Monetary Policy
Review


May 2006
Monetary Policy
Review
May 2006
South African Reserve Bank
Monetary Policy Review May 2006
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ISSN: 1609-3194
South African Reserve Bank
Monetary Policy Review May 2006
Contents
Monetary Policy Review


Monetary Policy Review
Introduction
Forecasts suggest that the inflation outlook has improved significantly, and there is
evidence that inflation expectations and wage settlements are increasingly in line with
the inflation target. At the same time, however, there are aspects of the inflation
environment that increasingly demand caution. Continued strong consumer demand,
which shows few signs of moderating, and resurgent international oil prices are
particularly significant concerns.
Against a backdrop of lower domestic inflation and interest rates, consumer and
business confidence remain high. The strong growth in household consumption
expenditure is reflected in rising household debt levels, vigorous credit extension, and
the widening deficit on the current account of the balance of payments. All carry
potential risks for the inflation and interest rate outlook. Furthermore, in an international
environment characterised by robust global demand and persistent global imbalances,
rising oil and commodity prices feature prominently. Geopolitical factors and tight market
conditions suggest that the risks of oil price spikes are significant.
This Monetary Policy Review provides an analysis of recent price developments, the
factors that affect inflation as well as the outlook for inflation. In addition, three focus
topics are presented in boxes. The first box considers international trends in household
debt, and discusses the factors underlying these trends and their implications. The
second box reports on research into the growth rate of potential output in South Africa,
and the third discusses recent proposals regarding how best to tackle global imbalances
in order to ensure longer-term sustainable global economic growth.
Recent developments in inflation
This section reviews recent trends in the main inflation indices, and provides an analysis
of developments in the main factors impacting on inflation in South Africa.
The evolution of indicators of inflation
Figure 1 shows that the measure of inflation targeted by the Bank, the year-on-year
increase in the consumer price index excluding mortgage interest cost for metropolitan
and other urban areas (CPIX), has remained within the inflation target range of 3 to 6 per
cent for 31 consecutive months up to March 2006. When the previous Monetary Policy
Review was published, the latest available rate (for September 2005) was 4,7 per cent.
Inflation then declined to 3,7 per cent in November 2005 before increasing to 4,5 per
cent in February 2006 and then decelerated once more to 3,8 per cent in March. The
analysis presented in this section shows that fluctuations in petrol and food prices have
been the major contributors to movements in CPIX inflation in this period.
With the repurchase or repo rate having remained unchanged from mid-April 2005,
inflation measured in terms of the headline consumer price index for metropolitan areas
(CPI) has tracked that of CPIX closely in the past year (Figure 1). The CPI inflation rate
declined from 4,4 to 3,4 per cent between September and November 2005, and then
increased to 4,0 per cent in January 2006 before slowing to 3,4 per cent in March.
South African Reserve Bank

Monetary Policy Review May 2006

The weighted contributions of the main components of the CPIX to the overall yearon-year inflation rate, presented in Table 1, confirm that developments in the
transport and food components of the index have had a significant influence on CPIX
inflation. Food prices, which have a weight of 23,7 per cent in the index, contributed
0,5 percentage points to CPIX inflation in November 2005 when the overall inflation
rate was 3,7 per cent. This contribution increased to 1,1 percentage points in
December 2005 and January 2006, and further to 1,2 percentage points in February
and March 2006. The contribution of the transport component to CPIX inflation, driven
mainly by petrol prices, declined from 1,3 percentage points in September 2005 to
0,8 percentage points in December 2005, before increasing to 1,2 and 1,3 percentage
points in January and February 2006, respectively. The contribution of this component
then declined to 0,7 percentage points in March, when the overall CPIX inflation rate
slowed to 3,8 per cent.
Table 1
Contributions to CPIX inflation
Percentage change over twelve months* and percentage points

Sep
Oct
Nov
Dec
Jan
Feb
Mar

Of which:

Source: Statistics South Africa
Monetary Policy Review May 2006
South African Reserve Bank
Percentage change over twelve months

CPI

CPIX
Figure 1
Consumer price inflation: CPIX and CPI
Source: Statistics South Africa
The contributions of the other main components of the CPIX remained relatively constant
over the period under review. The housing component, which contributed
0,6 percentage points in September and October 2005, contributed 0,5 percentage
points between November 2005 and March 2006. The medical care and health expenses
component and the education component remained subdued, contributing 0,6 and
0,4 percentage points, respectively, to the year-on-year inflation rates in Table 1.
Although inflation pressures from grain prices in the food component of the CPIX have
been muted, maize prices have gravitated towards their import parity prices in 2006
(Figure 2). The price of yellow maize increased from a low of R554/ton late in February
2005 to R1 000/ton on 25 April 2006, while that of white maize rose from R471/ton to
R1 084/ton over the same period.
The effect of excluding energy and food prices from the year-on-year CPIX inflation
measure is shown in Figure 3. The moderating effect of food prices on the overall CPIX
inflation rate, which was evident throughout 2005, has disappeared in recent months.
Excluding food, CPIX inflation declined from 5,3 per cent in September 2005 to 4,1 per
cent in December 2005, before increasing to 4,5 per cent in February 2006 and then
slowing to 3,5 per cent in March. Energy prices, by contrast, continue to deviate
significantly from the overall CPIX inflation rate. Excluding energy prices, CPIX inflation
South African Reserve Bank

Monetary Policy Review May 2006
White maize, rand per ton
Yellow maize, rand per ton
Figure 2
Maize prices

Export parity price

Import parity price

SAFEX spot price
Source: Grain South Africa

declined from 3,5 per cent to 3,0 per cent between September and November 2005,
then increased once more to 3,4 per cent in December 2005 before receding to 3,2 per
cent in March 2006.
Figure 4 presents the inflation rates for the goods and services categories of the CPIX, and
reveals that since January 2006 goods prices have increased at a faster rate than those
of services for the first time since April 2003. The year-on-year inflation rate for goods
Monetary Policy Review May 2006
South African Reserve Bank
Percentage change over twelve months

CPIX
CPIX excluding energy prices
CPIX excluding food prices
Sources: Statistics South Africa and SARB calculations


Figure 3
The effect of food and energy prices on CPIX

inflation
Percentage change over twelve months

Goods
Services
CPIX

Figure 4
CPIX: Goods and services inflation
Source: Statistics South Africa
prices declined from 4,4 per cent in September 2005 to 3,1 per cent in November 2005
before increasing to 4,8 per cent in February 2006 and then decelerating once more to
4,1 per cent in March.
Services price inflation declined continuously from 5,5 per cent in September 2005 to
3,5 per cent in March 2006. The deceleration in services inflation can be attributed to
significant declines in a number of components of the index. The inflation rate for the
housing services component (which has a weight of 40 per cent in the services index)
slowed from 7,0 per cent in August 2005 to 3,6 per cent in March 2006. Communication
services inflation declined from 2,5 per cent in August 2005 to a negative 2,4 per cent
in January-March 2006, while medical services inflation slowed from 9,9 per cent in
August 2005 to 7,0 per cent in March. Education services inflation declined from
8,0 per cent in the preceding twelve months to 7,1 per cent in March 2006.
Figure 5 presents the year-on-year inflation rate for the administered price index (API). In
the period under review, the API inflation rate declined from 10,3 per cent in September
2005 to 7,0 per cent in December 2005, before increasing to 9,3 per cent in February
2006 and then slowing to 6,2 per cent in March. As noted above, fluctuations in petrol
prices continue to have a significant impact on inflation in South Africa, and this is
particularly the case with API inflation since petrol has a weight of 25,4 per cent in the
API basket. Excluding the petrol component, the inflation rate for the remaining
administered prices declined from 4,5 per cent in September 2005 to 3,2 per cent in
March 2006.
Table 2 presents the contributions of various components of the API to the overall API
inflation rate. The dominant influence of the contribution of the petrol component is
clearly evident from the table, both in terms of size and in terms of the impact of
fluctuations on the overall API inflation rate. Its contribution declined from 7,0 percentage
South African Reserve Bank

Monetary Policy Review May 2006
Percentage change over twelve months

Administered price index (API)

API excluding petrol

CPIX
Sources: Statistics South Africa and SARB calculations
Figure 5
CPIX and administered prices

points in September 2005, when the API inflation rate was 10,3 per cent, to
3,8 percentage points in December 2005, when API inflation was 7,0 per cent. It then
increased to 7,1 percentage points in February 2006 when the corresponding API
inflation rate was 9,3 per cent. In March, the contribution of the petrol component
declined to 3,8 percentage points when the API inflation rate slowed to 6,2 per cent.
Table 2
Contributions to administered price inflation
Percentage change over twelve months* and percentage points

Sep
Oct
Nov
Dec
Jan
Feb
Mar

Of which:

Source: Statistics South Africa
The inflation rate measured in terms of the production price index (PPI) is presented in
Figure 6. After declining from 4,6 per cent in September 2005 to 4,2 per cent in October
2005, the overall PPI inflation rate rose to 5,5 per cent in January and February 2006
before slowing marginally to 5,4 per cent in March. The imported component of the
index continued to exert upward pressure on the overall PPI inflation rate. After declining
Monetary Policy Review May 2006
South African Reserve Bank
Percentage change over twelve months

-10
-5

Imported component

Domestically produced component

Production price index (PPI)
Source: Statistics South Africa
Figure 6
Production price inflation
from 6,8 per cent in September 2005 to 5,7 per cent in November 2005, the inflation
rate for this component increased to 6,9 per cent in February 2006 and then slowed to
6,7 per cent in March. Inflation measured in terms of the domestic component of the PPI
also increased from 3,8 per cent in September 2005 to 5,2 per cent in January 2006,
before receding slightly to 5,0 per cent in March.
The weighted contribution of the imported component declined from 1,7 percentage
points in September 2005 to 1,4 percentage points in November 2005 before increasing
to 1,6 percentage points in the four months thereafter. The domestic component’s
contribution to PPI inflation increased from 2,9 percentage points in September 2005 to
3,8 percentage points in March 2006.
Factors affecting inflation
Recent developments in some of the main drivers of inflation in South Africa are
reviewed in this section. The outlook for these variables, and therefore for inflation, is
discussed in a later section.
International economic developments
The International Monetary Fund (IMF) estimates that the world economy grew by
4,8 per cent in 2005 (Table 3), above an earlier estimate of 4,3 per cent but below the
5,1 per cent recorded in 2004. While growth in some of the advanced economies
slowed in 2005, emerging-market economies continued to grow strongly. The impact on
global growth of higher oil prices, which has been a recurring theme in recent editions
of this Review, has however been relatively moderate, and the global inflation rate rose
only marginally from 3,7 per cent in 2004 to 3,8 per cent in 2005.
Table 3
Annual percentage change in real gross domestic product and
consumer prices
Per cent
Real GDP
Consumer
prices
Share of global
real GDP*


Other emerging-market and developing countries ..

GDP shares based on the IMF’s purchasing-power-parity valuation of country GDPs for 2005
Source: IMF World Economic Outlook, April 2006.
South African Reserve Bank

Monetary Policy Review May 2006

The economy of the United States of America (US) proved resilient in 2005, despite
progressive monetary tightening, waning fiscal stimulus, natural disasters and a sharp
increase in energy prices. Real gross domestic product (GDP) growth of 3,5 per cent was
recorded, the fastest growth rate in the G7. As has been the case in many economies,
however, consumer prices in the US continue to be buffeted by oil prices, averaging 3,4
per cent in 2005. Core CPI inflation – which excludes food as well as energy prices –
moved higher in the first quarter of last year and then slowed slightly to stabilise at just
over 2 per cent.
Growth in Japan was faster than expected at 2,7 per cent in 2005, with business
investment and personal consumption expenditure acting as the main locomotives of
growth. CPI inflation averaged -0,3 per cent in 2005. However with stronger growth
resuming, the year-on-year headline CPI and core inflation rates became positive as of
January 2006 and November 2005, respectively.
The widely anticipated improvement in euro area growth finally materialised in the third
quarter of last year, with GDP advancing by 2,7 per cent, the fastest pace since the first
quarter of 2004. Growth subsequently slowed to 1,0 per cent over the final three months
of the year, resulting in overall growth of 1,3 per cent for 2005. The higher oil prices
impacted on headline CPI inflation throughout 2005, briefly pushing the year-on-year
rate as high as 2,6 per cent in September, well above the European Central Bank’s
(ECB’s) “close to but below 2,0 per cent” target ceiling.
The United Kingdom (UK), after posting an expansion of 3,2 per cent in real GDP in 2004
slowed significantly in 2005 to record growth of 1,8 per cent, largely as a result of a
deceleration in consumer spending associated with a cooling in the housing market. The
CPI inflation rate accelerated to 2,1 per cent in 2005, after averaging 1,3 per cent in 2004.
Growth in India in 2005 advanced impressively at 8,3 per cent, only slightly less
spectacular than the 9,9 per cent posted by China. In the Middle East, rising oil
production and prices have continued to support GDP growth, accompanied by dramatic
improvements in external current-account and fiscal positions. GDP growth of 5,9 per
cent was registered in 2005. Growth in oil-importing countries in the sub-Saharan Africa
region, while slowing, has so far held up surprisingly well. African economies grew by
5,2 per cent in 2005, with inflation rising from 8,1 per cent in 2004 to 8,5 per cent in 2005.
Oil prices
International oil prices have fluctuated sharply in the period under review, as geopolitical
factors and related concerns about supply disruptions as well as downstream
bottlenecks have impacted on the markets. As Figure 7 shows, the Brent crude oil spot
price declined from a peak of just below US$70 per barrel towards the end of August
2005 to around US$53 at the end of November, before increasing to over US$66 per
barrel late in January 2006 and then falling once more to around US$56 in mid-February.
By late April, the price had risen to new record-high levels above US$74 per barrel.
From the highs recorded in August 2005, prices fell immediately as emergency oil
reserves were released to the markets and Saudi Arabia promised to increase its output.
However, throughout December futures prices were supported by cold weather in the
US. Attention also began to focus on concerns regarding Iran’s nuclear programme as
well as Nigerian supply disruptions, and international crude oil prices began to rise early
in 2006 as a result of these concerns.
Monetary Policy Review May 2006
South African Reserve Bank
February 2006 was dominated by robust US inventories data, with the US Energy
Department reporting a jump in inventories around the middle of the month. At the end
of the month, crude inventories in the US reached their highest level since 1999. Prices
were lower in February despite an attack on a Saudi Arabian oil facility at month-end,
news that Nigerian oil production had been cut by 20 per cent as a result of attacks by
militants, as well as lingering concerns about Iran, as the International Atomic Energy
Agency reconvened to consider the country’s nuclear programme.
In March, despite the International Energy Agency (IEA) lowering its forecast of global oil
demand growth by 300 000 barrels per day to 1,5 million barrels per day, an unexpected
decline in US inventories at the end of the month pushed oil prices back up to a twomonth high. Prices then continued to rise amid increasing concerns that the dispute over
Iran’s nuclear programme could result in military conflict disrupting crude oil supplies,
reaching levels above US$74 per barrel by late April 2006.
Central bank interest rate developments
Table 4 depicts the most recent interest rate changes made by a selection of central
banks. Of those banks that made changes in the period since November 2005, when
the previous Monetary Policy Review was published, a significant majority have opted to
raise official interest rates.
The US Federal Open Market Committee (FOMC) raised its target for the federal funds
rate to 4,75 per cent in March 2006, the fifteenth consecutive 25-basis-point increase
since mid-2004. The FOMC indicated that while longer-term inflation expectations
remain well contained in the US, inflationary concerns centre around the increased
resource utilisation rates, and higher energy and commodity prices. In the short-tomedium term, monetary policy in the US is likely to have a bias towards tightening.
Canada’s central bank resumed interest rate increases in March and April 2006, raising
the target for the overnight rate to 4,00 per cent.
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Monetary Policy Review May 2006
US dollars per barrel

O
N
D
J
J
J
F
M
A
O
N
D
J
F
M
A
M
A
S
M

Figure 7
Price of Brent crude oil
Source: Bloomberg

Table 4
Selected central bank interest rates
Per cent
Countries
1 Jan 2005
3 May 2006
Latest change
(percentage points)
2,25
4,75
28 Mar 2006
(+0,25)
0,00
0,00
19 Mar 2001
(-0,15)
2,00
2,50
8 Mar 2006
(+0,25)
4,75
4,50
4 Aug 2005
(-0,25)
2,50
4,00
25 Apr 2006
(+0,25)
2,00
2,50
3 Mar 2006
(+0,25)
2,00
2,00
1 Mar 2006
(+0,25)
0,25 – 1,25
0,75 – 1,75
16 Mar 2006
(+0,25)
5,25
5,75
3 May 2006
(+0,25)
6,50
7,25
8 Dec 2005
(+0,25)
3,70
5,25
1 May 2006
(+0,25)
5,58
5,85
28 Apr 2006
(+0,27)
3,75
6,25
29 Mar 2006
(+0,25)
7,43
12,75
6 Dec 2005
(+0,50)
2,70
3,50
26 Apr 2006
(+0,25)
3,25
4,00
9 Feb 2006
(+0,25)
1,75
2,375
30 Mar 2006 (+0,125)
2,00
4,75
10 Apr 2006
(+0,25)
4,75
5,50
24 Jan 2006
(+0,25)
17,75
15,75
19 Apr 2006
(-0,75)
2,25
5,00
13 Apr 2006
(+0,25)
8,81
7,00
21 Apr 2006
(-0,25)
2,50
2,00
31 Oct 2005
(+0,25)
9,50
6,00
20 Sep 2005
(-0,25)
6,50
4,00
1 Mar 2006
(-0,25)
13,00
12,00
26 Dec 2005
(-1,00)
Source: National central banks
After maintaining an unchanged monetary policy stance since mid-2003, the ECB
raised interest rates by 25 basis points in December 2005 and again in March 2006.
The latter decision was due to perceived upside risks to price stability as a result of
strong monetary and credit growth, and changes in administered prices and indirect
taxes. After reducing interest rates by 25 basis points to 4,5 per cent in August 2005,
the Bank of England (BOE) has subsequently left interest rates unchanged.
The Bank of Japan (BOJ) announced an important shift in policy in March 2006 which
involved ending the quantitative easing policy which had been in place since March 2001. In
terms of the new policy, the operating target of money-market operations has been shifted
from the outstanding balance of current accounts of commercial banks held at the BOJ to a
short-term interest rate, the uncollateralised overnight call rate. Australia raised its cash rate
by 25 basis points to 5,75 per cent in May as a result of increased inflationary risks.
Taiwan’s discount rate was increased for the seventh consecutive quarter to 2,375 per
cent, the highest level in more than four years, in order to contain inflation pressures, while
China raised the benchmark lending rates of financial institutions to 5,85 per cent late in
April. The central banks of Thailand and South Korea also raised interest rates during the
first quarter of 2006 as a result of the robust domestic demand underpinning growth in
both countries. Given the anticipated upward pressure on core inflation, interest rates have
been increased to 4,75 per cent in Thailand and 4,0 per cent in South Korea.
In Latin America, the central banks of Brazil and Mexico reduced interest rates during
2006 as inflationary pressures continued to be benign. The Bank of Brazil has cut the
Monetary Policy Review May 2006
South African Reserve Bank
overnight rate to 15,75 per cent, its lowest level since March 2001, although real rates
remain among the highest in the world. After reducing interest rates by a further 25 basis
points in April, the Bank of Mexico gave some indication that it may be reaching the end
of its loosening cycle.
Exchange rate developments
Figure 8 shows that the nominal effective exchange rate of the rand measured against a
basket of thirteen currencies (NEER) strengthened to near its year-2000 average level in
January and mid-February 2006, before weakening in March and recovering once more
in April. The NEER is currently trading at around the levels recorded at the end of 2005.
Measured on a bilateral basis, the rand has fluctuated between R5,97 and R6,77 against
the US dollar and between R7,19 and R7,95 against the euro since the publication of
the November 2005 Monetary Policy Review.
Alongside movements in the US dollar-euro exchange rate and changes in investor
sentiment regarding emerging markets in general, strong commodity prices and robust
investment flows into the country have continued to support the domestic currency.
Following a large foreign direct investment inflow of R32,2 billion during the third quarter
of 2005, an inflow of R5,7 billion was recorded in the fourth quarter. Portfolio investment
rose by 36,3 per cent in 2005, despite an outflow of R4,1 billion in the final quarter of
the year as non-residents reduced their holdings of South African bonds and a euroSouth African Reserve Bank

Monetary Policy Review May 2006
Index: 2000=100 (foreign currency per rand)
Rand per euro
Rand per US dollar
Figure 8
Exchange rates of the rand

Mar
Feb
May
Apr
Jul
Jun
Sep
Aug
Oct Nov Dec Jan Feb Mar Apr
Jan

Nominal effective exchange rate of the rand (NEER)

Rand per US dollar

Rand per euro (right-hand scale)


denominated bond was redeemed by Eskom. In the first three months of 2006, net
purchases of shares and bonds by non-residents totalled R32,8 billion and R3,5 billion,
respectively, although this may include some movements between asset classes
(Figure 9).
Labour markets
The December 2005 Quarterly Employment Statistics survey published by Statistics
South Africa reveals that wage inflation, measured as the year-on-year growth rate in
remuneration per worker in the formal non-agricultural sector of the economy, was
4,6 per cent in the fourth quarter of 2005 (Figure 10). The average growth rate for
2005 as a whole was 7,3 per cent, compared to 9,2 per cent for 2004. This
downward trend in wage inflation is consistent with wage settlement trends in South
Africa, as reported by Andrew Levy Employment Publications, which suggest that
average wage settlements were 6,3 per cent in 2006 compared to 6,8 per cent in
2004. Settlements averaged 6,3 per cent in the first quarter of 2006.
Labour productivity, measured as the ratio of value added to employment in the formal
non-agricultural sectors, rose at decelerating rates in 2005. In the final quarter,
productivity increased at an annual rate of 2,1 per cent compared to 5,5 per cent in
the first quarter of the year. The lower growth in labour productivity is largely
attributable to faster growth in employment levels. However, for 2005 as a whole the
average level of labour productivity growth was 3,8 per cent, compared to 2,5 per
cent in 2004.
These developments in wage inflation and labour productivity growth mean that the
growth in unit labour cost has been well contained. The growth in unit labour cost
slowed from 4,5 per cent in the third quarter to 2,5 per cent in the fourth quarter of 2005.
The average rate of increase for 2005 was 3,3 per cent, significantly down from the rate
of 6,5 per cent recorded in 2004.
Monetary Policy Review May 2006
South African Reserve Bank
R billions

-10
-5

Net purchases of shares

Net purchases of bonds
Figure 9
Net purchases of shares and bonds by

non-residents
Demand and output
Although growth in the South African economy slowed from an annualised rate of
4,2 per cent in the third quarter of 2005 to 3,3 per cent in the fourth quarter, the real
growth rate for the year at 4,9 per cent is the highest since 1984. The contributions to
growth in the fourth quarter of 2005 were confined to sectors other than mining and
manufacturing, while expenditure growth in all the components of real domestic final
demand accelerated. Table 5 examines the recent growth in real GDP in more detail.
Table 5
Growth in real gross domestic product and expenditure
components
Per cent*

3rd qr
4th qr
Year
1st qr
2nd qr 3rd qr
4th qr
Year
Final consumption expenditure

Final consumption expenditure

Changes in inventories (R billions)** ....

Quarterly data refer to quarter-on-quarter growth at annual rates of seasonally adjusted data
**
Constant 2000 prices
South African Reserve Bank

Monetary Policy Review May 2006
Percentage change over four quarters

Figure 10 Remuneration per worker, labour productivity and unit

labour cost in the formal non-agricultural sector

Nominal unit labour cost

Remuneration per worker

Labour productivity
Source: Statistics South Africa

Note: Data from the fourth quarter of 2004 are from the Quarterly Employment
Statistics (QES) published by Statistics South Africa, which replaced the Survey
of Employment and Earnings (SEE) in June 2005. Since these two surveys differ
both in terms of their sample sizes and content, data from the fourth quarter
2004 onwards may not necessarily be fully comparable with previous periods.

The slowdown in GDP growth in the fourth quarter of 2005 can be attributed mainly
to temporary or special technical factors that adversely affected output in both the
manufacturing and mining sectors. The real value added in the mining sector fell
significantly in the fourth quarter of 2005 as production of platinum group metals was
adversely affected by scheduled maintenance of a smelter at one of the platinum
mines, and manufacturing suffered the adverse effects of refinery plant conversions
related to the change-over to unleaded and lead replacement fuel. However, growth
in the real value added in other sectors remained buoyant in the fourth quarter of 2005
with certain secondary and tertiary subsectors recording impressive growth rates.
Continued brisk expansion in final consumption expenditure by households was
underpinned by the steady increase in household disposable income, continued
buoyancy in the real-estate and securities markets and a favourable interest rate
environment. The particularly rapid growth in household spending on durable and semidurable goods continued throughout 2005 (Figure 11).
Robust domestic demand fuelled growth in expenditure on imports of goods and
services and although import growth slowed significantly in the fourth quarter of 2005,
real imports of goods and services grew by 10,1 per cent for the year as a whole. The
decelerating global expansion in the second half of 2005 and a strengthening currency
constrained growth in exports of goods and services, and a contraction of 4,1 per cent
was recorded in the fourth quarter of 2005. Although overall annual growth in exports
was 6,7 per cent in 2005, the stronger growth in imports served to widen the deficit on
the current account to 4,2 per cent of GDP, compared with 3,4 per cent in 2004.
The record R98,4 billion net capital inflow on the financial account of the balance of
payments in 2005 more than comfortably financed the current-account deficit for the year.
Monetary Policy Review May 2006
South African Reserve Bank
Year-on-year percentage changes
-5

Durable goods
Semi-durable goods
Non-durable goods
Services
Total

Figure 11 Real final consumption expenditure by households
The resulting large surplus recorded on the country’s overall balance of payments enabled
South Africa’s reserve position to strengthen in 2005 as the Bank continued to purchase
foreign exchange with the objective of building up reserves prudently. On balance, the
country’s official reserves rose by US$5,9 billion in 2005. By the end of March 2006, gross
reserves measured in US dollars amounted to US$23 billion and the international liquidity
position stood at US$19,5 billion. This can be compared to the situation at the end of
September 2005, when gross reserves were US$19,5 billion and net reserves were
US$16,1 billion.
South African Reserve Bank

Monetary Policy Review May 2006
Box 1 Household debt: An international perspective
The escalation of household debt in recent years has become a source of concern in a number
of countries. Higher levels of debt may make households more vulnerable to interest rate and
house price shocks, with adverse implications for both economic growth and financial stability.
This box takes a closer look at international trends in household debt, the forces that drive these
trends and their implications.1
Internationally, household debt ratios have been influenced by a common set of fundamental
factors, although the timing and extent of these influences have tended to differ from one
country to another. Financial market deregulation for example, occurred in many countries,
particularly in the 1980s. The deregulation process, apart from removing many of the credit
constraints on household borrowing, generated competition among financial institutions with
the consequence that efficiency improved and costs were lowered. Together with high levels of
financial innovation, deregulation resulted in improved risk assessment by lending institutions,
declining transaction costs and the proliferation of credit and other financial products such as
securitisation and home equity withdrawal schemes. Access to credit by households improved,
and this increased debt levels.
Mortgages generally constitute a large proportion of household debt, therefore rising house
prices and demographic changes that increase home ownership contribute to rising debt levels.
Rising household debt may also reflect a rational response by households to low levels of
interest rates and inflation expectations, and high levels of consumer confidence. Together with
buoyant asset prices, both financial and real estate, the low inflation environment has resulted
in households being more comfortable with higher debt levels.
Figure B1.1 shows household debt as a percentage of disposable income for a selected group
of countries over the period 1990 – 2005.2 The generally increasing trend for this ratio is clearly
evident from the figure, although there are notable differences in the timing of accelerations
between the episodes. Although valid comparisons between countries cannot be made without
analyses of the underlying balance sheet positions of the various household sectors, it is
notable that a relatively wide range of ratios is reported by countries. Italy and Chile, for
example, have debt to disposable income ratios which are below 60 per cent while the UK and
New Zealand have ratios above 150 per cent. The household debt-to-income ratio of South
Africa rose from 49,1 per cent in the final quarter of 2002 to 65,5 per cent in the corresponding
quarter of 2005.
It has been argued that household debt ratios provide little information about whether
household debt is excessive or sustainable. The right-hand axes of the individual country
graphs therefore depict the costs of servicing the debt.3 Although rising household debt has
been offset somewhat by the global moderation in interest rates, servicing costs have risen
to double-digit levels in Australia, the US and New Zealand in recent years. South Africa’s
debt service costs are currently around 7 per cent of disposable income, less than half the
level that prevailed in 1998.

Given differences in
country characteristics and data
compilation, it must be stressed
at the outset that unconditional
comparisons between countries
should be treated with caution.

Countries were selected
largely on the basis of data
availability.

There is no single
universally accepted indicator of
sustainability. Another common
measure is the gearing ratio of
households, i.e. debt levels
relative to the assets of
households. A problem with this
measure is that it is easily
affected by changes in house
prices.
High levels of household debt have significant macroeconomic implications. The higher the level
of household indebtedness, the more sensitive the economy is to unexpected fluctuations in
the levels of both incomes and interest rates. Furthermore, this sensitivity may be affected by
country-specific factors that are not incorporated in ratios such as those presented in Figure
B1.1. The form of debt contract would be an example here. In the US, the interest rate applying
to the debt is predominantly fixed, whereas in Australia, the United Kingdom, and South Africa
it tends to be variable over the life-span of the loan, and closely linked to the policy rate. In the
latter case, the implications of increased household indebtedness are potentially much greater.4
Other factors that need to be considered when assessing the indebtedness of households
include the composition and distribution of debt, the vulnerability of debtors and the health of
the financial system in general.

Monetary Policy Review May 2006
South African Reserve Bank
United States
Figure B1.1
Household debt and debt service costs in selected countries
Per cent
New Zealand
Per cent
Australia
Per cent
United Kingdom
Per cent

Household debt as percentage of disposable income

Household debt service cost as percentage of disposable income (right-hand scale)
Sources: Bank of Australia; Federal Reserve Bank of St. Louis; FRB Flow of Funds; Reserve Bank of New Zealand; Office for
National Statistics (UK) and Bank of Canada.
Canada
Per cent
South Africa
Per cent

Debelle, G. 2004. Macroeconomic implications of rising
household debt. BIS Working
Paper No. 153.
Real-estate and equity prices
Developments in the real-estate and equity markets may generate wealth effects which
have the potential to impact on aggregate demand and inflation. Figure 12 shows that
the year-on-year increases in house prices, measured in terms of the Absa House Price
Index, continued to slow from the record high levels experienced in September and
October 2004. Since the publication of the previous Monetary Policy Review, growth in
nominal house prices has declined from 18,0 per cent in September 2005 to 13,7 per
cent in March 2006. In real terms, the rate of increase in house prices declined from
13,1 per cent to 9,9 per cent over the same period.
On average, nominal house prices rose by 22,5 per cent in 2005 compared with
32,0 per cent in 2004 while in real terms house prices grew by an average of 18,5 per
cent in 2005 compared with 30,2 per cent in 2004.
The slowdown in the growth in house prices can be explained partly by the impact of
sustained buoyant real-estate market conditions on the affordability of houses (an increase
denotes a decline in affordability in Figure 13). The price/disposable income (PDI) index,
which is the ratio of the indices of Absa nominal house prices to per capita disposable
income, shows a stronger decline in the affordability of houses than the
repayments/disposable income (RDI) index. The latter index is calculated as the ratio of
mortgage repayments on the average priced house to per capita disposable income, and
reflects the moderating effect of the prevailing interest rate environment.
Notwithstanding the slowdown in the rate of increase in house prices, building statistics
published by Statistics South Africa continue to suggest buoyant economic activity in
South African Reserve Bank

Monetary Policy Review May 2006
Percentage change over twelve months

Absa House Price Index (nominal)

Absa House Price Index (deflated by CPI)
Source: Absa
Figure 12 House prices
Note: The Absa House Price Index records the total purchase price of houses in the
80 – 400 m2 size category, valued at R2,2 million or less and for which loan
applications were approved by Absa.

the real-estate market (Table 6). In 2005, the real value of buildings completed rose by
32,2 per cent compared with 22,5 per cent in 2004. The corresponding real value of
building plans passed (an indicator of future construction activity) increased by 41,8 per
cent in 2005 compared with 33,0 per cent in 2004.
Table 6
Real value of building plans passed and buildings completed by
larger municipalities
Annual percentage change

2006*
Building plans passed

Buildings completed

Figures for January – February 2006 compared with the corresponding months of 2005
Source: Statistics South Africa
Equity prices on the JSE Limited (JSE) continued to show a strong upward trend in the
period since September 2005, as Figure 14 shows. The closing levels of the daily allshare price index repeatedly set record highs, increasing by 8,5 per cent from 16 875 at
the end of September to 18 312 at the end of December 2005, before breaking the
21 000-level in April 2006. The resources index also performed strongly, breaching the
38 000-level at the end of April.
Monetary Policy Review May 2006
South African Reserve Bank
Indices: 2000=100

RDI

PDI
Figure 13 Housing affordability indices
Sources: Absa and SARB calculations
Less
More

Less affordable
More affordable
Note: A deposit of 20 per cent is assumed in the calculation of RDI. The mortgage rate
is proxied by the predominant rate of banks for dwelling units, and the monthly
repayment is calculated over a period of 20 years.
Fiscal policy
The Budget presented by the Minister of Finance on 15 February 2006 revised the
estimate of total revenue for the 2005/06 fiscal year to R411,1 billion, approximately
R41 billion more than originally budgeted (Table 7). The corresponding estimate for total
expenditure was revised upward only marginally to R419,0 billion, resulting in an
estimated budget deficit of R7,9 billion for 2005/06. This represents 0,5 per cent of GDP,
below the 3,1 per cent originally expected in February 2005 and the revised 1,0 per cent
presented in the Medium Term Budget Policy Statement (MTBPS) in October 2005. In
the medium term, the budget deficit as a proportion of GDP is expected to rise to
1,5 per cent in 2006/07 and then contract to 1,2 per cent by 2008/09.
Table 7
Public finance data
R billions and per cent
2003/04 2004/05 2005/06 2005/06
2006/07
2007/08 2008/09
Actual
Actual
Budget
Revised
Medium-term
estimates
estimates
National government

As percentage of GDP:

PSBR: Public-sector borrowing requirement
Source: National Treasury Budget Review 2006
South African Reserve Bank

Monetary Policy Review May 2006
Index
Index


FTSE/JSE all-share index
FTSE/JSE resources index (right-hand scale)
Figure 14 Share price indices

The public-sector borrowing requirement (PSBR) for 2005/06 has also been revised
downward to 0,6 per cent of GDP in the Budget Review from the 3,9 per cent of GDP
projected in February 2005 and the 1,2 per cent of GDP presented in the 2005 MTBPS.
The PSBR is projected at 2,4 per cent of GDP in 2006/07, and at 2,3 and 2,4 per cent
of GDP in 2007/08 and 2008/09, respectively.
Monetary conditions
Growth in the monetary aggregates remained robust during 2005, reflecting strong
domestic expenditure levels. The growth rate measured over twelve-month periods for
the broad monetary aggregate (M3) increased from 15,9 per cent in October 2005 to
21,1 per cent in February 2006 (Figure 15). The quarter-on-quarter annualised growth
in seasonally adjusted M3 declined significantly from 29,3 per cent in the third quarter of
2005 to 12,5 per cent in the fourth quarter of 2005. The growth in total loans and
advances to the private sector rose from 19,3 per cent in October 2005 to 21,9 per cent
in February 2006. On average, total loans and advances to the private sector increased
by 20,7 per cent in 2005 compared with 12,3 per cent in 2004.
Monetary policy
The monetary policy stance has remained unchanged since mid-April 2005 when the
repo rate was reduced by 50 basis points to 7 per cent per annum (Figure 16). Since
the previous Monetary Policy Review there have been three meetings of the Monetary
Policy Committee (MPC) and at each of these meetings the issues facing the
committee were similar. In brief, the MPC was faced with an improving inflation outlook
as reflected in the central forecast generated by the Bank’s macroeconomic model. At
the same time there were significant risks, including emerging macroeconomic
imbalances, that the committee had to take cognisance of. These risks related primarily
to the continued strong domestic demand growth which was fuelled in part by high
credit extension and relatively low nominal interest rates; a burgeoning current-account
deficit which is also in part a manifestation of the high domestic demand; and resurgent
international oil prices.
Monetary Policy Review May 2006
South African Reserve Bank
Per cent

Total loans and advances to the domestic private sector

M3
Figure 15 Growth in M3 and in bank loans and advances
As noted earlier, CPIX inflation has remained within the target range for the 31 months
to March 2006. The Monetary Policy Committee (MPC) has been particularly
encouraged by the evolution of some of the components of CPIX. It has become clear
that there has been a steady convergence of the inflation rates of many of the
categories of goods and services which make up the index to within the target range
of 3 – 6 per cent. In particular, the committee noted the fact that services price inflation
had fallen to within the inflation target range after an extended period of inertia around
the 8-per-cent level. In addition, the inflation rate for administered prices excluding
petrol had fallen to a level significantly below the overall CPIX inflation. These
developments bode well for the sustainability of inflation within the target range.
Although food price inflation had increased from very low levels in the first half of 2005,
the most recent rate of increase of 4,5 per cent was still well within the inflation target
range, despite the sharp increase in maize prices in the latter part of 2005.
In the previous Monetary Policy Review, the central forecast presented to the October
MPC meeting was published. That forecast showed that CPIX inflation was expected to
rise to about 5,8 per cent in the second quarter of 2006 before easing to 5,3 per cent
in the final quarter of 2007. Since then the forecasts have shown successive
improvements. In December 2005, CPIX inflation was expected to rise gradually to reach
an upper turning point around 5,5 per cent in the fourth quarter of 2006, whereafter it
was expected to decline to a level of around 5 per cent by the end of 2007. By February
2006 there was a further improvement in the forecast. At that time the forecast was for
the inflation trajectory to follow a more moderately rising trend compared to that
discussed at the previous meeting. According to the central forecast, CPIX inflation was
expected to peak at around 4,9 per cent in the first quarter of 2007 whereafter it was
expected to decline slowly to reach around 4,7 per cent at the end of the forecast
period. The forecast at the April 2006 meeting was similar to this. By then the forecast
period had been extended to the end of 2008 and a level of 4,6 per cent was expected
by the end of that period. This was despite the fact that the oil price assumption in the
forecast was increased significantly. The forecast presented to the MPC in April is
reproduced later in this Review.
South African Reserve Bank

Monetary Policy Review May 2006
Per cent

Figure 16 The repo and other short-term interest rates

Prime overdraft rate

Repo rate

3-month NCD rate

These benign inflation forecasts were a result of a number of positive factors which were
anchoring inflation within the target range. These factors are generally expected to
continue to help keep inflation under control, and therefore are not considered to pose
a significant upside or downside risk to the forecast. Of particular significance is the
evolution of inflation expectations over the past few months. At the time of the October
meeting, the MPC noted, with concern, the results of the inflation expectations survey
conducted by the Bureau for Economic Research (BER) for the third quarter of 2005. At
that time it appeared that the rising trend in oil prices was impacting unfavourably on
inflation expectations and expectations had moved higher. These fears were allayed
somewhat with the publication of the survey for the fourth quarter of 2005 which
showed that expectations had not deteriorated further and that there was a slight
improvement for 2007. The survey for the first quarter of 2006, which was presented to
the April meeting, showed a significant improvement in expectations. Not only was there
a decline in the expected inflation for 2006, but the expected inflation rate for the end of
the forecast period in 2008, although marginally higher than that expected in 2006 and
2007, was a moderate 4,8 per cent. This reflects confidence that low and stable inflation
will prevail over the medium term. These trends were confirmed in the breakeven
inflation rates, measured by the spreads between the yields on South African CPI
inflation-linked bonds and conventional nominal bonds of the same maturity.
Entrenched inflation expectations are also expected to feed into wage and price
formation. Over the past two years there has been increasing evidence that nominal
wage settlements are declining. These settlements were still above the inflation rate, and
therefore implied real wage increases. Nevertheless, the MPC was satisfied that these
settlements had become consistent with the inflation target range. Furthermore, the
trend in unit labour cost was extremely favourable, with unit labour cost increases
averaging 3,3 per cent in 2005, which was half the average increase measured in the
previous year. If these trends persist they will make an important contribution to
sustaining inflation within the target range.
Fiscal policy also remained supportive of monetary policy over this period. At the time of
the Medium Term Budget Policy Statement in October 2005, the National Treasury had
revised down its budget deficit forecast for 2005/06 from 3,9 per cent to 1,0 per cent
of GDP. At the time of the February 2006 Budget, this forecast was revised down further
to 0,5 per cent as a result of higher-than-expected tax revenues. At the same time the
estimated budget deficit for 2006/07 was reduced from the October estimate of 2,2 per
cent to 1,5 per cent of GDP.
Expected movements in the exchange rate have a significant impact on expected inflation.
Although the rand exchange rate has been subject to some volatility, it has remained within
a fairly limited trading range for some time and therefore has had a stabilising effect on
inflation. Since the beginning of the year the nominal effective exchange rate has
appreciated by around 2 per cent. The movements of the rand continued to be determined
by factors such as movements in the US dollar against the euro; changes in investor
sentiment towards emerging markets; strong capital inflows to South Africa; and
continued strong commodity prices. The MPC is aware that there are potential risks in
both directions to the exchange rate outlook. However, given the underlying improvements
in the foreign exchange market with the elimination of the net open forward position and
the build-up of reserves, the rand exchange rate is expected to be less vulnerable to
exogenous shocks, and to react in a more orderly manner than was previously the case.
There was some change in the outlook for output growth in the economy. At the
December 2005 and February 2006 MPC meetings, it was already apparent that growth
in output was moderating. This was evident in the mining and manufacturing output data
Monetary Policy Review May 2006
South African Reserve Bank
and the Investec/BER Purchasing Managers Index (PMI) which indicated a possible
contraction in manufacturing in January and February. By April 2006 this weakening
trend had been confirmed. The annualised GDP growth rate in the fourth quarter of 2005
was 3,3 per cent, and the most recent output data continue to indicate that although
growth is expected to remain robust in 2006, it is likely to be more in line with the
estimated potential output in the economy. Box 2, on the next page, reports on the
results of research by the Bank to estimate potential output in the economy.
World inflation is also expected to be well contained, despite the higher international oil
prices and resilient world growth. The most recent World Economic Outlook of the IMF
shows that world inflation is expected to average 3,8 per cent in 2006 and 3,5 per cent
in 2007, while global growth is expected to average 4,8 per cent in these two years.
These developments have been accompanied by a general tightening of monetary
policy in most major industrial countries.
Despite the promising inflation outlook, the MPC became increasingly concerned about
the growth rate of domestic consumption expenditure. This has been identified as one of
the main risk factors for some time. In 2005, household final consumption expenditure
grew by 6,9 per cent, and all indications are that this trend is going to continue. As noted
in the April 2006 MPC statement, the FNB/BER consumer confidence index was at an
all-time high, and had been at high levels for some time. It was noted that the reasons for
this high level of demand included low nominal interest rates, higher real incomes and
wealth effects emanating from record high prices on the JSE, and a buoyant housing
market. Despite the strong expenditure, there had been little impact on domestic inflation.
The MPC noted in February that if these trends continued unabated, some impact on
prices would be inevitable. At issue then is how pre-emptive the MPC should be, given
the absence so far of significant price increases in the wake of this high demand.
The robust domestic demand has been reflected in the growth of money supply and
credit extension, both of which have accelerated significantly. By the time of the April
meeting, domestic credit extension to the private sector was growing at a year-on-year
rate of over 20 per cent, and asset-backed credit was growing at around 27 per cent.
The MPC noted with some concern the pace at which household indebtedness was
rising. The level of such indebtedness had, by the fourth quarter of 2005, risen to almost
66 per cent of disposable income. The cost of servicing this debt, while still low,
increased moderately during the past year. By the end of 2005 debt servicing costs had
risen to around 7 per cent of disposable income.
The MPC also became increasingly concerned about the widening deficit on the current
account of the balance of payments, which is also in part a manifestation of the high
consumption expenditure. Although the current-account deficit of 4,2 per cent of GDP is
high by historical standards for South Africa, it is recognised that it is also a consequence
of the higher investment and growth in the economy. As noted in various MPC statements,
the widening current-account deficit is not in itself inflationary. The potential threat to inflation
comes through its possible impact on the exchange rate, should the deficit be regarded as
unsustainable. At current levels the deficit has been comfortably financed by capital inflows,
which have even allowed the Bank to continue with its accumulation of foreign exchange
reserves. At these levels the deficit appears to be sustainable. However, the MPC would be
concerned about a continuous and rapid widening of the deficit.
The behaviour of international oil prices continued to be identified as a major risk factor.
In the past few months, there have been numerous occasions when it appeared that the
oil prices would stabilise at slightly lower levels. Brent crude oil prices had peaked at
around US$70 per barrel in August 2005 in the wake of hurricane Katrina. Prices then
South African Reserve Bank

Monetary Policy Review May 2006

moderated, and in February of this year had fallen to around US$55 per barrel. Since
then, however, renewed geopolitical tensions and tight supply and demand conditions
in the oil markets resulted in a surge in prices to US$70 per barrel. These developments
resulted in the MPC raising its assumptions about future prices, but there is nevertheless
the risk that international oil prices could in fact increase even further than assumed. The
MPC has stated on numerous occasions that it would not react to first-round effects of
higher oil prices. However, the higher and faster these prices rise, the more likely they
are to feed through to generalised inflation.
During the past few months, the MPC has been faced with contradictory signals. On the
one hand, the inflation outlook as reflected in the inflation forecast of the Bank has
improved at each successive meeting. On the other hand, the MPC has become
increasingly concerned about international oil price developments and the level of
domestic demand which are also contributing to higher consumer indebtedness and a
widening of the current-account deficit. The MPC has left the monetary stance
unchanged but has indicated that, on balance, the risks to the outlook are on the upside.
Monetary Policy Review May 2006
South African Reserve Bank
Box 2 Measuring potential output in South Africa
The estimated level of potential output plays an important role in monetary policy making. If potential
output is interpreted as the maximum sustainable level of output consistent with stable inflation,
then its growth rate provides a useful guide for the assessment of sustainable growth in output and
employment in an economy. It follows that the gap between actual and potential GDP, often referred
to as the GDP or output gap, is a key variable determining the evolution of prices and thus inflation.
A level of real GDP above its potential suggests excess demand and is thus a source of inflationary
pressures, while the converse is true for a level below potential. However, because potential output
is a non-observable variable, measuring it with any degree of accuracy is a difficult assignment, and
estimates should not be employed in a mechanical fashion. This box provides a summary of the
results of recent research that has been undertaken at the Bank on the estimation of potential
output for South Africa (Du Toit et al, 2006).
Two broad categories of methods are employed in the literature to estimate potential output. The first
category comprises statistical detrending methods, with examples including the well-known HodrickPrescott (HP) filter, Beveridge-Nelson decompositions and unobserved components methods. A
common characteristic of these methods is that they are purely statistical and mechanical in nature
and have no explicit economic foundation. Cerra and Saxen (2000) and Van Norden and St-Amant
(1997) provide detailed discussions of these and other methods. The second category comprises
structural methods which are based on estimated structural models. Examples here include
production function methods and structural vector autoregression (SVAR) models. It is important to
realise that the results obtained using different methodologies may differ substantially (Cerra and
Saxen, 2000). It is also the case that estimates of potential output will change as the structure of the
economy changes, an issue which appears to have particular relevance in the South African case.
The work reported here falls into the second of the categories discussed above. A structural
production-function method is employed to estimate potential output for South Africa, based on a
Cobb-Douglas production function with constant returns to scale. This production function may
be represented by the following expression:
Yt = At K αt Nßt
(1)
where Yt is actual gross domestic product at factor cost; At is unobservable total factor productivity
(TFP); Kt is the actual capital stock, and Nt is actual employment. α and ß represent the capital and
labour share parameters, respectively.
By estimating the potential levels of all the variables on the right-hand side of Equation 1, the
potential level of output can be determined. If one uses a * to denote potential levels of all variables,
then potential output Yt* is obtained from:
Y*t = A*t K* α
t N* ß
t
(2)
South African Reserve Bank

Monetary Policy Review May 2006
Employing a Solow-residual approach to estimate the potential level of total factor productivity A*,
a neoclassical (Jorgenson) approach to estimate the desired capital stock K*, and adjusting labour
input for the gap between actual unemployment and the non-accelerating wage rate of
unemployment (NAWRU) to obtain potential employment1 N*, a 10-equation structural model was
simulated to determine the potential output for the South African economy. Four alternative
scenarios were considered:
(a)
Status quo: This scenario assumes the existence of structural unemployment given the current
structure and growth impediments of the South African economy, i.e. it assumes a positive
NAWRU.
(b) Utopia: This assumes full employment, i.e. potential output is equal to the economically active
population and therefore NAWRU is set to zero.
(c)
Government targets: This assumes that the quantified targets of the government are achieved
(halving unemployment in 10 years, attracting an additional US$ 804 million per annum resulting
in an FDI to GDP ratio of 1,3 per cent, and increasing the savings to GDP ratio to 22 per cent).
(d) International benchmark: This assumes that the South African economy becomes more
competitive in terms of the average performances of emerging markets (the unemployment rate
was set to 12 per cent, the FDI to GDP ratio to 4 per cent, the savings to GDP ratio to 25 per
cent, and openness to 0,55).
The results are reported in Table B2.1
Table B2.1 Summary of the results
Per cent
Scenario
Real potential output
growth rate

These results suggest that South Africa’s current growth potential is a rate of 4,1 per cent. This can
be compared with the results of Arora and Bhundia (2003) who also use a production function
approach and estimate an average potential output growth rate of 3 per cent for the period 1995 –
2003. However it must be stressed these results should be viewed as indicative and a contribution
to the literature, and not as immutable numbers to be applied in a mechanical fashion. At the
extreme, adopting the utopia scenario, the simulations generate a potential output growth rate of
6,9 per cent, while in the intermediate cases, a growth rate of 5,1 per cent results when government
meets its own targets and 6,5 per cent is possible if the South African economy’s competitiveness
rises to around the average level of other emerging economies.
References
Arora, V and Bhundia, A. 2003. Potential Output and Total Factor Productivity Growth in PostApartheid South Africa. IMF Working Paper No. 03/178, Washington: International Monetary Fund.
Cerra, V and Saxen, S C. 2000. Alternative Methods of Estimating Potential Output and Output Gap:
An Application to Sweden. IMF Working Paper No. 00/59, Washington: International Monetary Fund.
Du Toit, C B, Du Toit, A, Ehlers N, Kuhn, K and Mashiane, M M. 2006. South Africa’s growth
potential: Prospects and challenges. South African Reserve Bank Discussion Paper DP/06/04.
Van Norden, S and St-Amant, P. 1997. Measurement of Output Gap: A Discussion of Recent
Research at the Bank of Canada. Bank of Canada Technical Report No. 79.

The potential level of
employment is defined in two
different but related ways in
the paper. First, potential
employment is defined as the
level of labour resources that
might be employed without
resulting in additional inflation.
This definition admits the
existence of some natural rate
of unemployment, sometimes
referred to as the NAWRU.
According to this definition
potential employment (N*) is
the difference between the
economically active population
(EAP) and the fraction of EAP
that is naturally unemployed,
i.e. N* = EAP (1-NAWRU). The
second definition assumes that
potential employment is equal
to the EAP, i.e. NAWRU is
equal to zero.

The outlook for inflation
The outlook, risk and uncertainties relating to some of the factors that determine the
outlook for inflation and that are embodied in the forecast, are presented in this section.
International outlook
Recent data suggest that the global recovery that began in 2002 will remain on track,
with world GDP advancing at a robust pace (Table 8). The projection for global GDP
growth in 2006 has been revised upward by the IMF from 4,3 to 4,9 per cent, followed
by growth of 4,7 per cent in 2007. The buoyancy of activity in China, India, and Russia
together accounted for two-thirds of the upward revision to global growth in 2006. In the
four-year period 2004 – 2007, the global economy is set to expand at close to 5,0 per
cent annually, well above its 3,7 per cent long-term average.
Although global headline inflation has risen slightly in response to higher oil prices,
with the latest forecast for 2006 revised upward by 0,1 percentage points to 3,8 per
cent, core inflation has not been affected significantly and inflationary expectations
remain well grounded. The current worldwide boom is also not expected to spark
significant inflationary problems. While advanced country inflation is expected to be
slightly higher than previously estimated, estimates for most developing countries
have been lowered.
Table 8
IMF projections of world growth and inflation for 2006*
and 2007
Per cent
Real GDP
Inflation rates


Other emerging-market and

Commonwealth of Independent

IMF projections for 2006 as at September 2005 in parentheses
Source: IMF World Economic Outlook, April 2006
In the G7 countries, growth is generally forecast to accelerate in 2006 and moderate
somewhat in 2007. The US and UK are clear exceptions. In the former, growth is
Monetary Policy Review May 2006
South African Reserve Bank
expected to slow during 2006, while in the latter growth improves progressively over the
forecast interval. After faltering in the fourth quarter of 2005, the US economy recently
regained strong momentum in the first quarter of 2006. However, growth is expected to
slow in the remaining quarters of 2006 to record 3,4 per cent for the year. US inflation
has been revised upward to 3,2 per cent in 2006. The UK’s economic growth, after
slowing to 1,8 per cent in 2005, is projected to accelerate to 2,5 and 2,7 per cent in
2006 and 2007, respectively. Inflation is expected to remain well contained in the
neighbourhood of the Bank of England’s 2 per cent inflation target.
Growth is expected to accelerate in the euro area, averaging 2,0 per cent over the next
two years. Although ECB officials have expressed concern about excess liquidity and
rapid money growth, inflation forecasts remain relatively benign, with headline CPI
inflation projected to slow from 2,2 per cent in 2005 to 2,1 per cent in 2006 before rising
to 2,2 per cent in 2007. The Japanese recovery is also expected to stay on track, with
GDP rising by 2,8 per cent in 2006 – the fastest rate since 1991 – before slowing to
around 2,1 per cent in 2007. With the long road out of deflation seemingly finally ended,
consumer prices are projected to rise by 0,3 per cent in 2006 and 0,6 per cent in 2007.
The IMF raised its growth forecasts for the greater part of the Asia-Pacific region, although
it warned that the projected favourable outlook could worsen existing global imbalances
(Box 3 discusses the issue of global imbalances). Developing Asia is forecast to grow by
8,2 per cent this year, above the September 2005 forecast of 7,2 per cent. Key areas of
strength are China and India. China’s economy is expected to grow at 9,5 per cent this year
while India’s growth rate is expected to be a similarly impressive 7,3 per cent. Sustained in
certain cases by high prices for oil and other commodities, sub-Saharan African nations are
projected to grow 5,8 per cent this year, the fastest rate in more than 30 years. Growth
forecasts for Southeast Asia, Australia and New Zealand have been trimmed, however.
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Monetary Policy Review May 2006
Box 3 Tackling global imbalances
Global imbalances have continued widening in recent years, raising fears regarding their
sustainability over the long run (Figure B3.1 depicts global current-account balances as estimated
for 2005). Three aspects of global capital flows are deemed as being without precedent and are
referred to by Summers (2006)1 as the capital flows paradox in the current world financial system.
Firstly, the net flow of capital is mainly from developing countries and emerging markets towards the
industrialised world and, principally, the United States. Secondly, escalating US foreign debt is
mirrored in foreign reserve accumulation by emerging-market countries that in many instances is far
in excess of any acknowledged criterion of reserve need for financial protection. Finally, expected
real returns on these foreign reserves are expected to be low and relatively risky.
The main risks for the global economy resulting from these imbalances are that exchange rates
might adjust abruptly and in a disorderly fashion, characterised by substantial overshooting, a large
increase in interest rates and a sharp contraction of global activity. Concern about such an outcome
has led to an increasing consensus worldwide that exchange rates should more appropriately reflect
economic fundamentals. The IMF has in this regard called for greater currency flexibility in emerging
Asia, arguing that in the absence of significant movements in relative prices, Asian countries will
have few incentives to rebalance their economies towards domestic demand or the US towards
export industries.
In order to address current global imbalances, policy changes are required in almost all regions of
the world, unlike in the 1980s when large current-account imbalances were mainly confined to the
US, Japan and Europe. The G7 finance ministers and central bankers have repeatedly declared that
vigorous action on various fronts is needed to unwind global imbalances and to ensure sustainable
growth. They have stressed that these actions include fiscal consolidation in the US; further
structural reforms in Europe; and further structural reforms including fiscal consolidation in Japan.
However, the policy changes required to address global imbalances are spread more widely and are

Summers, L H. 2006.
Reflections on Global Account
Imbalances and Emerging
Markets Reserve Accumulation.
L K Jha Memorial Lecture.
Reserve Bank of India. Mumbai,
India, March.

Monetary Policy Review May 2006
South African Reserve Bank
of concern not only to the developed economies. The differences between desired savings and
desired investment rates in different regions of the world will have to be reduced if sustainable global
economic growth is to be achieved and the probability of a sudden unfavourable correction in the
world economy is to be reduced significantly.
The strong growth in the foreign exchange reserves of Asian central banks has been one of the
most visible features of growing global imbalances, along with the US current-account deficit. Large
Asian trade surpluses and foreign direct investment inflows into East Asia have resulted in central
bankers in the region buying US dollars to prevent their currencies appreciating. The accumulation
of foreign exchange reserves is deemed by many to be artificially depressing Asian exchange rates,
boosting trade surpluses, hindering natural adjustment mechanisms to rectify imbalances and
creating the risk of financial crisis. The IMF recommends that relative changes should be gradual to
minimize the costs of adjustment and also recommends increased national savings with fiscal
consolidation in the US and more effective measures to strengthen domestic demand in Europe,
Japan and emerging Asia. In oil-producing countries the IMF recommends spending on
infrastructure, health and education, and gradual currency appreciation.
It is becoming increasingly clear that an outcome characterised by a benign unwinding of global
imbalances in the international monetary system will require an effective international institutional
forum for debate and effective policy formulation. Although the IMF is still deemed by many to be
the most appropriate institution for this role, it has in the past few years concentrated more on being
the lender of last resort to middle income countries and on surveillance of economies without a
specific focus on systemic macroeconomic problems. Some countries have therefore, among other
measures, called for more active surveillance by the IMF as well as a number of other measures to
improve the institution’s effectiveness although other countries are less enthusiastic in this regard.
Some countries have called for effective forums to discuss global imbalances in small groups and
have suggested that there should be a group of at most three or four countries representing the big
currency blocks – the euro area, the US, Japan and China. Regular discussions have also been
proposed for a new group of 11 countries that would comprise the G7 plus the newly important
economies of Brazil, Russia, India and China.
The world economy has in recent years been characterised by rapid above-trend growth within a
relatively low inflation environment. Although there are a number of factors that could remain
supportive of continued beneficial global growth outcomes, tackling the problem of global
imbalances effectively will be the most important prerequisite in ensuring that favourable conditions
continue underpinning longer-term sustainable global economic growth.
US$ billions
Source: Summers (2006)
Figure B3.1:
Global current-account balances for 2005
Oil exporters
Japan
China
Rest of world and statistical
discrepancy
Emerging Asia
Euro area
United States


Deficit
Surplus
The forecasts of moderate expansion in the Organisation for Economic Cooperation and
Development (OECD) are confirmed by the latest composite leading indicators (CLIs)
compiled by the OECD. These CLIs are aggregate time series compiled for 23 member
countries that show a leading relationship with the growth cycles of key macroeconomic indicators (the average lead is 6 months). As shown in Figure 17, the sixmonth rate of increase of the CLI for the overall OECD area was 4,7 per cent in February
2006, reflecting improved performance in the corresponding CLIs in most of the major
OECD economies. Figure 17 also presents a trade-weighted OECD CLI, where the
weights are based on South Africa’s exports to OECD member countries. The six-month
rate of increase in the SA trade-weighted OECD CLI was 3,7 per cent in February 2006,
reflecting an improved but slightly less resilient performance in South Africa’s OECD
trading partners than that recorded for the overall OECD.
The outlook for the international oil markets remains uncertain. While the underlying
dynamics of the market will probably continue to change slowly, as investment by OPEC
and non-OPEC producers eventually allows capacity to grow slightly faster than demand,
the market seems set to remain tight. Recent forecasts by the IEA put global oil demand
at 84,7 million barrels per day, with non-OPEC production in February at approximately
50,7 million barrels per day (close to the IEA projected average production of
approximately 51,3 million barrels per day in 2006). If the status quo is maintained, then
the call on OPEC production (including natural gas liquids) will be around 34 million barrels
per day in 2006, which is very close to OPEC’s output level in February 2006. Given the
supply concerns in some of the major oil-producing countries, the uncertainty surrounding
the hurricane season in the Gulf of Mexico, the limited spare production capacity and the
anticipated strong demand as a result of robust global growth rates, tight conditions are
expected to characterise developments in the oil market for some time. Geopolitical
developments are expected to add further to volatility in the coming months.
Outlook for domestic demand and supply
The economic growth momentum in the domestic economy is expected to continue in
2006, although at a lower rate than in 2005. Among other factors, the government’s
South African Reserve Bank

Monetary Policy Review May 2006
Per cent, annualised 6-month rate of change


OECD trend restored CLI
SA trade-weighted OECD CLI
Sources: OECD and SARB calculations
Figure 17 OECD composite leading indicators

strong focus on improving the growth potential of the economy through the Accelerated
and Shared Growth Initiative of South Africa (ASGISA), infrastructural investment
associated with the 2010 Soccer World Cup preparations and the improved global
outlook will underpin this growth momentum. The tertiary sector, which contributed
most to growth in 2005, is expected to remain resilient in 2006.
According to the April 2006 Reuters consensus forecasts, the South African economy
is expected to grow at 4,5 per cent in 2006 and 2007, and by 5,0 per cent in 2008.
These forecasts represent the mean of 14 individual forecasts for both 2006 and 2007
and the mean of 7 forecasts for 2008. They range from 4,1 to 4,8 per cent for 2006,
4,0 to 5,7 per cent for 2007 and 4,7 to 5,8 per cent for 2008. In its Budget Review, the
National Treasury expects economic growth of 4,9 and 4,7 per cent for 2006 and 2007,
respectively.
Consumer spending, which has been driving economic expansion, is expected to remain
robust. Factors that will underpin consumer spending include a steady increase in the real
disposable income of households, tax relief provided in the 2006/07 national Budget,
especially for the low income groups, substantial equity price increases on the JSE,
continued lower levels of expected inflation, and buoyant levels of consumer confidence.
Consumer confidence, measured by the FNB/BER consumer confidence index as the
percentage of respondents expecting an improvement less the percentage expecting
deterioration, increased by one percentage point to +21 in the first quarter of 2006. On
the downside, increasing levels of household debt and a cooling down of house prices
are factors that should moderate consumer spending going forward.
Business confidence levels generally remain upbeat. The RMB/BER business confidence index, which reports the gross percentage of respondents who perceive business
conditions as satisfactory, rose to 86 per cent in the first quarter of 2006. This is just
below the 88 per cent recorded in late 2004, which was the highest level since 1980.
The SACOB/Absa Trade Activity Index also remained high in March 2006, with 66 per
cent of respondents optimistic about trade conditions. Although this index declined for
the second consecutive month in March, having recorded values of 68 per cent in
January and 67 per cent in February, it nevertheless remains at a higher level than in
March 2005. The Investec/BER Purchasing Manager’s Index (PMI), which is a barometer
of manufacturing activity, rose to 54,3 index points in April 2006 from 51,5 in March,
suggesting some improvement in conditions for the manufacturing sector this year.
Overall, the short-to-medium-term outlook for aggregate demand and supply remains
favourable and continues to be underpinned by domestic demand. However, sustained
robust domestic demand growth generates some upside risk for inflation, particularly
since recent growth in consumer demand has been strongest for durable and semidurable goods which are either imported or have high import content, and thus
contribute to a widening of the current-account deficit.
Indicators of inflation expectations
The various measures reviewed here suggest that inflation expectations are currently
anchored around the midpoint of the inflation target range. The results of the latest BER
survey, undertaken in the first quarter of 2006 and reproduced in Figure 18, show that
respondents expect CPIX inflation to average 4,4 per cent in 2006, before increasing
slightly to 4,6 and 4,8 per cent in 2007 and 2008, respectively. The results for 2006 and
2007 are notably below those obtained in the previous three quarterly surveys.
Monetary Policy Review May 2006
South African Reserve Bank
According to the April 2006 Reuters survey of long-term forecasts for the South African
economy (Table 9), CPIX inflation is expected to average 4,2 per cent in 2006, before
rising to 4,7 per cent in 2007 and 2008. The median forecasts do not differ from these
averages or from the median forecasts of the previous survey.
Table 9
Reuters survey of CPIX forecasts: April 2006*
Per cent


(16) 14
(9)

*
March 2006 survey results in parentheses
Source: Reuters
An indication of developments in inflation expectations may also be obtained from the
breakeven inflation rates in Figure 19, measured as the difference between the yields on
South African CPI inflation-linked bonds and conventional nominal bonds of similar
maturity. Breakeven inflation rates obtained from the R197 (maturing 2023),
R189 (maturing 2013) and R198 (maturing 2008) inflation-linked bonds are all currently
close to the midpoint of the inflation target range.
South African Reserve Bank

Monetary Policy Review May 2006
Annual averages, per cent

Figure 18
BER surveys of CPIX inflation expectations

05Q2
05Q3
05Q4
06Q1
Source: Bureau for Economic Research, University of Stellenbosch

The Reserve Bank inflation forecast
The Reserve Bank’s latest quarterly forecast for CPIX inflation, which was presented to
the MPC meeting on 12 and 13 April 2006, is presented in Figure 20. The central
projection is for the CPIX inflation rate to accelerate to just below 5 per cent in the first
quarter of 2007, and then remain slightly above the midpoint of the inflation target range
until the end of the forecast period in the first quarter of 2008.
Monetary Policy Review May 2006
South African Reserve Bank
Percentage points

Figure 19 Breakeven inflation rates

Spread between R189 and R153 bonds

Spread between R197 and R186 bonds

Spread between R198 and R194 bonds
Per cent

Figure 20 CPIX forecast

Note: The fan chart uses confidence bands to depict varying degrees of certainty.
The darkest band of the fan chart covers the most likely 10 per cent of
probable outcomes foreseen for CPIX inflation, including the central
projection. Each successive band, shaded slightly lighter and added on either
side of the central band, adds a further 10 per cent to the probability until the
whole shaded area depicts a 90 per cent confidence interval (see Box 4
“Understanding the fan chart” on p. 27 of the March 2001 Monetary Policy
Review).
The future is of course uncertain, as the fan chart technique is intended to communicate,
and there are a number of risks that could cause the actual rate of CPIX inflation to differ
from the central projection. Consumer demand continues to grow strongly, and with
sustained asset price growth and consumer confidence at an all-time high, this shows
few signs of abating. The related growth in credit extension to the private sector, and the
increases in household indebtedness and debt servicing ratios are cause for concern,
as is the widening of the deficit on the current account of the balance of payments. On
the international front, the oil market remains beset by geopolitical tensions and tight
demand and supply conditions, and the possibility of price spikes therefore also pose a
risk to the inflation outlook.
Assessment and conclusion
Monetary policy faces a challenging period ahead as a result of conflicting tendencies. On
the one hand the inflation outlook, as reflected in the recent inflation forecasts of the Bank,
has improved significantly. Most private-sector forecasts have also improved over the
past few months. These forecasts are also consistent with the improved inflation
expectations which are evident in the latest inflation expectations survey. Moreover, wage
settlements are in line with the inflation target, and the inflation rates of most components
of the CPIX basket have converged to within the target range. These factors, inter alia,
appear to point to a very comfortable picture for monetary policy going forward.
On the other hand there are a number of developments that have led the MPC to remain
vigilant. One of these concerns is the growth in household consumption expenditure.
Although there have not been any significant inflationary consequences of this growth to
date, the MPC has expressed concern that if it continues to grow unchecked,
inflationary pressures could emerge in the future. The brisk growth in demand has also
had a significant impact on the current account of the balance of payments. Although
the current levels of the deficit appear to be sustainable, a further material widening
could bring about a change in sentiment towards South Africa. Added to these concerns
are the movements in the international oil prices which have experienced a renewed
surge in recent weeks.
On balance, the current outlook for inflation remains benign and indicates that the
prevailing stance of monetary policy is appropriate. However, during the period ahead
the MPC will continue to be faced with the difficult task of fashioning monetary policy to
obviate the negative consequences to the economy which would arise should the risk
factors which have been identified materialise.
South African Reserve Bank

Monetary Policy Review May 2006