Bottom Line:
• Rate hike expectations have intensified. They have adjusted sharply upwards through the course of the past month, thanks in part to the uber-hawkish communication from the Fed and others. Domestic investors have moved to price in a SARB that moves in lockstep with other central banks. It may be expecting too much.
• SA’s economy remains under considerable pressure. The credit cycle remains tight and there is limited room for inflation to take hold the way it has abroad. On the contrary, these supply-side shocks could prove more recessionary than inflationary and so the SARB will need to act more cautiously than what the market currently has priced in. Moving aggressively could prove to be counterproductive if it undermines the social stability within the economy even more.
• There are times when the SARB would do well to turn sensitive to the plight of households and businesses when the inflation in the system functions outside of the realm of which monetary policy can influence. About the only claim the SARB can make, is that raising interest rates will help protect the value of the ZAR by keeping SA’s carry attractiveness alive.
Baseine view:
SARB guidance suggests it could lift the repo rate to 6% by the end of 2023. The risk to the SARB’s QPM forecast rests on the downside through 2023, especially if growth disappoints. In contrast, we expect up to five hikes through 2022, but with a possible pause towards year-end if inflation surprises to the downside or recession materialises.
Broad Expectations:
There has been a sharp upwards shift in the repo rate expectations of the professional market since the last report a month ago. Whereas the market anticipated repo to rise towards 6.5-7.0% by the end of 2023, that has now shifted all the way up to 8.0%. Such is the fear that inflation will remain elevated for longer and that investors expect the SARB to respond. The other development that changed expectations was the sharp deterioration in the value of the ZAR from levels of R14.50/dlr just over a month ago to levels of R16.00/dlr currently.
This is a very aggressive shift in expectations and one that might prove difficult to sustain given the financial market reaction to such guidance from the central banks. The risk to the market view is that investors are underestimating the degree to which a credit cycle can reverse, given how leveraged the global system has become. This holds the potential to change expectations to become a little less hawkish over time.
Rate expectations shifted a long way in a short space of time
The accompanying chart highlights just how much rate hike expectations have changed since Jan. It is an enormous amount which hints at the SARB turning just as aggressive as the Fed. At face value, that makes sense, but it does not adequately reflect whether so many rate hikes are even possible, without inflicting some significant damage to an economy that is already floundering with unstable power supply, high unemployment and social unrest, structurally weak GDP, and a fragile fiscal position.
What little life is left in the economy will be dealt yet another blow, something SA can ill-afford. It is also worth noting that unlike other countries where inflation is higher and even further away from their inflation target, SA’s inflation still remains within the target band, and if it had to exceed the target band, it would do so temporarily and potentially to a lesser extent than is currently being priced in.
Rates have a long way to go to get back to neutral
The latest adjustment to the confidence bands shows that there has been an upward shift here as well. As things stand, there is an exceptionally wide spread between where the neutral rate of inflation +2.5% is and where the repo rate is.
Where it currently stands is quite plainly unsustainable and needs to be corrected. That can be corrected through a reduction in inflation or through the lifting of interest rates. Historically, higher rates have tended to remove some of the monetary accommodation, to unwind the credit cycle and impact inflation. This time, the same will apply, although the risk is that inflation remains elevated for longer due to the drivers being supply-side focused rather than purely demand-driven.
Judging by the core, midpoint scenario, the repo rate could rise to as much as 6.5%. The lower bound places the repo rate closer to 5.5%, while the upper bound is closer to the market expectation of 8.5%.
Our view is something between the core and the lower bound of the repo rate expectations.
Inflationary pressures remain well contained
ETM’s inflation risk indicator remains comfortably above the breakeven level, denoting that inflationary pressures remain skewed to the upside. The extent of the deviation from the break-even level gives investors a sense of just how strong the underlying pressures are.
The indicator is close to the recent highs of the past ten years, but the second derivative of inflation (the momentum indicator) is even higher. It is potentially an unsustainable situation and suggests that inflation in SA might struggle to surge too much further without a commensurate surge in the growth in money supply and a coinciding depreciation in the ZAR.
For now, the indicator confirms that while high, inflationary pressures remain reasonably somewhat constrained. Admittedly, this is partly a function of the fuel levy reduction, which will expire in the next few months. If the ZAR price of oil has not dipped back significantly by then, the prospect of a bump up in inflation through Q3 becomes inevitable. This will complicate the SARB’s policymaking.
Inflation pass-through will be limited
The latest credit cycle remains relatively subdued. So long as that remains the case, the pass-through into inflation will stay reasonably well contained. The second derivative of inflation (red line) is trending to zero and will break above, but underlying momentum remains subdued, and inflation is not yet a runaway train.
As the monetary space is limited, inflation will struggle to intensify sustainably. Any spikes in cost-push pressures could be more recessionary than inflationary. Ignoring the fuel levy that may be added back into the fuel price, inflation could even surprise expectations to the downside.
That does not mean that inflation cannot rise any further. It means that the momentum behind the rise is weaker and that the market and the SARB could enjoy some downside surprises, i.e., inflation beats the medium to longer-term expectations to the downside.
This holds implications for monetary policy that may not tighten quite to the degree initially envisaged by either the SARB or the market.
Credit cycle remains weak and will restrain inflation
Inflation is rising at the fastest rate in six years. As growth in M3 has accelerated, there has been some room for inflation to manifest, although some context is important. The growth in M3 money supply is less than half of what it used to be prior to the global financial crisis. Inflation episodes that characterised that time carried much higher amplitude. Ever since growth in M3 and PSCE subsided to
grow on average 5%.
Such low levels of M3 money supply growth, cannot accommodate high levels of inflation. Through a period of low money supply growth, cost-push factors as the world has experienced through the past year turn out to be more recessionary than inflationary.
Unlike many other countries, the money supply cycle is not out of character with what has happened before. Judging from the accompanying chart, neither is inflation and so investors should be careful in anticipating a period of blow-out inflation. If it were to materialise, it could prove devastating to the economy and the SARB would attract much criticism if it pushed rates up too quickly.
Inflation spike more acute abroad than in SA
Inflation has become a global problem. What SA is experiencing is in keeping with the global theme, but it is important to note that the spike in inflation is of a smaller magnitude. From trough to peak, SA inflation has risen 4%, high-income countries have risen 5-6%.
This is especially significant because they all target inflation closer to 2%. Whereas SA has kept its inflation trajectory within its target band, most other countries experienced a significant break above their targets, forcing their central banks to respond.
Therefore, SA’s response is not as desperate as other central banks.
In addition, it aims to protect the spread between SA and developed economy bond yields to reduce overall ZAR volatility, which would be conducive to reducing general price pressures.
The take-home point is that the SARB will have far more flexibility in conducting its monetary policy than most other central banks will have and will therefore retain great sensitivity to the state of the economy.
Conclusion
The SARB has moved pre-emptively. Furthermore, there are no demand-driven inflationary pressures within the SA economy. Not only is the credit cycle subdued, but SA is facing many structural headwinds. What inflation does exist operates out of the realm of what the SARB can control. At best, the SARB could argue that they are guarding against inflation expectations turning more entrenched at higher levels. At worst, it is only adding to the misery of households already struggling with vastly reduced disposable incomes.
Finally, it is worth noting that while many developed economies have dealt with runaway inflation, SA has not. On the contrary, inflation throughout this period has remained within its inflation target range. The SARB would argue that inflation is well above the midpoint and needs attention. But understanding the root cause of inflation is then just as important. The risk is that investors are looking at the inflation outlook too mechanically and are assuming that the Fed and other major central banks will be able to carry out the full extent of the tightening they have signalled. There is a more than even chance that they can’t and that doing so would threaten the stability of the global economy to such a degree that it would be counter-productive.
Written for TreasuryONE by George Glynos and Kieran Siney, ETM Analytics