Last week was a big one for monetary policy. The Bank of Japan’s (BoJ) meeting was keenly awaited as it promised to deliver a “comprehensive assessment” of its policies. With the aim of ending Japan’s chronic deflation, Governor Kuroda launched the world’s most ambitious quantitative easing programme when he took office in 2013. He has ballooned the Bank’s balance sheet to a size equal to the country’s annual economic output, while the Federal Reserve’s balance sheet is only a quarter of that of the US.
Initially, this had the desired effect of weakening the yen from ¥80 to ¥120 against the US dollar, boosting exporters and lifting import prices, but the yen has since rallied back to ¥100 per dollar and inflation is barely positive, well below the 2% target. Cutting interest rates below zero in January 2016 did not help, making life difficult for Japan’s banks. Consequently, the BoJ decided not to cut rates any deeper into negative territory but will now buy bonds with the aim of capping the 10-year bond yield at around 0%. The other innovative step taken by the BoJ was to commit to let inflation overshoot its 2% target, to raise expectations for future inflation. Whether this will work remains to be seen, but it’s a step that other central banks may still follow.
Federal Reserve waiting for more evidence
There is an argument that the US should follow the same route, allowing inflation to overshoot the 2% target for a while (when it gets there) since it has been below target since April 2012. The Federal Reserve (the Fed) hasn’t bought into that view, but recognises that it would be easier to nip runaway inflation in the bud with rate hikes than to prevent potential renewed economic weakness with rate cuts. Therefore it remains cautious, saying last week that it was waiting for more evidence of progress towards its twin objectives of stable inflation around 2% and full employment, even though the case for a rate hike later this year has strengthened. Three members of the rate-setting committee voted in favour of hiking rates.
This view that the case for a rate hike has strengthened rests almost entirely on the idea that the US unemployment rate is about as low as it will get (and that this will result in higher wage increases, which will in turn push up consumer inflation). Other economic indicators have, in fact, been softer over the past few months. This includes retail sales, industrial production and the manufacturing and services purchasing managers’ indices.
Rate hikes expected to be gradual
While much ink has been spilled in the financial media over the timing of the next rate hike (with consensus now settling on December, a year after the previous rate hike), it is more important to focus on the longer-term rate trajectory for two reasons. If the Fed hikes too aggressively, it could induce an economic slowdown that would result in company earnings falling, followed by share prices. Indeed, recessions are often deliberately triggered by central banks to reduce inflation. Furthermore, steady rate hikes could place pressure on emerging market currencies like the rand. For us, this would increase inflation while for other emerging markets with a lot of dollar-denominated debt, it could get messy. However, the Fed has consistently said that rate hikes would be gradual. With no sign of the economy overheating (in fact, it is still a touch too low), there is no reason to hike aggressively. Structural forces that weigh on the potential growth rate of the US (such as an ageing population and slower productivity growth) also point to a lower and neutral interest rate.
In the previous two hiking cycles, the federal funds rate peaked at 6.5% in 2000 and 5.25% in 2006 respectively. The Fed’s latest set of projections (the so-called dot plots) suggest interest rates will settle at only 2.9%, from 4% at the time of the September 2013 meeting. Over this time, the Fed and the market had different views of where rates will settle; it is the Fed that is coming round to the market’s thinking and not vice versa.
Fed Chair Janet Yellen noted that the current stance was only modestly accommodative. In other words, she sees the current federal funds rate range of 0.25% to 0.5% as only slightly below its neutral level.
Search for yield still underway
Gradual interest rate hikes in the US (and plenty of accommodation in Europe and Japan) imply that the search for yield is still underway, supportive of emerging markets. This creates a positive feedback loop where stronger currencies lead to lower inflation, lower rates, a better growth outlook, and therefore more attractive bonds and equities. Stronger currencies also amplify the dollar (or euro) returns from the underlying assets, making them even more attractive to investors in New York and other global financial centres. In South Africa, we’ve experienced the opposite of this process over the past four years. But now the stronger rand promises to limit inflation and give the South African Reserve Bank (SARB) room to eventually cut rates.
Repo rate unchanged
The SARB’s Monetary Policy Committee has left the repo rate unchanged at 7% last week as expected, but softened its stance on the outlook for interest rates. It previously insisted that it is still in a hiking cycle, but now admits that rates are close to peaking.
Actual inflation came in more or less as expected in August, falling to 5.9% year-on-year from 6% in July. A big petrol price cut in August helped, but the petrol price is likely to rise by between 30 and 40 cents per litre in October. This time last year also saw large declines, which means the base is unfavourable and petrol inflation could rise sharply towards year-end.
Food inflation rose to 11.4%, with sugar prices picking up 5% in the month and 21% year-on-year, but the peak of the food inflation cycle is in view. The Reserve Bank expects food inflation to peak at 12.3% later this year, which together with higher expected petrol inflation should see headline inflation drifting upwards, but peaking at a lower level (6.7% according to the Reserve Bank) than previously thought. Next year could see large declines in food inflation (not to be confused with declines in food prices, though the maize price is falling).
Core inflation, excluding volatile food and energy prices, was 5.7% in August, never rising above 6% in this cycle.
Inflation and growth forecast improved
The SARB cut its inflation forecast for 2016 to 6.4% from 6.6% previously, while the 2017 forecast was trimmed to 5.8% (these are averages for the year). The 2018 outlook is unchanged at 5.5%. Inflation will fall below the upper-end of the target sooner than previously expected, while core inflation is no longer expected to breach 6%. The MPC views the risks to inflation forecasts as more or less balanced. The rand is currently stronger than the assumptions built into the SARB’s forecasts, while the pass-through from currency weakness to inflation has also been lower than assumed in their models.
Along with a better inflation outlook, the SARB’s real economic growth forecasts have also improved. The 2016 forecast was revised up from 0% to 0.4%, with 2017 upgraded to 1.2% from 1.1% and 2018 from 1.5% to 1.6%. These are modest changes, but it is the first time in several years that the forecast has been revised upwards, not downwards.
Bar for cuts remains high
Despite improving, the longer-term inflation outlook is close to the upper-end of the target range, instead of the middle. Similarly, inflation expectations, as per the BER’s survey, also remain close to 6%. Seventeen years after inflation-targeting was introduced, this is frustrating for the SARB and will probably result in rates falling slowly. It also sees above-inflation wage increases as a source of upward pressure on consumer prices, while also resulting in high unemployment.
The MPC is also aware of event risk that could cause rand volatility: the October mini-Budget; the results of the ratings agencies’ reviews in November and December (interestingly, Moody’s, already the most generous of the big three, indicated that there is a good chance of them not downgrading South Africa); a potential US interest rate hike in December and to a lesser extent, the US election in November.
Perhaps the biggest factor for this rate outlook is that the MPC is not convinced that the current favourable conditions for the exchange rate will last. For these reasons, the MPC statement noted that the bar for rate cuts remains high. South Africa therefore remains among a handful of important economies where rates are not being cut (Brazil is another, as is the US). The MPC’s conservative stance is not expected to last forever, and it seems unlikely that it will not cut rates once expected inflation falls below 6% on a sustained basis. However, this conservatism and determination to keep a lid on inflationary pressures is positive for long-term holders of South African bonds. For local investors, this is more important than whether or not South Africa is downgraded later this year.
Chart 1: US interest rate history (federal funds rate, %)
Chart 2: South African inflation and interest rates