sector. The recent BER manufacturing survey indicates that
although there has been a marginal decline in confidence in the consumer goods
sector, the capital and intermediate goods sectors have maintained a positive
outlook.
Monetary policy stance
Having considered in detail all the recent economic data and other
developments impacting on inflation, the MPC remains concerned about the
outlook for inflation and is of the view that the risks to the outlook are
still on the upside. Accordingly the MPC has decided that a further upward
adjustment in the repo rate is appropriate at this juncture. The repo rate is
therefore increased by 50 basis points to 8,5 percent per annum with effect
from Friday, 13 October 2006. The Monetary Policy Committee will continue to
monitor all economic, financial and other relevant developments and stands
ready to act in order to ensure that the monetary policy stance remains
consistent with achieving the inflation target.
Enquiries:
Samantha Henkeman
Tel: (012) 313 4669
E-mail: Samantha.Henkeman@resbank.co.za
Issued by: South African Reserve Bank
12 October 2006
Source: South African Reserve Bank (http://www.resbank.co.za)
