My take from the Monetary Policy Forum last week is very selective. A strong dose of policy realism points to more rate easing. But by how much?
Central is a further inflation decline from 8,5% now into the 3-6% target by 2010.
Noticeable was the emphasis on the large output gap. With potential growth of 4%, but with GDP this year declining by 1% after only 3% growth last year, the output gap by late 2009 could be some 5-6%.
That's massive, apparently dominating thinking regarding downward pressure on CPI inflation, locally and abroad.
Also the balance of risk is seen on the downside. Thus commodities, currency and even domestic conditions point to lower inflation, at least for now.
Interestingly, the current-account deficit appears adequately covered by capital inflows for the rand to be stable to firm. There seems to be enough confidence to make this sustainable.
There is no nervousness about temporarily encountering negative real interest rates as CPI inflation takes its time falling but apparently not interfering with the Reserve Bank's willingness to lower interest rates.
Though the Bank hasn't targeted financial stability (for we are one of the few countries not having any sick banks), our house prices are falling (with more to come). Although equity values are off their cyclical lows, they are still well below peak levels.
This suggests a negative wealth effect. This may well come to be taken into account as central banks expand inflation targeting from inflation and output gaps and balance of risks to include financial behaviour in setting interest rates.
So besides facing a large (but declining) inflation gap, the Bank also faces an even larger (but still expanding) output gap, the balance of risk is on the downside and wealth effects are negative.
Eskom tariff increases are problematic, with the Bank last week even suggesting exploration of a tax solution to capital shortfalls rather than loading prices.
What kind of interest rate bottom does all this suggest in coming months?
There is the question whether the April and June 2008 interest rate increases were unnecessary.
But hindsight is a perfect science, given what we now know. At the time things were hardly clear regarding a broad spectrum of inflationary forces. Raising interest rates into an inflation storm didn't seem wrong.
Perhaps a better question is why the Bank lowered rates only by 0,5% in December 2008 as it started easing.
Lehman's bankruptcy was already three months old. The bottom had been falling out of our industrial activity and exports for two months. Surely this warranted a less cautious monetary policy mindset?
But the world, and South Africa, took its time fully registering that the bottom had indeed dropped out of industrial activity in response to the credit disaster. It took time for the data to crystallise.
So policy was conservative at the peak (keeping rates rising when they could have stopped) and was slow into the cutting cycle.
So how will we get the present wrong? By prematurely stopping the rate easing cycle or getting too many cuts?
We are currently sitting at prime 12%. The market is suggesting another 1.5% lower to 10,5% within three months, and then lifting rates by 1% in 2H2010.
The Taylor Rule is more aggressive than that.
A real rate premium of 5,5%, CPI next year of 5%-5,5%, inflation gap of half 8,5%-4,5%, and output gap later this year of half -5% or even -6% yields prime interest rate of about 10% shortly.
This is nearly what markets already discount (10,5%, though not for long) but not what commentators have in mind (looking for prime of 11% at best).
Yet the Bank could yet mean business if it really feels the output gap excessive, the inflation gap eroding enough, balance of risk residing on the downside, and wealth effects (housing) remaining negative.
This suggests a prime rate of 9-10%, also by Taylor estimates as inflation falls towards 6,5% in 3Q2009. It may seem excessively low (remembering 2003-2004), but is it really?
Banks are demanding large deposits now before granting mortgage and other loans. Taking into account the National Credit Act, they are applying strict credit criteria. All this may be equivalent to 2% of the Bank rate tightening. That means the current 12% prime rate feels more like 14%, barely off its 15,5% cyclical high.
No wonder car and property conditions remain suppressed. Effective interest rates are too high to trigger much spending revival in these markets, though we have to allow for slowly falling debt levels and debt servicing burdens (already improving furniture trade prospects).
There remains scope for interest rate cuts at the late May and even June MPC meetings. We may see another 1% cut shortly to 11%, after which pausing could occur.
But if the expanding output gap lingers, inflation falls as expected and credit-based interest-sensitive sectors (cars, housing) remain weak, prime at 11% may not be the bottom of this interest rate cycle.
Cees Bruggemans, chief economist of FNB, gives his thoughts
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