What is keeping the SARB from cutting rates?

The South African Reserve Bank (SARB) opted to leave their repo rate on hold at 7% at their latest meeting a week or what ago. Although this was largely anticipated by the market, there were some that made sensible arguments in favour of another rate cut.

Why then their decision to stay put? According to the closing remarks in the statement issued by their Monetary Policy Committee (MPC), the main reason for this decision was because “the risks to the inflation outlook appear to be fairly evenly balanced”. What does this mean exactly? A couple of things really. First of all it appears as though the focus of the SARB is starting to move back to inflation and away from economic growth.

This in essence also reveals the SARB’s view of the global economic recovery. South Africa’s economic recovery will very much be dependant on the global recovery and one may therefore assume the SARB is of opinion that the global recovery is well underway, paving a similar route for the South African economy. Therefore they may argue that further economic stimilus by way of interest rate reductions is overcooking the pot.

Typically, with the SARB now apparently focused primarily on inflation, they will more likely want to err on the side of higher interest rates than lower. The second thing the statement by the MPC points out is their view of inflation going forward. The SARB’s view is that inflation will continue to moderate going forward – they expect inflation to move into their target band of 3-5% sometime in mid 2010 and to stay there until the end of 2011.

Inflation has subsided much since August 2008, with the producer inflation (PPI) moving into negative territory for the first time in 5 years. (See graphic) If one takes into account that consumer inflation (CPI) typically lags behind the PPI (as can be seen in the graph), one may expect consumer inflation to decrease somewhat further. Furthermore, the spread between the CPI and PPI has recently been the largest for some time.

Whether the SARB will take this into consideration is up for debate – they announced their recent decision even before the latest PPI was even released. Although this technical analysis may point to lower inflation going forward, there are still some significant inflation risks lurking. Commodity prices have risen quickly since bottoming out in Nov/Dec 2008 and as the current global monetary stimulus gathers more traction, so commodities can get even more expensive.

The rand is also very volatile and although relatively strong at present, it may depreciate quickly resulting in a potential inflation bomb. Local electricity tariff hikes and double digit wage increases will undoubtedly pose another threat to inflation ahead.

Therefore, depending on how one views the inflation outlook, it may provide sufficient justification to cut interest rates or even to start to increase rates. It is for this reason that Mr. Tito Mboweni stressed twice in the MPC statement that the “inflation risks are evenly balanced”.

Central banks rarely take any action in this type of environment, hence their decision to leave rates on hold. The decision can be seen as a “wait-and-see” approach. Only time will prove the sustainability of the global economic recovery and also the direction of inflation. Overall there are many signs indicating that we have reached an interest rate bottom.

However, if the global economic recovery appears to be shortlived, we may just witness further monetary easing. The SARB will continue to keep an eye on the global recovery and also the inflation figures for a definite trend which, if still not that clear at their next meeting in October and November, will leave these interest rate decisions to be very much touch and go.