In October 2009, the CPI moved back inside the 3-6% target band for the first time in more than two and a half years. Even though the CPI might well again pop out of the target band for the next month or so, there is limited upside risk to inflation in 2010. Given the inflation-targeting mandate of the SA Reserve Bank (SARB) this means that interest rates are unlikely to be significantly increased this year, with some analysts even expecting another one of two small cuts of 50 bps. This is good news for homeowners and others with debt, but bad news for those with savings or reliant on a fixed income.
Recent developments in inflation
The year-on-year inflation rate as measured by the consumer price index (CPI) for all urban areas declined from 6.1% in September 2009 to 5.9% and 5.8% in October and November respectively. The categories of housing and utilities, and miscellaneous goods and services remained the single biggest contributors to the inflation outcome in November, having contributed 1.7% and 1.5% respectively. These categories were mainly driven by electricity and insurance cost increases. Food price inflation continued to moderate, and measured 4.0% in November, while administered prices excluding petrol and paraffin increased by 11.0%, primarily as a result of electricity price increases.
The outlook for inflation
CPI inflation is expected to increase to above the target range in the coming three months, due to technical base effects related to petrol price changes. The Monetary Policy Committee (MPC) forecasts indicate that inflation could measure around 6.5% in December and January, before moderating in the subsequent months. Investec Securities estimate inflation at 4.6% by the middle of the year and 5.2% average for the full year (see chart). This is in line with market forecasts and those of the SARB.
The most recent inflation expectations survey conducted by the Bureau for Economic Research (BER) at Stellenbosch University shows that in the fourth quarter of 2009 there were no significant changes in expectations compared with the previous survey. According to the survey, inflation is expected to average 7.5% in 2010. While both business and trade union respondents continued to expect inflation to remain outside the target range, the forecasts of financial analysts deteriorated moderately but remained within the SARB target range of 3%-6%.
Taking a look at the different subcategories within the CPI, it looks like the decline in food inflation still has legs. In the 18 months starting in January 2004, food inflation recorded 11 months of negative month-on-month rates. In the current food inflation cycle, there has only been four negative months since the start of 2009. Food has a significant weighting of 14.27% in the overall CPI basket.
Housing and utilities is another category which could surprise on the downside due to actual rentals and owners’ equivalent rent. These two items within housing and utilities account for 15.7% of the overall CPI basket. The quarterly newsletter from Rode & Associates Property Consultants (dated 22 December 2009) mentioned the weak growth rates in flat rentals. According to this source, flat rentals in both Johannesburg and Cape Town were up by a measly 2% yoy.
Adverse employment trends and employment insecurity are likely to constrain household consumption expenditure. According to Statistics South Africa’s Quarterly Employment Statistics, employment levels decreased further during the third quarter of 2009, despite a more favourable growth performance. Formal non-agricultural employment declined by 4.2% in this quarter, representing almost 110,000 jobs.
Credit extension to the private sector reflects weak demand and tight credit supply conditions, and is also seen as a constraint on spending. Total loans and advances to the private sector contracted by 2.0% in November compared with the previous year. This was the third consecutive month of credit contraction. These developments were also reflected in the level of household debt, where the ratio of household debt to disposable income declined from 80.1% in the second quarter of 2009 to 79% in the third quarter. This relatively high level of debt is expected to continue to constrain consumption expenditure.
There are continued signs that the domestic economic recovery is underway following the 0.9% annualised GDP growth rate measured in the third quarter of 2009. However, the recovery is expected to remain relatively subdued and below the potential growth rate of the economy for some time. The MPC forecasts that GDP growth will average just 2.0% in 2010.
The global recovery has continued with relatively strong performances in some of the emerging market economies. However the recovery is expected to remain relatively slow in some economies that are important export destinations for South African goods. Unsustainable fiscal positions as well as the need to reverse previous unconventional monetary policy interventions may also pose a risk to the global growth outlook. The global environment remains benign from an inflation perspective. Despite moderately higher commodity prices, there are no significant risks to the global inflation outlook.
Other supply side or exogenous factors are not expected to impart a significant upside risk to the inflation forecast. International oil prices appear to have stabilised somewhat over the past months, and moderate increases have been assumed over the forecast period. The outlook for food price inflation, as reflected in producer prices and futures prices, is favourable and these prices are unlikely to pose an upside risk to the inflation outlook for some time despite higher food prices in international markets.
Eskom has now modified its tariff application to the National Energy Regulator of South Africa (NERSA). While there remains continued uncertainty related to the electricity tariff increases, the full multi-year increases of 35% requested by Eskom are unlikely to be approved. Most analysts estimate that price increases of 25% in 2010 and 2011 would be the top end of the acceptable range for NERSA. The outcome of the Eskom application is expected to be announced in February. This will remove a major uncertainty in the economic outlook for 2010.
Conclusions
Electricity price increases remain the single biggest unknown to the inflation outlook. There is the risk that increases granted to Eskom could be markedly higher than those currently expected by the market. If this were to occur then it would be extremely detrimental to the stock market, interest rate outlook and GDP growth prospects in 2010.
Assuming no upside shocks from electricity price increase, inflation is not expected to average outside the 3-6% SARB target range in 2010. However this may not necessarily result in further interest rate reductions. If the CPI numbers are not low enough by the 24/5 March MPC meeting to trigger further cuts, then by the time of the following meeting in May, there may be enough evidence of an economic recovery to resist further easing.