South African Reserve Bank

PRESS STATEMENT
EMBARGO DELIVERY
21 May 2015


STATEMENT OF THE MONETARY POLICY COMMITTEE

Issued by Lesetja Kganyago, Governor of the South African Reserve Bank

The challenges facing monetary policy have persisted, and, as expected, the
downward trend in inflation which was mainly attributable to the impact of lower oil
prices, has reversed. Headline inflation is expected to breach temporarily the upper
end of the target range early next year, and thereafter remains uncomfortably close
to the upper end of the target band for most of the forecast period. The upside risks
have increased, mainly due to further possible electricity price increases. The
exchange rate also continues to impart an upside risk to inflation as uncertainty
regarding impending US monetary policy continues. Domestic demand, however,
remains subdued while electricity constraints continue to weigh on output growth and
general consumer and business confidence.

The year-on-year inflation rate as measured by the consumer price index (CPI) for all
urban areas measured 4,0 per cent and 4,5 per cent in March and April respectively.
The petrol price increase of R1,56 per litre in April resulted in a decline in the rate of
disinflation from the transport category, from -5,0 per cent in March to -1,1 per cent

in April, while food price inflation moderated further. The main contributions to the
April headline rate came from the categories of food and non-alcoholic beverages,
housing and utilities, and miscellaneous goods and services, which together
accounted for 3,2 percentage points of the outcome. Core inflation, which excludes
food, petrol and electricity, moderated from 5,7 per cent in March to 5,6 per cent in
April.

Producer price inflation for final manufactured goods appears to have reached a low
point in February at 2,6 per cent, following the 3,1 per cent outcome in March, higher
than market consensus. While food price inflation moderated, the main upside
contribution came from coal and petroleum products where disinflation slowed. The
recent increase in international oil prices and higher agricultural crop prices, along
with further electricity price increases from mid-year are likely to sustain the upward
momentum.

The inflation forecast of the Bank has changed since the previous meeting of the
MPC. Inflation is now expected to average 4,9 per cent in 2015, with a first quarter
low of 4,1 per cent. A temporary breach of the upper end of the inflation target band
is still expected during the first quarter of 2016, to peak at 6,8 per cent, and to
decline to 6,0 per cent by the second quarter of that year. An average inflation rate of
6,1 per cent is forecast for the year. The forecast period has now been extended to
the end of 2017, with an average inflation rate of 5,7 per cent expected for the year,
and 5,6 per cent in the final quarter.

The forecast for core inflation has also increased marginally, to 5,6 per cent in 2015,
and to 5,4 per cent in 2016. Core inflation is expected to average 5,2 per cent in
2017, with a final quarter average of 5,1 per cent. Much of the persistence of core
inflation at these levels is attributed to high levels of wage growth, currency
depreciation and inflation expectations entrenched at the upper end of the target
range.

The headline inflation forecast assumes electricity price increases of 13,0 per cent
from July 2015 and July 2016 in line with the original multi-year price determination
process of Nersa. However, the application by Eskom for a further 12,6 per cent
increase from 1 July 2015 will be decided at the end of June. Given the uncertainty
regarding this decision, both in terms of quantum and timing of implementation, it
has not been incorporated into the forecast, but poses a significant upside risk.
Should Nersa fully accede to the Eskom request, a higher peak of headline inflation
as well as a more extended breach of the target can be expected. The direct and
indirect effects of such an increase could increase average inflation by around 0,5
percentage points over a year.

The BER inflation expectations survey for the second quarter of 2015 will only be
released in June. Median inflation expectations as reflected in the Reuters
Econometer poll, at 4,9 per cent and 5,9 per cent for 2015 and 2016, are similar to
the Bank’s forecast, although there is a fairly wide dispersion between respondents.
The break-even inflation rates, as reflected in the yield differential between
conventional bonds and inflation-linked bonds, have been more volatile, and are

above the upper end of the target range over all maturities, having reversed their
earlier declines this year.

The outlook for the global economy is broadly unchanged since the previous meeting
of the MPC. The US growth forecast for 2015 has been revised down by about half a
percentage point following the broad-based first quarter estimate of 0,2 per cent,
although this deterioration is generally believed to be temporary. Growth of around
3,0 per cent is now expected in 2015, still above estimated potential. Eurozone
growth has surprised on the upside, and while still relatively subdued at an expected
1,5 per cent for 2015, there are indications that the region is responding to the ECB
monetary stimulus. Any possible fall-out from the debt crisis in Greece remains
uncertain. Japan is expected to growth by just below one per cent this year.

Growth in some of the larger emerging markets remains weak. Negative growth is
being experienced in Brazil and Russia, and although the Chinese economy is still
slowing, with first quarter growth of around 5,3 per cent, a hard landing is not
expected amid further monetary policy easing. By contrast, the Indian economy has
been performing strongly, partly in response to policy reforms. While growth in Africa
has remained relatively robust, downside risks have emerged in some of the oil and
commodity-producing countries.

Global inflation remains benign, but the partial recovery in the international oil price
has ameliorated the deflationary risks in some of the advanced economies in
particular. Higher, but still low, inflation expectations contributed to a sharp rise in
bond yields in some of the advanced economies, with spillovers to other bond

markets. However, most central banks remain in loosening mode, with further
reductions in policy interest rates in a number of countries since the previous
meeting of the MPC. A notable exception has been Brazil, where monetary policy
was tightened for the third time this year.

Global financial markets remain focused on the timing of US monetary policy
tightening. Low inflation and the weaker first quarter growth outcome have pushed
out expectations regarding the starting date, but financial markets generally expect
the first move to be during 2015, most likely in September, followed by a gradual
data dependent tightening cycle. Continued financial market volatility is likely to
ensue with each relevant data release.

The uncertainty regarding US growth prospects contributed to a weakening of the
dollar against most currencies in recent weeks. Since the previous meeting of the
MPC the rand traded in a relatively narrow band of between R11,80 and R12,20
against the US dollar, and is currently almost unchanged since then. However, in line
with dollar weakening, the rand has depreciated by 0,6 per cent against the euro and
by 4,0 per cent against the pound sterling. On a trade-weighted basis, the rand has
depreciated by 0,3 per cent.

The rand continues to be vulnerable to the ebbs and flows of global risk perceptions
and associated capital flows, particularly in response to anticipated changes to US
monetary policy. At the same time, there is a great deal of uncertainty regarding the
extent to which US monetary policy normalisation has been priced into the rand.
However, past patterns suggest that some further pressure is likely on the exchange

rate and long bond yields as the start of the US tightening cycle becomes more
certain. Reflecting this uncertainty, non-resident bond and equity flows have been
quite volatile. According to JSE data, non-residents have been net buyers of bonds
and equities to the value of around R15 billion since the beginning of this year.

The rand therefore remains an upside risk to the inflation outlook, although the
degree of upside risk is tempered somewhat by the continued relatively low level of
pass-through to consumer price inflation. The Bank estimates that the actual passthrough could be about half of what is currently implied in the forecast model, but it is
still uncertain as to whether this reflects a permanent change or a temporary
phenomenon which can reverse rapidly.

The domestic growth outlook remains weak, amid continued electricity supply
constraints and low and declining levels of business and consumer confidence. The
Bank’s forecast for GDP growth is marginally down from the previous forecast:
growth is expected to average 2,1 per cent and 2,2 per cent in 2015 and 2016, and
to increase to 2,7 per cent in 2017. Growth for the next two years therefore is
expected to be more or less in line with our estimate of short-term potential output
growth of between 2,0 and 2,5 per cent. It also suggests that the negative output
gap, currently estimated at around 1,5 per cent, is likely to persist. This forecast
makes an assumption regarding the persistence of electricity shortages, which are
expected to be relieved somewhat only in 2017. However, the risks to growth are
assessed to be on the downside. The moderate decline in the Bank’s composite
leading business cycle indicator also suggests a continuation of the sluggish growth
outlook.

Despite a strong performance by the mining sector in March, first quarter growth is
expected to be subdued and much lower than the 4,1 per cent measured in the
fourth quarter of 2014. According to Statistics South Africa, the physical volume of
mining output increased at a quarter-to-quarter rate of 1,9 per cent in the first
quarter. Platinum group metals output was particularly strong in March with a monthon-month increase of 26,6 per cent. By contrast, manufacturing output appears to
have contracted by about 0,6 per cent in the quarter, consistent with the continued
decline in the Kagiso PMI, down to 45,4 index points in April, and the slight decline in
capacity utilisation in the manufacturing sector. The real value of building plans
passed declined for a fourth successive month in February, in line with a weaker
FNB/BER Building Confidence index in the first quarter of the year.

Consumption expenditure by households is expected to remain relatively subdued,
as higher personal tax rates take effect and the benefits of lower petrol prices
dissipate. There are mixed signals from the retail trade sales which rebounded
strongly in February but then contracted in March on a month-on-month basis. A
quarterly growth rate of 0,9 per cent was recorded in the first quarter of 2015. Growth
in expenditure on durable goods in particular is expected to decline, as reflected in
the sluggish new vehicle sales, which decreased further in April. The FNB/BER
consumer confidence index declined sharply in the first quarter of 2015, signalling
modest growth in consumption expenditure going forward.

Subdued levels of household consumption expenditure are reflected in credit
extension by banks to households, where the divergence between households and

corporates continues. Growth in credit extension to the corporate sector was 13,9
per cent in March 2015, compared with 3,6 per cent to households. The latter is
reflective of continued weak growth across all the main categories of credit,
influenced by both supply and demand factors. These trends are likely to be
reinforced further by the implementation of affordability assessment regulations as
part of revisions to the National Credit Regulations in March. The impending
changes in the Basel III regulatory requirements are also contributing to relatively
tight credit conditions. At the same time, weak employment growth, high debt levels
and continued household deleveraging, as well as expectations of higher interest
rates may have impacted on the demand for credit.

Trends in remuneration growth remain a concern to the MPC. Average wage and
salary growth has been in excess of inflation for some time, imparting some degree
of automatic indexation to wage settlements, and therefore maintaining higher levels
of inflation. In the fourth quarter of 2014, year-on-year growth in nominal
remuneration per worker in the non-agricultural formal sector increased by 7,7 per
cent. Once accounting for labour productivity growth of 1,3 per cent, unit labour costs
showed an increase of 6,3 per cent, from 5,7 per cent in the previous quarter.
According to Andrew Levy Employment publications, the average wage settlement
rate in collective bargaining agreements measured 7,9 per cent in the first quarter of
2015. The public sector wage settlement appears to have been settled at an
increase of 7 per cent, but the full impact on the total government wage bill is still
unclear. Upside risks to inflation from wage pressures are still expected, with the
unresolved settlements in the coal and gold mining sectors of particular concern.

While high wage settlements could underpin household consumption expenditure,
this could be offset in part by inevitable reductions in employment.

Food price inflation is expected to contribute to upside inflation pressures. This is
despite the continued moderation of global food prices and a recent declining trend
of food price inflation at the CPI level and lower meat price inflation at the producer
price level. Food price inflation measured 5,0 per cent in April following eight
successive months of moderation. Similarly, final manufactured food producer price
inflation moderated to 5,8 per cent in March. However, domestic drought conditions
have resulted in a need to import yellow maize, contributing to maize prices rising
close to import parity levels. These pressures, along with the weaker exchange rate,
are expected to reverse the favourable trend in food price inflation by the second half
of this year.

The international oil price appears to have stabilised in the US$60-US$70 per barrel
range, as capital expenditure plans have been scaled back following the collapse of
prices in the later part of last year. Since the previous meeting of the MPC, Brent
crude oil prices have increased by about US$10 per barrel. Domestic petrol prices
remained unchanged in May, but a further increase of around 50 cents per litre,
should current trends persist, is likely in June, attributable mainly to higher
international product prices.

Although the upward revision of the inflation forecast was relatively small, the
persistence of medium term inflation at elevated levels and the deteriorating risks to
the outlook are an increasing concern to the MPC. While currently the breach is
expected to be temporary, the longer term trajectory is close to the upper end of the
target range, and the upside risks make this trajectory vulnerable to any significant
changes in inflation pressures.
The main risks to the outlook remain electricity tariff increases, the exchange rate
and wage settlements. Significant additional electricity tariff increases are likely to
cause inflation to diverge significantly from the target range for a more extended
period than our baseline forecast suggests. The rand remains vulnerable to global
market reaction to US policy normalisation, particularly in the context of South
Africa’s twin deficits. Any significant weakening of the exchange rate in reaction to
US monetary policy tightening could cause inflation to diverge even further from
target, and set in motion an exchange rate-inflation spiral. Furthermore, the
possibility of a wage-price spiral, should settlements well in excess of inflation
become an economy-wide norm, also poses a risk to the outlook.

The MPC recognises that domestic inflation is not driven by demand factors that are
more easily dealt with through monetary policy responses. Household consumption
expenditure remains relatively subdued. While monetary policy should generally look
through supply side shocks, such as large electricity tariff increases and oil price
changes, we have to be mindful of the second-round effects of such shocks. In
particular, we need to monitor closely the possible impact on inflation expectations

which remain uncomfortably close to the upper end of the target range over the
longer term.
Growth remains fragile, constrained by electricity shortages and low business
confidence and the risk to the outlook remain on the downside. But this cannot be
solved by monetary policy alone. Monetary policy action will need to achieve a fine
balance between achieving our primary mandate of price stability and not
undermining growth unduly.
The MPC has decided to keep the repurchase rate unchanged at this meeting. Four
members of the committee favoured an unchanged stance while two favoured a 25
basis point increase. The deteriorating inflation outlook suggests that this unchanged
stance cannot be maintained indefinitely. The MPC will continue to closely monitor
the evolution of inflation expectations and other factors that could undermine the
longer term inflation outlook and stands ready to act when appropriate.
From the next meeting in July the Bank will take further steps to increase
transparency by publishing the assumptions underlying the Bank’s forecast with the
MPC statement.


Lesetja Kganyago

GOVERNOR

Contact person:
Nosipho Theyise
+27 12 313 3465