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Is it too early for lower interest rates?

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In recent official statements by the Monetary Policy Committee (MPC), the South African Reserve Bank (SARB) has been sending some cautiously positive signals about interest rates.
By Maura Feddersen, economist: financial risk management at KPMG in South Africa
SARB Governor Lesetja Kganyago repeatedly noted that a more accommodative monetary policy stance is possible if inflation continues to surprise on the downside and inflation expectations settle sustainable within the target range of 3% – 6%. The SARB said in May it expects inflation to average around 5,5% towards the end of 2017, although various risks to the upside remain in an environment beset by high levels of uncertainty.
Softer food prices, exchange rate resilience and lacklustre consumption spending will likely feature this week, as the MPC meets to balance the risks of a possible interest rate cut.

Inflation could stay inside target range on the back of easing food price inflation
The latest Statistics South Africa (StatsSA) headline inflation data recorded 5,4% year-on-year (y-o-y) in May, up from 5,3% y-o-y in April. Since December last year, inflation has decelerated on the back of softening food price inflation. In April this year, headline inflation returned to the SARB’s target range, down from the recent high of 6,8% y-o-y in December last year.
StatsSA’s benchmark food basket cost 7% y-o-y more in May, up from 6.6% y-o-y in April. In spite of this increase, food price inflation has recently softened after accelerating to double-digit growth rates between April 2016 and February 2017. Good summer rains have assisted a recovery in agriculture, raising local maize harvest expectations to 16-million tonnes this year and causing wholesale maize prices to fall 65% compared to a year ago.
While inflationary outcomes have recently surprised on the downside, inflation remains close to the upper end of the target range for now. SARB Governor Kganyago previously warned when inflation is uncomfortably close to the 6% limit, the MPC is cautious about lowering interest rates.

Exchange rate buoyed by global liquidity: lower risk of imported inflation
High levels of global liquidity and demand for high-yielding emerging market assets continue to reinforce the rand’s performance. The resilient exchange rate suggests lower risks of imported inflation and may support a decision by the SARB to consider lowering interest rates sooner rather than later.
However, notoriously fickle international portfolio flows in tandem with more constrained domestic economic conditions raise the risk of exchange rate weakness. As a result, the SARB may resist easing monetary policy, so long as “the current environment of high levels of uncertainty” continues, as noted by Governor Kganyago in his last MPC statement in May. Uncertain domestic political and policy conditions elevate risks of rand vulnerability which could yield a deterioration in the SARB’s inflation expectations.

Consumers still depressed: low risk of demand-pull inflation
South African consumers continue to face mounting pressures. The technical recession confirmed in the first quarter of 2017 suggests that job creation is falling short.
Indeed, unemployment reached a 13-year high at 27,7% in the first quarter. Youth unemployment, in particular, remains sticky at around 50%, implying every second young person looking for work remains jobless.
High unemployment, tighter bank lending criteria and a higher tax burden explain the drop in real household expenditure, down 2,3% q-o-q in the first quarter of 2017. In a similar vein, although increasing to -5 in 2017Q1 from -10 in 2016Q4, the FNB/BER Consumer Confidence Index (CCI) fell back to -9 in the second quarter of this year – any reading below 0 indicates net negative sentiment.
Against this background, the SARB faces little risk that excessive demand pressures give rise to increased inflation, prompting higher interest rates. To the contrary, the MPC will likely consider when to commence a possible interest rate cut to ease the pressure on consumers and facilitate a faster economic growth recovery, particularly in light of South Africa’s reliance on consumption spending as a source of economic growth.
The SARB has noted, where possible, it prefers a more accommodative monetary policy stance when rising inflation is not due to exuberant consumer spending, but rather a result of supply constraints. For example, last year’s double-digit food price inflation followed a serious drought that eroded agriculture production.
Although food price inflation pushed headline inflation outside the target band for most of 2016, the SARB raised interest rates only by 25 basis points at the beginning of 2016, bringing the repo rate to 7% and the prime rate to 10,5%.

The balance of risk
Although easing food price inflation, a comparatively resilient exchange rate and muted consumer demand count in favour of an interest rate cut in the short term, the SARB will likely resist easing monetary policy this month due to current conditions of uncertainty. Instead, the MPC may want to see headline inflation displaying a more sustained return to the target range.
n May, Governor Kganyago noted prospects of a possible end to the SARB’s interest rate hiking cycle, however, he warned an end to the central bank’s interest rate hiking cycle did not necessarily equate to the beginning of a cutting cycle.
Indeed, the monetary policy tightening seen between 2014 and 2016 has been comparatively moderate in view of previous cycles of policy tightening. Therefore, even if conditions are deemed favourable for lower interest rates, the SARB is unlikely to make large downward adjustments in coming months.