Reserve Bank dashes hopes of early interest rates cut
Bank says indications are that the downward trend inflation will continue, but warns that tight monetary policy will remain
Economics Correspondent
MOST economists expected interest rates to be cut by June as a result of a positive inflation outlook, but the Reserve Bank's Monetary Policy Review released yesterday suggests that tight monetary policy may be a feature for another few months.
The Bank says the inflation outlook has improved "considerably in the past few months and that there are indications the downward trend in inflation would be sustained ".
However, the Bank also cautions that being too hasty in easing interest rates could be "destabilising". The Bank reiterated this view at the Monetary Policy Forum last night, reducing hopes that an early rate cut would be on the cards.
In the review, the Bank said the positive outlook for inflation was influenced by the weaker global economic environment and domestic factors, such as lower producer and consumer inflation numbers and the rand's continued strength all of which should help to steer inflation towards its target this year.
The Bank has forecast that its targeted inflation rate, CPIX (consumer inflation excluding mortgage costs), should reach 5,7% by the last quarter this year, slightly below the upper limit of the 3%-6% target.
It is likely that inflation may slow even more sharply than projected by the Bank. These forecasts are based on data from the final quarter last year and used in last month's monetary policy committee meeting, where it a decision was made to keep interest rates unchanged.
But since then the rand has continued its rapid appreciation against the dollar gaining 13% against the US currency this year alone and strengthened considerably against other major currencies.
Also, international oil prices have fallen sharply, which bodes well for the outlook in inflation.
The CPIX has slowed for four months in a row from a peak of 12,7% in November, but has raised concern that consumer inflation was not decelerating as fast as producer inflation.
Last month CPIX slowed to a worse than expected 11,3%, while producer price inflation hit 5,1% last month, its lowest level in almost four years.
The committee is scheduled to meet in June to decide whether or not to cut interest rates. Most economists expect the Bank to ease rates by 100 basis points at the June meeting, but recently some have argued that a rate cut may be delayed until September.
But the relatively positive outlook for inflation outlined in the review should raise hopes once again of a rate cut sooner than later.
In addition to the slowdown in inflation numbers, consumer demand and money supply have also started decelerating since the final quarter of last year.
Demand for durable goods slowed considerably as the four interest rates hikes last year dampened consumer spending.
This also slowed down manufacturing activity, which was also hit by lower export growth as a result of the stronger rand.
Inflationary pressure from the domestic economy has started abating as a result, something that bodes well for inflation reaching its target later this year.
The threat to inflation from high international oil prices has also "receded", according to the review.
World oil prices had a turbulent time last year in the run-up to the war in Iraq. Threats of disruption to oil production in Iraq and a crippling strike by oil workers in Venezuela sent Brent crude oil prices from $19 a barrel in January last year to a peak of almost $35 a barrel last month. Oil prices fell sharply in the first week of the war in Iraq, and have since been trading at about $25.
Lower inflation and a better inflation outlook indicates the Bank's tighter monetary policy stance is working, the review says.
"There is no doubt that the tightening of monetary conditions has contributed to the improved outlook for inflation. The (committee) came under considerable criticism in the course of 2002 for the measures taken to combat the surge in inflation. It would appear, however, that the monetary policy actions taken in 2002 have prevented an uncontrolled inflation spiral," the review notes.
The biggest risks to the inflation outlook, the Bank said, were "stubbornly high" inflation expectations, and their effect on pay settlements, as well as high administered prices charged by government agencies.
The University of Stellenbosch's Bureau of Economic Research, which measures inflation expectations on a quarterly basis, showed that all three sectors finance, business and labour raised their inflation expectations for this year.
Those surveyed in the first quarter this year predicted CPIX would reach an average of 9,2% this year up from 8,6% when surveyed in the previous quarter. But over the longer term, inflation expectations have abated.
Labour costs also remain a threat to the inflation picture, with unit labour costs on an upward trend since last year.
The Bank says nominal unit labour costs increased 8,4% between the second half of 2001 and the same period last year. This was higher than the upper limit of the inflation target. Inflationary pressure from administered prices has also continued to be a problem for the inflationary outlook because of its almost 25% weighting in the CPIX basket.
The average increase in administered prices last year was 8,4%, with the prices of medical, education services and water rates rising 10% or more in the same period.
Some economists have argued that domestic inflationary pressure from wages and administered prices remain too strong still, which would persuade the Bank to hold interest rates steady in June.
At 11,3%, last month's CPIX was almost double the 6% upper limit, which has made some economists doubt if interest rates would be cut in June.
The Bank forecast of CPIX reaching 5,7% by this year's final quarter is based on the assumption that interest rates remain at current levels.
With very low interest rates in developed country markets, high domestic interest rates have attracted foreign investors looking for returns from high-yielding money market assets.
Some analysts have cautioned that a cut in interest rates would see a reversal of these speculative capital inflows, something that could see the rand retreat sharply from the two-year peaks at which it was currently trading.