Monetary Policy
Review


November 2007
Monetary Policy
Review


November 2007
South African Reserve Bank
Monetary Policy Review November 2007
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Monetary Policy Review November 2007
Contents
Monetary Policy Review


South African Reserve Bank

Monetary Policy Review November 2007
Monetary Policy Review
Introduction
Inflation breached the upper end of the inflation target range of 3 to 6 per cent for the first
time since August 2003 when a year-on-year increase of 6,3 per cent was recorded in
April 2007. The pressures which were primarily responsible for the breach in the inflation
target range were largely exogenous, emanating from oil and food price shocks, and have
posed a challenge to many central banks around the world. However, given the potential
impact on inflation expectations, more generalised price-setting behaviour and monetary
policy credibility, the breach of the inflation target is of significant concern to the Monetary
Policy Committee (MPC) of the South African Reserve Bank. The most important
challenge for monetary policy-makers is to ensure that inflation is brought back to within
the target range and that inflation expectations remain anchored within the range.
The deterioration in the perceived medium to long-term risks to the inflation outlook have
been noted by the MPC since its June 2006 meeting, when it began raising the
repurchase (repo) rate in response to these risks. In the period since the previous
Monetary Policy Review was published in May 2007, some of the key inflation risks have
proved persistent, and there has been significant volatility and uncertainty in the
international environment. However, there are some signs that the economy is responding
to the changes which have been made to the monetary policy stance. As inflation reacts
with a lag to these changes, the task of the MPC is to assess whether the observed
inflation response at a particular point in time is consistent with the desired return to within
the target range in future.
This Monetary Policy Review provides an analysis of recent price developments, the
factors that affect inflation and the outlook for inflation. In addition, three focus topics are
presented in boxes. The first box sets out the key points contained in a recent discussion
document published by Statistics South Africa on proposed changes to the South African
consumer price index. The second considers the implications for monetary policy of the
turmoil in financial markets that has arisen from spill-over effects of the subprime lending
crisis in the United States (US), and the third box provides an international perspective on
the impact of biofuels production on food prices.
Recent developments in inflation
This section analyses recent trends in the main inflation indices, and reviews
developments in the main determinants of inflation in the South African economy.
The evolution of indicators of inflation
The Bank’s targeted measure of inflation, the year-on-year increase in the consumer
price index excluding mortgage interest cost for metropolitan and other urban areas
(CPIX), breached the upper limit of the 3 to 6-per-cent inflation target range in April 2007
(Figure 1). After having measured 5,5 per cent in March 2007, the CPIX inflation rate was
6,3 per cent in April. It then increased to 6,5 per cent in July before slowing to 6,3 per
cent in August and then rose further to 6,7 per cent in September. The impact of
developments in food prices on the CPIX inflation rate has been particularly important in
recent months.

Inflation measured in terms of the headline consumer price index for metropolitan areas
(CPI) increased from 6,1 per cent in March 2007 to 7,0 per cent in April, declined
marginally to 6,9 per cent in May, and returned to 7,0 per cent for both June and July.
In August, CPI inflation slowed to 6,7 per cent, before increasing to 7,2 per cent in
September 2007. Proposed changes to the South African consumer price indices
contained in a recent discussion document published by Statistics South Africa are
discussed in Box 1 on .
Food prices, which have a weight of 25,7 per cent in the CPIX index, continued to
increase strongly in the period under review. Food inflation increased from a rate of
7,8 per cent in March to 12,0 per cent in September 2007, the highest rate of increase
since March 2003. Figure 2 shows that the prices of grain products, vegetables as well
Monetary Policy Review November 2007
South African Reserve Bank
Percentage change over twelve months

CPI
CPIX
Figure 1
Consumer price inflation: CPIX and CPI
Source: Statistics South Africa
Percentage change over twelve months
-10
-5

All food items

Meat

Source: Statistics South Africa

Vegetables

Grain products


CPIX

Milk, milk products and eggs
Figure 2
CPIX and food inflation
as milk, milk products and eggs have all risen strongly in recent months. The inflation
rate for milk, milk products and eggs increased from 4,6 per cent in March 2007 to
19,5 per cent in September. Grain and vegetable prices also recorded notable rates of
increase from March to September 2007, accelerating from 9,6 to 17,0 per cent and
from 4,1 to 21,5 per cent, respectively. Over the same period the rate of increase in meat
prices declined from 11,7 to 7,5 per cent.
In recent months the spot prices of maize moved closer to import parity prices. Due to
domestic drought conditions, the final estimated size of the maize harvest was 11,0 per
cent lower than initially estimated. Yellow maize prices declined from R1 810 per ton on
30 March 2007 to R1 592 per ton on 23 April. After increasing to R1 975 per ton on
24 September, yellow maize traded at R1 945 per ton on 25 October. The price of white
maize moved in a similar fashion, declining from R1 846 per ton on 30 March to
R1 548 per ton on 23 April, then increasing to R1 924 per ton on 24 September before
declining to R1 863 per ton on 25 October.
Table 1 reports the weighted contributions of the main components of the CPIX to the
overall year-on-year inflation rate. As the table shows, developments in the food
component continued to contribute significantly in this regard, with its contribution
increasing from 2,1 percentage points when the overall inflation rate was 5,5 per cent
in March 2007 to 3,2 percentage points when the overall rate was 6,7 per cent in
September. The transport component, which reflects the impact of petrol price
changes, contributed 1,1 percentage points in both April and May 2007, before
declining to 0,2 percentage points in August. In September, the contribution of
transport increased to 0,4 percentage points mainly as a result of year-on-year growth
being measured from a lower base. The contribution of the housing component
increased from 0,7 percentage points between April and June 2007 to 0,9 percentage
points in July and recorded 0,8 percentage points in both August and September. The
contributions of the other components to CPIX inflation remained relatively stable, with
household operations and education contributing 0,4 percentage points and fuel and
power 0,3 percentage points to CPIX inflation in September.
Table 1
Contributions to CPIX inflation
Percentage change over twelve months* and percentage points

Mar
Apr
May
Jun
Jul
Aug
Sep

Of which:

Medical care and health expenses ....

Source: Statistics South Africa
The effect of excluding food and energy prices from the year-on-year CPIX inflation
measure is shown in Figure 3. As Table 1 suggests, excluding food from the CPIX has a
significant impact. The inflation rate for the CPIX excluding food increased from 4,5 per
South African Reserve Bank

Monetary Policy Review November 2007

cent in March 2007 to 5,5 per cent in April, declined to 4,5 per cent in August and rose
to 4,8 per cent in September. Energy prices, after providing some upward pressure
between April and June 2007, had a slight moderating effect on CPIX inflation in August
and September. The inflation rate for the CPIX excluding energy prices increased from
5,4 per cent in March 2007 to 6,1 per cent in June, before increasing further to 6,9 per
cent in September. The inflation rate for the CPIX excluding both food and energy prices
trended upward in the period under review, increasing from 4,4 per cent in March 2007
to 4,9 per cent in September.
The inflation rates for the goods and services categories of the CPIX are presented in
Figure 4. Goods prices have continued to increase at a faster pace than those of
services in the period under review. The inflation rate for goods increased from 5,6 per
cent in March 2007 to 6,7 per cent in April and May, and 6,8 per cent in June and
July. In August 2007 the inflation rate for the goods category receded slightly to
6,6 per cent, before increasing to 7,2 per cent in September. The acceleration in the
year-on-year rate of increase in food prices from 7,8 per cent to 12,0 per cent
between March and September 2007 contributed to the movement in total goods
inflation. Services inflation increased from 5,3 per cent in March to 5,8 per cent in
both August and September 2007, with notable contributions from the housing
services and communication services components.
The year-on-year inflation rate for the administered price index (API) increased from
6,3 per cent in March 2007 to 8,3 per cent in April, then declined to 5,0 per cent in
August before moving higher to 5,8 per cent in September (Figure 5). However,
excluding petrol prices, the API inflation rate decreased from 5,8 per cent in March
to 5,5 per cent in May, rose to 7,4 per cent in August and then declined to 7,0 per
cent in September.
Monetary Policy Review November 2007
South African Reserve Bank
Percentage change over twelve months

CPIX

CPIX excluding energy prices

CPIX excluding food prices

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

Figure 3
The effect of food and energy prices on CPIX inflation

Table 2 on the following page shows that petrol prices contributed 3,9 percentage points
to the April 2007 API inflation rate of 8,3 per cent. The contribution of the petrol
component then declined to 1,5 percentage points in July, before contracting sharply
and subtracting 0,1 percentage points from the API inflation rate in August. In
September, the contribution of petrol prices rose once more to 0,8 percentage points.
By contrast, the contribution of the electricity component increased from 1,1 percentage
points between March and June 2007 to 1,5 percentage points in July and August,
before declining to 1,3 percentage points in September.
South African Reserve Bank

Monetary Policy Review November 2007
Percentage change over twelve months

Goods
Services
CPIX

Figure 4
CPIX: Goods and services inflation
Source: Statistics South Africa
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

Table 2
Contributions to administered price inflation
Percentage change over twelve months* and percentage points

Mar
Apr
May
Jun
Jul
Aug
Sep

Of which:

Source: Statistics South Africa
Figure 6 shows that inflation measured in terms of the year-on-year change in the
production price index (PPI) has receded slightly in recent months. The overall PPI
inflation rate increased from 10,3 per cent in March 2007 to 11,3 per cent in May, before
slowing to 9,4 per cent in both August and September. The inflation rate for the domestic
component of the PPI rose from 10,5 per cent in March to 11,2 per cent in April, then
declined to 9,3 per cent in August before rising once more to 9,7 per cent in September.
Movements in domestic mining and manufacturing prices played an important role in this
regard. Domestic mining prices increased from 19,3 per cent to 21,9 per cent between
March and April and then slowed to 3,6 per cent in September. Manufacturing prices
increased from 8,8 per cent in March to 9,7 per cent in May, receded to 8,0 per cent in
August and then increased to 8,2 per cent in September. The inflation rate for the
imported component of the PPI rose from 9,9 per cent in March to 11,7 per cent in May,
then declined to 9,2 per cent in July before rising once more to 9,7 per cent in August.
In September this rate declined to 8,5 per cent.
Monetary Policy Review November 2007
South African Reserve Bank
Percentage change over twelve months

Production price index (PPI)

Imported component of PPI

Domestically produced component of PPI
Source: Statistics South Africa
Figure 6
Production price inflation
-10
-5

The weighted contribution of the domestic component to PPI inflation increased from
7,9 percentage points in March to 8,4 percentage points in April and May 2007, declined
to 7,0 percentage points in August and then increased to 7,2 percentage points in
September. The imported component’s contribution increased from 2,4 percentage
points in March to 2,9 percentage points in May, before contracting to 2,2 percentage
points in September.
Food prices continued to place upward pressure on the PPI inflation rate. Between
March and September 2007, inflation for domestic agricultural food prices in the PPI
increased from 19,2 to 23,2 per cent, while the inflation rate for imported agricultural
food increased from 19,8 to 43,6 per cent. Manufacturing food price inflation also
increased over the period, although to a lesser extent. Excluding the food component
from the PPI, the inflation rate for the remaining items declined from 9,2 per cent in
March to 6,6 per cent in September.
South African Reserve Bank

Monetary Policy Review November 2007
Box 1 Statistics South Africa’s proposed new consumer price index basket
As part of the ongoing review and improvement of official statistics in South Africa, Statistics South
Africa (Stats SA) published a discussion document titled “Unpacking the CPI basket: A proposed
new selection methodology and basket for the South African CPI” on 12 September 2007. The
discussion document details the rationale and composition of the proposed new consumer price
index (CPI) basket. Specifically, the discussion document provides interested parties with a list of
products and services that are proposed to comprise the CPI as from January 2009 and solicits
comments thereon. The purpose of this box is to communicate key information contained in the
discussion document.
According to the discussion document, the composition of the proposed new CPI basket is, in part,
informed by changes in the collection and calculation methodologies. Most notably, the use of
fieldworkers since 2006 to collect prices enables a broader range of items to be covered.
Consequently, items such as minibus taxi fares; funeral and funeral insurance costs; restaurant, takeaway and hotel prices; internet service provider fees; and laptop prices will be included for the first
time. Technological changes also impact on the selection of the items for the basket, e.g. VHS and
audio cassettes and players fall out of the basket and are replaced by DVD and CD disks and players.
Given this broader range of products, the document proposes that the inclusion of products into the
basket should meet at least two criteria, namely the estimated total expenditure on a product as well
as the percentage of households purchasing the product. These are sometimes termed plutocratic
and democratic criteria, respectively. All those goods and services for which expenditure exceeds a
certain percentage1 of the total amount spent by the average household are candidates for inclusion
in the basket, provided the proportion of households purchasing it exceeds a certain percentage. The
combination of these two criteria prevents entry into the basket of items that account for large outlays,
but are bought by relatively few households. Air travel tickets, which are purchased by slightly more
than 1 per cent of households, are a case in point. The proposed approach also prevents entry into
the basket of items that might be bought by many households, but the cost of which is insignificant,
e.g. matches. Furthermore, the new basket takes into account variation in expenditure patterns
among provinces which is not adequately dealt with in the current CPI. In line with the guidelines from
the International Labour Organization (ILO), a basket has been selected for each province so that the
national basket contains all the items that entered any one of the provincial baskets. It is also
proposed that the interest cost of mortgage bonds no longer be part of the CPI basket but that an
imputed rent variable be included.
The proposed changes overall will result in the total number of products in the national CPI basket
dropping from the current 1 124 to 386 (excluding health items, which will be added later). A total of
389 products disappear because of methodological changes, while 349 have been eliminated from
the basket because they do not meet the inclusion criteria (Stats SA, 2007b). The total of 386 is well
within the range of products appearing in the CPIs of other countries around the world. Although this
number is significantly lower than the number of indicator products in the current basket, the rigorous
selection criteria ensure that each product is represented sufficiently by indicator products. The
collection of prices for those products which are not part of the current basket will start in January
2008. The CPI will continue to be published on the basis of the current basket and weights until the
December 2008 release (in January 2009). The January 2009 CPI (published in February 2009) will
be the first to be published on the basis of the new basket and weights (Stats SA, 2007a).

Stats SA is not yet in a
position to determine the
precise proportions of
expenditure to be allocated to
each of the products chosen
to represent consumer
expenditure patterns. This step
will occur after the results of the
2005/6 IES are published (Stats
SA, 2007b).

Factors affecting inflation
Recent developments in some of the main drivers of inflation in South Africa, including
domestic and international factors, are reviewed in this section. The outlook for these
variables, and therefore for inflation, is discussed in a later section.
International economic developments
The global economic expansion continues apace and is increasingly being driven by
rapid economic expansion in emerging markets. The most recent International Monetary
Fund (IMF) data show that growth in real gross domestic product (GDP) was 5,4 per
cent in 2006 and remains robust at an estimated 5,2 per cent in 2007 despite the recent
turmoil in global financial markets (Table 3). The IMF forecasts that the pace of world
inflation will increase to 3,9 per cent in 2007 from 3,6 per cent in 2006.
Table 3
Annual percentage change in real gross domestic product and
consumer prices
Real GDP
Inflation*

(estimate)
(estimate)

Other emerging-market and developing countries

Inflation data exclude Zimbabwe
Source: IMF World Economic Outlook, October 2007
Monetary Policy Review November 2007
South African Reserve Bank
According to the discussion document, the newly weighted CPI will continue to sample prices at
the current rate (100 000 prices per month) and the change in the basket, together with the change
of weights, is unlikely to change the behaviour of the overall indices (Stats SA, 2007b).
References
Statistics South Africa. 2007a. Proposed new CPI basket. Information note, September. Available
online: Accessed on 8 October 2007.
Statistics South Africa. 2007b. Unpacking the CPI basket: A proposed new selection methodology
and basket for the South African CPI. Discussion document.
Available online:
Accessed on 8 October 2007.
Growth in the US regained momentum in the second quarter of 2007, although it is
expected to slow somewhat in the second half of the year to record 1,9 per cent in 2007
compared with 2,9 per cent in 2006. Inflation in the US is projected to decline to 2,7 per
cent this year from 3,2 per cent in 2006.
Japan’s economy continues to expand moderately and the IMF forecasts real GDP growth
of 2,0 per cent this year compared with the 2,2 per cent recorded in 2006. Real GDP
growth in the euro area is forecast to moderate slightly to 2,5 per cent in 2007 from the
2,8 per cent recorded in 2006. Record employment growth and continued expansion in
the services sector have fuelled the longest stretch of continuous economic growth in more
than a century in the United Kingdom (UK), with growth accelerating slightly from 2,8 per
cent in 2006 to a forecast 3,1 per cent in 2007.
In Africa, real GDP growth is expected to increase slightly to 5,7 per cent in 2007 from
the 5,6 per cent recorded in 2006. Sub-Saharan Africa is experiencing robust
economic expansion and regional growth is expected to reach 6,1 per cent this year
(the fourth successive year of growth above 5 per cent). In 2006, growth in oilexporting countries in the region moderated due to supply disruptions and temporary
setbacks in the expansion of oil production. However, non-oil exporting economies
within the region grew strongly in 2006 against the backdrop of favourable export
prices. Stronger domestic policy frameworks improved economic performance and
lifted fixed capital formation outlays in the region.
Developing Asia remains the fastest growing region in the world and growth prospects
remain very favourable. The IMF forecasts that China will grow by 11,5 per cent in 2007
(its fifth successive year of double-digit growth) and India is expected to record 8,9 per
cent growth in 2007, compared with 9,7 per cent in 2006. Economic growth improved
somewhat in the Latin-American economies in 2006 when these economies expanded
at a rate of 5,5 per cent and continues to be robust in 2007 with growth estimated at
5,0 per cent. Middle Eastern economies are estimated to be expanding by 5,9 per cent
this year compared with growth of 5,6 per cent in 2006.
Oil prices
Crude oil prices rose sharply in the first seven months of 2007 amid strong global oil
demand, mounting geopolitical concerns, supply constraints and limited spare
capacity. Figure 7 shows Brent crude oil prices rebounded from levels of around
US$51 per barrel in mid-January 2007 to new record-high levels approaching
US$80 per barrel in July. Upward pressure on oil prices throughout this period
stemmed from tight US fuel supplies, supply disruptions in Nigeria, supply restrictions
by the Organization of the Petroleum Exporting Countries (OPEC), US refinery
interruptions and geopolitical tensions in Nigeria and the Middle East. Oil prices
subsequently started to decline as Middle East geopolitical tensions eased and
adequate levels of US crude and fuel stocks soothed supply concerns.
After declining in late August, the oil price increased further amid a series of
US refinery interruptions, hurricane-related concerns and large declines in US crude
inventories. The price of Brent crude oil subsequently increased to an all-time high
level of around US$88 per barrel in late-October, notwithstanding OPEC having
decided to increase crude oil supply by 500 000 barrels per day with effect from
South African Reserve Bank

Monetary Policy Review November 2007

1 November 2007. OPEC further noted a need to keep the market adequately
supplied during peak winter demand and will reassess the market situation at its
next meeting on 5 December 2007.
Central bank interest rate developments
Central banks remained concerned about inflationary pressures stemming from high
levels of growth as economies increasingly operated near or beyond potential with
associated robust domestic demand, high resource utilisation rates and low
unemployment ratios. Monetary policy has been tightened in various countries since April
2007 including Australia, Canada, the Czech Republic, Korea, and Poland (Table 4).
Some emerging-market countries including Brazil, Hungary, Russia and Thailand lowered
their policy rates. Furthermore, central banks in certain industrialised countries intervened
to provide liquidity subsequent to the turmoil that erupted in global financial markets in
August 2007. The monetary policy implications of increased uncertainty in global credit
markets are discussed in Box 2 on .
In the US, the Federal Open Market Committee cut the discount rate by 50 basis points
in mid-August to supplement liquidity. After remaining unchanged since June 2006, the
target for the federal funds rate was reduced by 50 basis points to 4,75 per cent in
September 2007 to further neutralise tight credit conditions. The European Central Bank
(ECB) raised its main interest rate by a quarter percentage point to 4,00 per cent in June
2007 citing upside risks to price stability in the medium term, but then kept it on hold as
credit conditions tightened. The Bank of England raised the repo rate by a further
25 basis points to 5,75 per cent in July and has kept it unchanged since then. Both the
ECB and the Bank of England intervened to provide liquidity due to tight credit
conditions in September 2007.
Monetary Policy Review November 2007
South African Reserve Bank
Figure 7
Price of Brent crude oil

J M M J S N J M M J S N J M M J S N J M M J S N J M M J S N
US dollar per barrel

Brent crude spot price

Futures prices (11 October 2007)

Futures prices (26 October 2007)
Source: Bloomberg

Table 4
Selected central bank interest rates
Per cent
Countries
1 Jan 2007
26 Oct 2007
Latest change
(percentage points)
5,25
4,75
18 Sep 2007
(-0,50)
0,25
0,50
21 Feb 2007
(+0,25)
3,50
4,00
13 Jun 2007
(+0,25)
5,00
5,75
5 Jul 2007
(+0,25)
4,25
4,50
10 Jul 2007
(+0,25)
3,50
4,00
7 Jun 2007
(+0,25)
3,00
3,75
7 Sep 2007
(+0,25)
1,50 – 2,50
2,25 – 3,25
13 Sep 2007
(+0,25)
6,25
6,50
8 Aug 2007
(+0,25)
7,25
8,25
26 Jul 2007
(+0,25)
4,50
4,00
30 Aug 2007
(+0,25)
6,12
7,29
15 Sep 2007
(+0,27)
6,75
6,25
19 Sep 2007
(-0,50)
9,75
8,25
5 Jul 2007
(-0,25)
3,50
3,50
26 Apr 2006
(+0,25)
4,50
5,00
9 Aug 2007
(+0,25)
2,75
3,25
21 Sep 2007
(+0,125)
5,00
3,25
18 Jul 2007
(-0,25)
7,25
7,75
30 Mar 2007
(+0,25)
13,25
11,25
6 Sep 2007
(-0,25)
5,25
5,75
13 Sep 2007
(+0,25)
7,00
7,50
26 Oct 2007
(+0,25)
2,50
3,25
31 Aug 2007
(+0,25)
8,00
7,50
24 Sep 2007
(-0,25)
4,00
4,75
29 Aug 2007
(+0,25)
11,00
10,00
19 Jun 2007
(-0,50)
17,50
16,75
16 Oct 2007
(-0,50)
Source: National central banks
Inflationary prospects in several countries also continued to be adversely influenced by
higher food and fuel prices and wage pressures. The People’s Bank of China raised the
one-year working capital rate to 7,29 per cent in September, and the Bank of Israel
raised its main interest rate in August due to inflationary pressures. The Swedish
Riksbank also tightened monetary policy due to strong growth and rising cost pressures,
and the Swiss National Bank raised the target for the three-month Libor as the monetary
environment tightened and the inflation outlook deteriorated.
Monetary policy was also tightened in Chile, Mexico, the Czech Republic, Poland and
Taiwan. Chile raised its rate in response to second-round inflationary effects stemming
from food price increases, while Mexico raised rates in response to a slower-thanexpected deceleration in inflation. The Bank of Poland increased its rate due to a
significantly higher inflation forecast based on economic growth above potential, wage
pressure and deterioration in the fiscal balance. The Czech National Bank and the Bank
of Taiwan raised their policy rates due to rising inflationary pressures.
Monetary policy was relaxed in Brazil, Russia and Turkey. Brazil cut its Selic rate by
25 basis points to an all-time low of 11,25 per cent in September 2007. Having reduced
rates at each of its previous eighteen meetings the Selic rate was held constant at the
October meeting. The Central Bank of the Russian Federation lowered its refinancing
rate by 50 basis points to 10,0 per cent in June, and the Central Bank of Turkey started
easing monetary policy and lowered its rate in September as inflation is expected to
decelerate further.
South African Reserve Bank

Monetary Policy Review November 2007

Monetary Policy Review November 2007
South African Reserve Bank
Box 2 The subprime lending crisis in the United States and implications for
monetary policy
The international economy has been characterised by weeks of turmoil in financial markets that has
largely arisen from spill-over effects of the subprime lending crisis in the United States (US). This
box looks at the implications for monetary policy.
Subprime lending is the practice of making loans to borrowers who do not qualify for the best
market interest rates because of their deficient credit history. A subprime mortgage is a residential
loan that does not conform to the criteria for “prime” mortgages, and therefore has a lower expected
probability of full repayment. This assessment is based on the borrower’s credit record, debt
service-to-income ratio and at times the mortgage loan-to-value ratio. The subprime mortgage is
offered at a higher interest rate due to the increased risk for lenders and the term “subprime”
therefore refers to the credit status of the borrower and not the interest rate on the loan itself.
Subprime lending is risky for both lenders and borrowers due to the combination of high interest
rates, poor credit history and adverse financial situations usually associated with subprime
applicants. Subprime lending has become increasingly controversial to the extent that its opponents
have alleged that most subprime lending is the result of predatory lending practices that inevitably
lead to default, seizure of collateral, and foreclosure. However, proponents of subprime lending
maintain that the practice extends financial services to people who would otherwise not have access
to them.
Several legal amendments in the US and other countries during the 1980s and 1990s encouraged
the growth of the subprime market and resulted in significant financial innovation. Although these
developments extended financial services to lower income groups, they also resulted in a systemic
deterioration in credit quality in these countries largely as a result of some of the innovation that
enabled banks to sell their loans. Various new financial instruments enabled loans to be packaged
into complex products designed to satisfy investors’ demand for income when yields on most
alternative financial instruments were much lower. When loans can be rapidly ejected from bank
balance sheets, bankers have less incentive to worry about the creditworthiness of borrowers.
Questionable practices also occurred in the subprime mortgage lending market, such as selling
adjustable rate mortgages with temptingly low rates initially without adequately explaining the
implications when the full interest rates kick in. As thousands of borrowers began defaulting,
several major American subprime lenders filed for bankruptcy. The collapse of the subprime
mortgage market in the US boosted market interest rates and prompted lenders to hold back on
loans to all but the safest borrowers. The problem extended beyond the subprime mortgage sector
in the US and elsewhere as credit conditions tightened across the board and parts of the credit
markets in various countries ceased to function effectively. This financial contagion has led to a
restriction on the availability of credit in world financial markets.
Central bankers have increasingly warned that the markets are under-pricing risk. However, at the
onset of the financial crisis in August, the main central banks' first responses varied – the European
Central Bank (ECB), at one extreme, was the first to augment money-market liquidity and the Bank
of England, at the other, refrained from adopting any unusual measures. It was also important to
determine whether this particular crisis was one of liquidity or solvency because the respective
diagnoses call for different policy remedies – liquidity constraints can be addressed with monetary
policy while an enduring credit problem would require a fiscal solution as well. The different policy
responses by central banks in part reflected the specific nature of the first financial pressures to
break the surface in each country. The initial problems surfaced in July 2007 when two hedge funds
run by Bear Stearns, a Wall Street investment bank, incurred significant losses in subprime
mortgages. This raised the question of whether billions of dollars worth of other mortgages around
the system in other highly leveraged funds were similarly mispriced. Investors suddenly realised that
if ratings agencies had done a poor job of rating subprime debt, the market could not be certain
that the same mistakes were not being made with all the other innovative products.
In the first weeks of August 2007 confidence ebbed and the risk appetite diminished across the
credit markets to the point where central bank intervention was required to address a seizure in
short-term money markets whereby banks became reluctant to lend to each other overnight. An
unprecedented de-leveraging process in the financial system gained momentum as many of the
newer financial products were not required to be marked to their market value in a timely way. The
Exchange rate developments
The nominal effective exchange rate of the rand (NEER), which measures the foreign
exchange rate against a basket of thirteen currencies, changed little between May and
early October 2007 (Figure 8). After depreciating to 74,5 index points in mid-August in
the wake of the turbulence in international financial markets, the NEER recovered to
average 78,4 index points in the week preceding the October MPC meeting. By late
October the NEER had appreciated to around 82 index points.
South African Reserve Bank

Monetary Policy Review November 2007
new volatility in markets also caused self-feeding value destruction as widely used, but sometimes
flawed, risk-management models caused forced selling as everyone sought to reduce risk
exposure simultaneously. This is important for the real economy in the sense that if an economy is
robust but unsoundly financed, it will not remain robust for long.
After liquidity constraint announcements by certain banks in France, Germany and the United
Kingdom during the remainder of August, a desperate attempt by various financial institutions in
these countries followed to obtain sufficient funding in the interbank market and disparate attempts
to defend interest rates in various money markets. As uncertainty about risk emerged, confidence
and liquidity drained away. As more evidence arose of a more serious credit crunch where the
problems of over-stretched home owners, mortgage lenders, house builders and highly leveraged
financial institutions raised concerns about solvency, the differences between the central banks
began narrowing and a more common diagnosis of developments and the most appropriate
response began emerging. It had become abundantly clear that significant damage was done to
consumer and business confidence and to the robustness of expenditure and that output gaps
may also be impacted by less robust expenditure. After a meeting of the Bank for International
Settlements (BIS) in September, central bankers stressed the importance of resolving the current
financial crisis without more serious dislocation of capital markets, possible large-scale bank
losses, and widening potential damage to the real economy.
Emerging markets have not experienced the same level of disruption as the developed economies
from the recent financial market turbulence. According to the IMF’s latest Global Financial Stability
Report, emerging markets are characterised by risks that are balanced between slightly lower
sovereign risks because of their generally good economic fundamentals, and increasing risks in
some emerging-market economies that are experiencing rapid credit growth and an increasing
reliance on flows from international capital markets. However, authorities in some emerging
markets have been advised to strengthen surveillance to ensure vulnerabilities do not build to more
systemic levels, even though key indicators suggest that banking systems in emerging markets are
currently profitable and well capitalised.
Ideally, even in times of financial turbulence, decisions on interest rates by monetary authorities are
based on a forward-looking economic forecast and a balance of risks around that forecast. Sharp
swings in financial market prices and volumes that change the financial conditions for the real
economy can affect both the central forecast and, perhaps to a greater extent, the risks around the
forecast. This, in turn, could lead to a change in policy stance and amounts to a middle way on the
important question of moral hazard, i.e. no policy rate cuts simply to bail out distressed investors,
but no undue risks with the economy to prove the point. These risks accentuate the importance of
maintaining a stable and transparent monetary policy regime.
References
Callan, E and Krishna, G. 2007. “Bankers try to piece together subprime puzzle”. Financial Times,
30 August.
International Monetary Fund. 2007. “Financial Market Turbulence: Causes, Consequences, and
Policies”. Global Financial Stability Report. September.
Kiff, J and Mills, P. 2007. “Money for Nothing and Checks for Free: Recent Developments in U.S.
Subprime Mortgage Markets”. IMF Working Paper (WP/07/188).

The bilateral exchange rates of the rand against the US dollar and the euro in Figure 8
partly reflect the weakness of the US dollar against a number of major currencies
including the euro in recent months, as well as capital inflows, strong commodity prices
and the favourable outlook for the South African economy. The recent offer by the
Industrial and Commercial Bank of China for a 20 per cent stake in Standard Bank is
also important in this regard. The rand strengthened from R7,48 against the US dollar
on 17 August to R6,51 per US dollar on 26 October. Over the same period, the currency
strengthened from R10,05 to R9,32 against the euro.
Labour markets
Despite wage trends reflecting the upward drift in inflation expectations, developments
in the labour markets remain broadly consistent with the inflation target (Figure 9).
Wage inflation as measured by the year-on-year growth in nominal remuneration per
worker in the formal non-agricultural sector declined from 8,6 per cent in the fourth
quarter of 2006 to 4,9 per cent in the first quarter of 2007 before increasing to 7,5 per
cent in the second quarter. Over the same quarters, the year-on-year growth in labour
productivity (the ratio of real value added to employment in the formal non-agricultural
sector) slowed from 3,2 per cent to 2,3 per cent and further to 1,9 per cent.
Consequently, economy-wide unit labour cost inflation (i.e. wage inflation adjusted for
productivity changes in the formal non-agricultural sector) declined from 5,3 per cent
in the final quarter of 2006 to 2,5 per cent in the first quarter of 2007 before rising to
5,5 per cent in the second quarter.
Monetary Policy Review November 2007
South African Reserve Bank
Index: 2000=100 (foreign currency per rand)
Rand per euro
Rand per US dollar
Figure 8
Exchange rates of the rand

Mar
May
Jul
Sep
Nov
Jan

Nominal effective exchange rate of the rand (NEER)

Rand per US dollar

Rand per euro (right-hand scale)


Mar
May
Jul
Sep
Nov
Jan
The results of the wage settlements survey published by Andrew Levy Employment
Publications in September 2007 are reproduced in Figure 10. According to the survey,
the average level of wage settlements was 7,2 per cent for the nine months ending
30 September 2007 compared to 6,4 per cent in the same period in 2006, and the
annual average of 6,5 per cent for 2006 as a whole.
South African Reserve Bank

Monetary Policy Review November 2007
Percentage change over four quarters

Figure 9
Remuneration per worker, labour productivity and

unit labour cost in the formal non-agricultural sector

Nominal unit labour cost

Remuneration per worker

Labour productivity


Sources: Statistics South Africa and SARB calculations

Per cent
Figure 10 Average annual inflation and wage settlements

CPI


Data for 2007 are for the nine months ending 30 September 2007
Sources: Andrew Levy Employment Publications and Statistics South Africa

Average wage settlements
CPIX

Demand and output
South Africa’s economic upswing continued in the first half of 2007 (Table 5). The real
output growth rate of 4,5 per cent in the second quarter of 2007, which was marginally
lower than the 4,7 per cent recorded in the first quarter, is in line with the Bank’s estimates
of potential output growth. Both sustained global economic growth and a favourable
domestic environment have continued to underpin robust activity in the economy.
Table 5
Growth in real gross domestic product and expenditure components
Per cent*

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

Quarterly data refer to quarter-on-quarter growth at annual rates of seasonally adjusted data
**
Constant 2000 prices
Real output growth in the second quarter of 2007 reflected the improved performance
of the primary and tertiary sectors which grew at rates of 2,6 per cent and 5,5 per cent,
respectively. In the primary sector, a growth rate of 10,5 per cent was recorded in the
agricultural sector while the real value added by the mining sector was essentially
unchanged from the level achieved in the first quarter of 2007. The tertiary sector’s faster
growth performance in the second quarter was mainly due to increased activity in the
finance, insurance, real-estate and business services sector as well as the transport,
storage and communication sector. The performance of these sectors more than
neutralised a moderation in the growth in real value added by the trade sector. Real
output growth in the secondary sector slowed to a rate of 2,7 per cent in the second
quarter of 2007 as growth in the manufacturing sector, in particular, slowed to just 0,5 per
cent. Growth in the real value added by both the construction sector and the sector that
supplies electricity, gas and water also moderated slightly in the second quarter.
Table 5 shows that growth in domestic expenditure slowed significantly. Real gross
domestic expenditure recorded annualised growth of 1,1 per cent in the second quarter
of 2007, reflecting slower growth in real domestic final demand and a further slowdown
in inventory accumulation. Real final consumption expenditure by households grew at a
rate of 5,5 per cent and real gross fixed capital formation at a rate of 14,2 per cent, while
real government consumption expenditure contracted by 3,1 per cent in the quarter. The
slowdown in growth in real final consumption expenditure by households during the
second quarter of 2007 was mainly due to a contraction in real spending on durable
goods as well as a moderation in the spending on non-durable goods. After increasing
by 13,9 per cent in the first quarter of 2007, largly as a result of the purchase of military
equipment, final consumption expenditure by government declined by 3,1 per cent in
the second quarter. General government’s real compensation of employees edged lower
Monetary Policy Review November 2007
South African Reserve Bank
during the second quarter of 2007 due to a decline in salaries and wages accruing
to employees participating in the four-week public-sector strike. Gross fixed capital
formation as a percentage of GDP increased to 21,1 per cent in the second quarter
of 2007.
Although the deficit on the trade account narrowed in the second quarter of 2007, a
substantial increase in net service, income and current transfer payments to nonresidents resulted in the deficit on the current account of the balance of payments
narrowing only slightly to 6,5 per cent of GDP from 6,9 per cent in the first quarter.
Export proceeds gained from an increase in the volume of goods exported in the second
quarter of 2007 as well as from higher rand prices of exports. Real exports had
contracted by 3,1 per cent in the preceding quarter. Although the volume of
merchandise imports contracted by 1 per cent in the second quarter due to the
moderate slowdown in domestic demand, the value of merchandise imports increased
by 1,4 per cent as rising international oil and other prices outweighed the appreciation
of the rand during the same period.
The deficit on the current account of the balance of payments continued to be
comfortably financed by net financial inflows. By 25 October 2007, net non-resident
purchases of bonds and equities totalled R91,9 billion. Both the gross gold and other
foreign-exchange reserves and the international liquidity position of the Bank increased
over the past six months to reach levels of US$30,5 billion and US$28,4 billion,
respectively, at the end of September 2007.
Real-estate and equity prices
Figure 11 shows that the growth in house prices continued to moderate in the period
under review. The year-on-year rate of change in the Absa House Price Index declined
slightly from 15,5 per cent in May 2007 to 14,2 per cent in September, while the
Standard Bank House Price Index slowed from 10,9 per cent to 5,7 per cent over the
same period despite spiking to 18,8 per cent in June2.
South African Reserve Bank

Monetary Policy Review November 2007
Percentage change over twelve months

Absa House Price Index

Standard Bank House Price Index
Sources: Absa and Standard Bank
Figure 11 House prices

The Absa House Price
Index records the total
purchase price of houses in the
80 – 400 m2 size category,
valued at R2,7 million or less in
2006 and for which loan
applications were approved by
Absa. The Standard Bank index
is based on the median price of
the full spectrum of recorded
house prices. states that these
prices are generally highly
correlated with those of the
Deeds Office.

Building statistics published by Statistics South Africa suggest that the level of
economic activity in the real-estate sector continued to decelerate when compared to
2005 levels (Table 6). After increasing by 25,7 per cent in 2005, the total real value of
buildings completed increased by 21,4 per cent in 2006 and by 14,3 per cent in the
first eight months of 2007 when compared to the same period a year ago. This
slowdown is a result of developments in the residential sector, where growth has
slowed from 32,7 per cent in 2005 to 16,7 per cent in 2006, and to 7,1 per cent in
the first eight months of 2007 compared to the same period in 2006. By contrast, the
total real value of buildings completed in the non-residential sector rose by 30,6 per
cent in 2006 and has increased by 47,5 per cent in the first eight months of 2007
when compared to the same period a year ago.
Table 6
Real value of building plans passed and buildings completed in
larger municipalities
Annual percentage change

2007*
Building plans passed

Buildings completed

Figures for January – August 2007 compared with the corresponding months of 2006
Source: Statistics South Africa
The corresponding real value of building plans passed, which provides an indication of
future construction activity, points to a significant decline in building activity in both the
residential and non-residential sectors. The total real value of building plans passed
increased by 0,6 per cent in the first eight months of 2007. This was the result of a
significant slowdown in the non-residential sector, where the real value of plans passed
contracted by 2,1 per cent over the period.
On the JSE Limited (JSE), the all-share index (Alsi) traded above the 29 000 level for
the first time in May 2007 (Figure 12). Mergers and acquisitions, increased demand for
securities by non-resident investors, and favourable conditions for resource stocks
contributed to the record highs. Negative sentiment emerged between July and
August due to concerns surrounding large foreclosures and delinquencies in the
US subprime mortgage markets, as well as rising oil prices that pointed to a
deteriorating inflation outlook. Towards the end of July the market rebounded as
investors became convinced that the sell-off was overdone. On 11 October, the Alsi
traded at new record levels of above 31 500 and then receded to around 30 805 on
26 October due to global credit and liquidity concerns. The record highs were due to
renewed investor interest in commodity and financial stocks, as well as an
improvement in global investor sentiment.
Monetary Policy Review November 2007
South African Reserve Bank
Fiscal policy
The Medium Term Budget Policy Statement (MTBPS) which was released on
30 October 2007 depicts a continued strong fiscal position which remains supportive of
monetary policy. Revised estimates of key public finance data for the fiscal year
2007/08, as well as medium-term projections for the fiscal years to 2010/11 are
presented in Table 7. As a consequence of revisions to both revenue and expenditure,
the budget surplus for 2007/08 is now projected at R10,8 billion, or 0,5 per cent of GDP,
compared to the 0,6 per cent of GDP projected in February 2007. In the medium term
revenue is expected to exceed expenditure, resulting in projected budget surpluses of
0,7 per cent, 0,6 per cent and 0,5 per cent of GDP for fiscal years 2008/09, 2009/10
and 2010/11, respectively.
Table 7
Public finance data
R billions* and per cent

Actual
Budget
Revised
Medium-term
estimates
National government*:

As percentage of GDP:

PSBR: Public-sector borrowing requirement
Source: National Treasury Medium Term Budget Policy Statement 2007
South African Reserve Bank

Monetary Policy Review November 2007
Index
Index

FTSE/JSE all-share index
FTSE/JSE resources index (right-hand scale)
FTSE/JSE industrials index
FTSE/JSE financials index
Figure 12 Share price indices


In line with continuing sustained economic performance and revenue collection, the
national government revenue for 2007/08 has been revised to R553,1 billion, which is
R8,5 billion more than the estimate provided in the February 2007 Budget. The revised
estimate for expenditure in 2007/08 is R542,4 billion, compared to R533,9 billion
projected in the 2007 Budget. Upward revision of expenditure is partly a reflection of
continuing infrastructural investments. The revised public-sector borrowing requirement,
which is the consolidated cash borrowing requirement of general government and public
enterprises, is estimated at 0,3 per cent of GDP in 2007/08 and is projected to rise to
0,8 per cent, 1,1 per cent and 1,2 per cent of GDP in 2008/09, 2009/10 and 2010/11,
respectively.
Monetary conditions
Figure 13 shows that the 12-month growth rate of the broad monetary aggregate (M3)
increased from 20,0 per cent in March 2007 to 25,8 per cent in August before decelerating
to 24,9 per cent in September. While more volatile, the growth rates of the narrower M1
and M2 aggregates were slightly lower than that of M3 in the period under review. The
strong monetary growth continued to be underpinned by rising nominal income and
expenditure, buoyant turnover in the financial markets and positive wealth effects, while
speculative and precautionary demand for money probably also played a significant role.
Total loans and advances to the private sector3 have continued to grow strongly despite
increases in lending rates since June 2006 (Figure 14). In the period under review, the yearon-year growth in total loans and advances to the private sector increased from 26,2 per
cent in March 2007 to 27,7 per cent in June before slowing to 25,2 per cent in September.
The growth in mortgage advances was an influential component of total loans and
advances, slowing from 27,9 per cent in March to 26,1 per cent in September. The growth
in instalment sale credit and leasing finance slowed from 17,2 to 11,7 per cent in July and
then accelerated to 15,2 per cent in September. Growth in the category other loans and
advances increased from 28,1 per cent in March to 36,7 per cent in June before slowing to
28,4 per cent in September.
Monetary Policy Review November 2007
South African Reserve Bank
Percentage change over twelve months

Figure 13 Growth in the monetary aggregates
M1
M2
M3

Total loans and advances
to the domestic private sector
consist of instalment sale credit,
leasing finance, mortgage
advances, overdrafts, credit
card and general advances. The
first three categories are
referred to as asset-backed
credit, while the last three
categories together are referred
to as other loans and advances.
Monetary policy
Since the previous Monetary Policy Review (MPR) there have been further changes in
the stance of monetary policy. As was outlined in the previous MPR, the monetary policy
stance remained unchanged at the first two meetings of the MPC in 2007 following the
cumulative 200-basis-point increase at the last four meetings of 2006 (Figure 15). In
February and April 2007 the outlook was initially viewed as having improved sufficiently
to justify a pause in the upward phase of the interest rate cycle. However, as noted in
the previous MPR, the MPC had indicated that the unchanged stance at these two
meetings did not necessarily signal an end to the tightening cycle. The outlook for
interest rates would be dependent on the MPC’s further assessment of the evolution of
the determinants of inflation as well as the assessment of the risks to the outlook.
South African Reserve Bank

Monetary Policy Review November 2007
Percentage change over twelve months

Figure 14 Growth in loans and advances
Other loans and advances
Total loans and advances
Mortgage advances
Instalment sale and leasing finance
-10

Per cent

Prime overdraft rate
Repo rate
3-month NCD rate
Figure 15 The repo and other short-term interest rates

By the time the MPC met in June 2007, the most recent CPIX data, for April, showed
that inflation had breached the upper end of the inflation target range for the first time
since August 2003. A year-on-year increase of 6,3 per cent was recorded in April and it
has remained above 6 per cent since then. Although it was of significant concern to the
Bank that inflation had breached the upper level of the inflation target range, the actions
of the MPC were not predicated on the actual breach but on the expected path of
inflation. There is little that monetary policy can do to influence current and near-term
inflation, given the lags with which monetary policy operates.
The South African Reserve Bank is also not alone among central banks in missing its target
in the past year. The pressures primarily responsible for the breach of the inflation target
range, emanating from exogenous oil and food price shocks, are global phenomena which
are posing challenges to many central banks. However, this does not mean that near-term
developments can be ignored. Inflation expectations and monetary policy credibility are
determined in part by such considerations, and the overriding challenge for monetary
policy-makers is therefore to ensure that inflation is brought back to within the target range
and that inflation expectations remain anchored within this range.
At the past three meetings of the MPC, the focus remained on ensuring a return of the
inflation rate to within the target range. By the June 2007 meeting there had been some
deterioration in the inflation outlook compared to the previous two meetings. The risks to
the outlook were seen to be strongly on the upside despite continued low global inflation,
sustained fiscal discipline and a relatively stable exchange value of the rand. Oil prices,
having declined to a low of US$51 per barrel in January, were trading above US$72 per
barrel once again and indications were that these higher levels would be sustained.
Pressures from food prices were also expected to persist. Despite some moderation in
meat price inflation, food price increases were becoming more generalised. Grain
products were responding strongly to the higher maize prices.
Of further significance was the fact that household consumption expenditure growth
remained very strong at around 7 per cent and apart from some decline in motor vehicle
sales, had shown little sustained response to the previous monetary policy tightening.
Furthermore, the results of the inflation expectations survey conducted in May showed
that inflation expectations had risen again to the levels recorded in the fourth quarter of
2006, a finding corroborated by evidence from long-term bond yields and break-even
inflation rates.
The forecasts of the Bank also showed a further deterioration in the inflation outlook
compared to the April forecast. It was projected that CPIX inflation would remain
marginally above the upper level of the inflation target range in the second quarter of
2007, decline for technical reasons in the third quarter and then exceed 6 per cent in
the subsequent two quarters, peaking at an average of 6,3 per cent in the first quarter
of 2008. Thereafter, CPIX inflation was projected to decline to an average of 5,3 per cent
in the fourth quarter of 2008. Given these developments, it was decided that the repo
rate be increased by 50 basis points to 9,5 per cent per annum in June 2007 to ensure
that CPIX inflation returns to within the inflation target range over time.
At the time of the August 2007 meeting of the MPC, the international environment had
become increasingly volatile and uncertain. Financial market developments in certain of
the developed economies had had spill-over effects on emerging markets, including
South Africa, and had prompted a number of central banks to inject substantial amounts
Monetary Policy Review November 2007
South African Reserve Bank
of liquidity into their banking systems. The impact on South Africa was felt in the foreignexchange and the equities markets. In the wake of the financial market turbulence, the
rand depreciated from around US$6,80 in July to R7,45 at the August meeting. The allshare index on the JSE had also declined by about 13 per cent. The MPC felt it was still
too early to assess the longer-term implications of these developments. The committee
decided that it was appropriate to remain focused on the inflation target and react to
financial market developments insofar as they impacted on the inflation outlook.
However, the upside risks to the inflation outlook identified in June remained in place,
and the central forecast of the Bank indicated a slight deterioration when compared to
the June forecast. CPIX inflation was now expected to remain above the upper level of
the inflation target range at an average of around 6,3 per cent before reverting to within
the inflation target range in the second quarter of 2008, and reaching around 5,1 per
cent by the end of 2009.
There was also further evidence that the inflation pressures were not emanating only
from food and energy, but were more generalised. Household consumption expenditure
growth was showing no significant signs of abating and indicators of consumer
confidence were still high. Rates of growth in credit extension were also high at around
25 per cent. The MPC accordingly decided that a further adjustment to the monetary
policy stance was required and increased the repo rate by 50 basis points to 10,0 per
cent per annum.
At the October 2007 MPC meeting there were signs that the economy was responding
to the higher interest rate environment. There was clear evidence of a moderation in
household consumption expenditure, which grew by 5,5 per cent in the second quarter
of 2007, and domestic economic growth had declined to levels broadly consistent with
the Bank’s view of potential output growth. The challenge for the committee was to
assess whether these developments would be sustained and sufficient to bring inflation
comfortably within the inflation target range.
The view of the MPC was that despite this moderation, the risks to the outlook were still
on the upside. The central forecast of the Bank’s core model showed that inflation was
expected to peak at a level of 6,8 per cent in the first quarter of 2008, decline to 6,0 per
cent in the second quarter, and reach 5,2 per cent at the end of 2009. Factors of
concern to the MPC included the further deterioration of inflation expectations which
were also reflected in higher nominal wage settlements, continued pressures emanating
from food and oil prices, and high rates of growth in credit extension to households. On
the positive side, the exchange rate of the rand had recovered to the levels prevailing
before the international financial market turbulence. On balance, it was decided that
despite the positive developments, a further upward adjustment of the repo rate was
required and it was accordingly increased by 50 basis points.
Going forward, the challenge for monetary policy remains to bring CPIX inflation back to
within the inflation target range. Although the breach of the target can be seen as a setback
for monetary policy, the main inflation drivers were factors beyond the direct influence of
monetary policy. However, the MPC is mindful of the impact of these developments on
inflation expectations and also of the need to act against the emerging generalised inflation
pressures. The most recent inflation forecasts of the Bank suggest that inflation should
return to within the inflation target range during the second half of next year, and monetary
policy will continue to be applied to ensure that this outcome is achieved.
South African Reserve Bank

Monetary Policy Review November 2007

Monetary Policy Review November 2007
South African Reserve Bank
Box 3 An international perspective on biofuels
Biofuels are of interest not only because of their potential as an alternative energy source to fossil
fuels, but also because of the impact their production may have on global food prices. These
prices, in turn, have a direct impact on domestic food prices. Driven mainly by maize, wheat and
soya bean oil prices, global food prices increased by 10 per cent in 2006 (Figure B3.1). Increased
demand, higher energy and fertiliser prices, and poor wheat crops due to severe drought
conditions in many wheat-producing countries contributed to recent price increases. A further
factor that has supported the strong demand for crops is the increased demand for agricultural
commodities as inputs to the biofuel production process.
Global interest in biofuels as an alternative to fossil fuels is stimulated by high oil prices,
uncertainties with regard to future availability of fossil fuels as well as increased global warming
concerns. Unlike fossil fuels, biofuel is a renewable source of energy that can be produced from
different starches and grains, from cellulosic materials such as straw, from other organic waste
material, or from oil-seed crops. Agricultural products such as maize, soya beans, sugar-cane, and
sunflower oil are mainly used in the production of biofuels.
The production cost of biofuel differs between countries, depending on the kind of feedstock and
energy that is necessary for production. Biofuel production is most sensitive to changes in the
feedstock price, which is the main contributor to production costs. Agricultural policies, which
influence the production of and trade in agricultural commodities, are an important factor
influencing the price of the feedstock.
Between 1991 and 2005, global production of biofuels increased significantly. Ethanol production
increased by 174,5 per cent, while production of biodiesel increased from 11 million litres in 1991
to 3 762 million litres in 2005 (Figure B3.2). Brazil and the United States of America (US) are
currently the world’s major biofuel producers, accounting for around 72 per cent of world ethanol
production during 2006 (Renewable Fuels Association, 2007). Brazil, the world’s largest exporter
of ethanol, produces ethanol from sugar-cane, while the US produces ethanol mainly from maize.
However, during 2006 global consumption of biofuel accounted for around 1,3 per cent of global
motor vehicle fuel consumption, and it is projected that it will account for around 3 per cent in
2015 (Panorama, 2007).
Annual percentage change

-15
-10
-5

Source: IMF World Economic Outlook Database, October 2007
Figure B3.1
World commodity food price index
South African Reserve Bank

Monetary Policy Review November 2007
Increased demand for agricultural commodities for biofuel production puts upward pressure on
global food prices. For example, the projected impact of ethanol production on maize prices in the
world’s dominant producer, the US, is reproduced in Table B3.1. It is estimated that ethanol
demand for maize will increase by 34,1 and 48,8 per cent in 2006/07 and 2007/08, respectively,
contributing to corresponding overall demand growth of 4,7 and 4,8 per cent while the projected
supply of maize remains relatively constrained. This situation is projected to continue in 2008/09
and 2009/10. Maize prices, which were around US$3,00 per bushel in 2006/2007, are projected
to peak at US$3,75 in 2009/10 before supply and demand equalise from 2010/11.
Table B3.1: Projected total supply, total demand, ethanol demand and price of
US maize
Annual percentage change and US dollar price*
Total
Total
Ethanol
Price
supply of
demand for
demand for
of
maize
maize
maize
maize*

Source: United States Department of Agriculture, 2007
Million litres
Million litres


Ethanol

Biodiesel (right-hand scale)
Source: Earth Policy Institute, 2006
Figure B3.2
World ethanol and biodiesel production

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 Bank’s forecast, are presented in this section.
International outlook
The global economy continued to expand vigorously in the first half of 2007, but the
subsequent turbulence in financial markets has clouded growth prospects somewhat for
2008. Inflation in most major countries remains well contained despite strong growth
although some countries face rising inflation pressures from food and energy prices.
According to the interim World Economic Outlook (WEO) Update published in July 2007
by the IMF, the projection for global growth was initially revised upward to 5,2 per cent
in 2007 and 2008; 0,3 percentage points higher for both years than was projected at
the time of the April 2007 WEO. In the subsequent October 2007 WEO, the IMF lowered
its forecast for global growth in 2008 to 4,8 per cent (Table 8) and warned that even its
new prediction may be too optimistic given threats posed by the sell-off in credit
markets. Risks to the growth outlook for 2008 are deemed to be firmly on the downside
and mainly centred around concerns that financial market strains could intensify and
trigger a more pronounced global slowdown. Supply constraints have tightened and
inflation risks have risen since the April WEO, and world inflation is now expected to be
3,9 per cent in 2007 and 3,6 per cent in 2008.
Growth in the US has slowed in response to developments in the housing market and it
is expected that the economy will grow by around 1,9 per cent in both 2007 and 2008.
The IMF deems risks to the short-term outlook in the US to be firmly on the downside
given the financial market turmoil, weak housing market, softening labour market and
Monetary Policy Review November 2007
South African Reserve Bank
Furthermore, other crop prices may be affected. As US maize production becomes more attractive
to farmers, they may decide to switch from competing crops, for example soya bean production
to maize production. This would tend to result in a decline in the supply of soya beans and an
increase in soya bean prices.
Finally, it is important to note that these international developments have a domestic impact. Because
agricultural crops such as maize are tradeable commodities, their prices are derived not only from
domestic supply and demand factors, but also from dollar-based export and import parities.
Increases in global feedstock prices resulting from higher demand for agricultural commodities as
inputs to the biofuel production process are therefore transmitted to domestic prices via import
and export parity pricing.
References
Panorama. 2007. Biofuels worldwide. Panorama technical report. Available online:
www.ifp.fr/IFP/en/events/panorama/IFP-Panorama07_05-Biocarburants_ monde_VA.pdf
Accessed on 23 October 2007.
Renewable Fuels Association. 2007. Building New Horizons: Ethanol Industry Outlook 2007.
United States Department of Agriculture (USDA). 2007. USDA Agricultural Projections to 2016.
Available online:

Accessed on 23 October 2007.
declining productivity growth. The growth projection for the US in 2008 has accordingly
been revised downward by 0,9 percentage points compared with that published in the
April WEO. The Institute for Supply Management (ISM) said that in September 2007 US
service industries expanded at the slowest pace in six months, a sign that the housing
recession is seeping into other parts of the economy. The ISM index of nonmanufacturing businesses, which make up almost 90 per cent of the economy, fell to
54,8 in September from 55,8 in August 2007. Compared with data projected in the April
2007 WEO, inflation is expected to be significantly higher in 2007 and somewhat lower
in 2008, averaging 2,7 per cent in 2007 and 2,3 per cent in 2008.
Table 8
IMF projections of world growth and inflation for 2007 and 2008*
Per cent
Real GDP (growth)
Inflation rates**

World ...................................................................... (4,9)

Advanced economies ............................................ (2,5)

Other emerging-market and developing countries .... (7,5)

China.............................................................. (10,0) 11,5

IMF projections for 2007 and 2008 as at April 2007 in parentheses
**
Inflation data exclude Zimbabwe
Source: IMF World Economic Outlook, October 2007
In the euro area it is expected that growth will moderate to 2,1 per cent in 2008 from
2,5 per cent in 2007. The balance of risks to near-term growth has, however, shifted to
the downside because of slowing growth in the US and developments in the financial
markets. Inflationary pressures are expected to remain well contained, with inflation
projected to average 2,0 per cent in 2007 and 2008.
Japan’s economy is expected to continue expanding moderately in the second half of
2007 but the annual forecasts for both 2007 and 2008 have been revised marginally
downward compared with the April 2007 estimates, after having been revised upward in
July 2007. The October 2007 WEO forecasts real GDP growth of 1,7 per cent in 2008
compared with 2,0 per cent for this year. The outlook for Japan is mixed, as growth
could be dampened by the recent financial market turmoil and yen appreciation. Inflation
is expected to increase from 0,0 per cent in 2007 to 0,5 per cent in 2008. The UK
economy is expected to expand by 3,1 per cent in 2007 and 2,3 per cent in 2008, with
projected inflation rates for the respective years of 2,4 per cent and 2,0 per cent.
South African Reserve Bank

Monetary Policy Review November 2007

The major upward revisions to IMF growth projections between the April and October
WEOs have been for emerging-market and developing countries, with growth
projections substantially revised for China, India and Russia. Emerging-market and
developing countries are expected to continue their strong growth performances and
are projected to grow at 8,1 and 7,4 per cent, respectively, in 2007 and 2008. Growth
in developing Asia is expected to be 9,8 per cent this year and 8,8 per cent in 2008.
Compared to the forecasts in the April WEO, these rates represent increases of 1,0 and
0,4 percentage points, respectively. Growth in China is projected at 11,5 and 10,0 per
cent in 2007 and 2008, respectively, while India is forecast to grow at 8,9 per cent in
2007 and 8,4 per cent in 2008. Greater exchange rate flexibility and measures to boost
domestic demand in developing Asia could help reduce the reliance on export-led
growth against the backdrop of continuing large current-account surpluses in many
countries in the region.
Africa’s economic expansion continues to be bolstered by the sustained global
economic expansion, improved policy implementation, debt relief, and firm demand for
fuel and non-fuel commodities. Sub-Saharan Africa’s real GDP is projected to expand
by 6,1 per cent this year and by 6,8 per cent in 2008. Growth is expected to accelerate
in 2008 in a number of countries in the region as new oil projects come on stream. In
the Middle East, high oil prices have supported buoyant growth and strong external and
fiscal balances in oil-exporting countries, and are expected to continue to do so in the
near term. The region’s GDP is projected to grow at 5,9 per cent in both 2007 and 2008.
However, inflationary pressures have risen against the backdrop of tightening resource
utilisation and rising import prices.
The IMF’s projection that growth will moderate somewhat in the advanced economies in
2008 is supported by the latest Organisation for Economic Co-operation and Development
(OECD) composite leading indicators (CLIs). The six-month rate of change in the CLI for the
OECD area has decelerated for the second consecutive month from 2,0 per cent in July
2007 to 0,7 per cent in August, suggesting some moderation in the period ahead.
Crude oil prices remain volatile and reached record-high levels exceeding US$88 per
barrel in late-October 2007. The high crude oil prices reflect strong global demand,
unfavourable geopolitical developments and limited excess oil production capacity.
Medium-term risks to the price of oil are likely to remain on the upside as market
fundamentals remain tight amid strong demand and moderate non-OPEC supply
growth. The futures prices for Brent crude oil to be delivered in May and November 2008
were around US$86 and US$83 per barrel, respectively, on 26 October 2007.
Outlook for domestic demand and supply
Domestic growth is set to remain robust. However, although consumer and business
confidence remain at relatively high levels, both have moderated in 2007. Measures of
trade, manufacturing and fixed investment activity have also decelerated recently.
According to the latest Reuters consensus forecasts, surveyed in September 2007, the
South African economy is expected to grow by 4,8 per cent in 2007, 4,7 per cent in
2008 and 5,1 per cent in 2009. These forecasts represent the mean of 16 individual
forecasts for both 2007 and 2008 and the mean of 14 forecasts for 2009. They range
from 4,7 to 5,0 per cent for 2007, from 4,1 to 5,3 per cent for 2008, and from 4,6 to
5,7 per cent for 2009.
Monetary Policy Review November 2007
South African Reserve Bank
Consumer confidence, measured by the First National Bank/Bureau for Economic
Research (FNB/BER) Consumer Confidence Index as the percentage of respondents
expecting an improvement in conditions less the percentage expecting deterioration,
declined from +21 in the second quarter of 2007 to +18 in the third quarter. The index
was at +23 in the first quarter of 2007, the highest level of consumer confidence
measured since the index was established 25 years ago. The decline in the third quarter
was partly the result of fewer consumers expecting economic performance to improve
over the next 12 months.
The level of business confidence, measured in terms of the Rand Merchant Bank
(RMB)/BER Business Confidence Index, is at its lowest level in three-and-a-half years
(Figure 16). The index measures business confidence on a scale of 0 to 100, with 0
indicating an extreme lack of confidence, 50 neutrality and 100 extreme confidence.
It declined from 80 in the second quarter of 2007 to 72 in the third quarter, with all
subcomponents declining in the quarter. The largest declines were reported for new
vehicle dealers (-13) and manufacturers (-13). However, the majority of respondents
remain optimistic, with confidence levels in all sectors except new vehicle dealers
remaining above the 50 level.
The South African Chamber of Business/Absa Trade Activity Index, which is a
composite index of sales volumes, new orders, supplier deliveries, inventory levels and
employment, declined by 2 index points from 52 in July to 50 in August. The index is
now eight index points lower than the level of 58 reported in March 2007. The Trade
Expectations Index, which has remained in the 66 – 68 range since March, was at
66 index points in August.
The Investec/BER Purchasing Manager’s Index (PMI), a barometer of manufacturing
activity, declined further to 51,4 index points on a seasonally adjusted basis in
South African Reserve Bank

Monetary Policy Review November 2007
Percentage

98 2000 02

Downward phases of business cycle
Sources: Rand Merchant Bank and Bureau for Economic Research
Figure 16 RMB/BER Business Confidence Index
Net positive
Net negative

September 2007 from 54,1 in August. The major contributors in this regard were the
declines in new sales growth, the employment index and the business activity index. The
decline to below the neutral 50 level in the latter two components of the index signifies
a shedding of labour and a contraction in business activity within the manufacturing
sector, respectively.
Confidence levels in the civil construction industry, which provide an insight into trends
in fixed investment, declined in the third quarter of 2007, despite the robust
performance of fixed investment growth in the economy. The FNB Civil Construction
Confidence Index, which reflects the proportion of managers expressing satisfaction
with current conditions in the industry, decreased from an index value of 85 in the
second quarter to 70 in the third quarter of 2007. However, respondents did expect
business conditions and growth in construction activity to improve in the final quarter
of the year.
Indicators of inflation expectations
Inflation expectations play an important role in price setting and wage negotiations and
are an important factor in determining future inflation outcomes. Most measures of
inflation expectations have been increasing recently as the CPIX inflation rate has
breached the upper limit of the inflation target range of 3 to 6 per cent since April 2007.
According to the latest BER quarterly survey of inflation expectations in the South
African economy, conducted in the third quarter of 2007, the average expectation for
CPIX inflation for 2007 is 5,9 per cent, declining slightly to 5,8 per cent for 2008 and to
5,6 per cent in 2009 (Figure 17). Compared to the results of the second quarter survey,
these expectations reflect upward revisions of 0,5 percentage points for both 2007 and
2008, and of 0,4 percentage points for 2009.
Monetary Policy Review November 2007
South African Reserve Bank
Annual averages, per cent

Figure 17
BER surveys of CPIX inflation expectations

Survey conducted during:

06Q4

07Q1

07Q2

07Q3
Source: Bureau for Economic Research, University of Stellenbosch
Table 9 shows the breakdown of CPIX inflation expectations according to the different
groups surveyed. The results for financial analysts, business executives and trade
unions are higher at each forecast horizon than in the survey undertaken in the second
quarter of 2007. Financial analysts expect the average CPIX inflation rate to breach the
upper limit of the inflation target range in 2007 and thereafter to slow slightly to 5,7 per
cent in 2008 and 5,0 per cent in 2009. Business and unions, however, expect average
CPIX inflation to remain within the upper limit of the inflation target range for each of the
forecast years.
Table 9
BER survey of CPIX inflation expectations: Third quarter 2007*
Per cent


Second-quarter 2007 results in parentheses
Source: Bureau for Economic Research, University of Stellenbosch
The results of the September 2007 Reuters survey of long-term forecasts for the South
African economy, depicted in Table 10, closely resemble those of the financial analysts
surveyed by the BER. According to the Reuters survey, the mean forecast is for CPIX
inflation to be above the upper limit of the inflation target range in 2007, averaging
6,2 per cent. Inflation is then expected to recede to 5,8 per cent in 2008 and to 5,1 per
cent in 2009. This reflects an upward revision of 0,1 percentage points for both 2007
and 2008 from the August 2007 survey, while the forecast for 2009 remains unchanged.
The median forecasts for 2007 and 2008 have also been revised upward, although the
2009 forecast has been revised downward from 5,3 per cent in the August 2007 survey
to 5,2 per cent in the September 2007 survey.
Table 10
Reuters survey of CPIX forecasts: September 2007*
Per cent


August 2007 survey results in parentheses
Source: Reuters
South African Reserve Bank

Monetary Policy Review November 2007

Market-based inflation expectations, measured by break-even inflation rates and
depicted in Figure 18, rose between May and July before easing somewhat in recent
months. Break-even inflation rates are measured as the yield differential between
South African government CPI inflation-linked bonds and conventional nominal
bonds of similar maturity, assuming constant inflation and liquidity risk premia over
the period until the bond matures. Break-even inflation rates obtained from the
R197 (maturing 2023) inflation-linked bond increased from around 4,5 per cent in
mid-May to 5,3 per cent at the end of July, before declining to around 5,1 per cent
in late-October. Over the same periods, break-even rates obtained from the
R189 (maturing 2013) inflation-linked bond increased from 5,2 per cent to 6,2 per
cent, and then declined to around 5,7 per cent.
The South African Reserve Bank inflation forecast
The latest quarterly inflation projections of the core inflation forecasting model of the
Bank, as presented to the MPC on 10 and 11 October 2007, are reproduced in
Figure 19. The forecast indicates a further deterioration in the inflation outlook when
compared to the outlook considered at the August 2007 MPC meeting. Conditional on
a constant repo rate of 10 per cent, the central projection was for the CPIX inflation rate
to remain above the upper level of the 3 to 6-per-cent inflation target range, peaking at
an average of 6,8 per cent in the first quarter of 2008. Thereafter it was expected that
CPIX inflation would decline towards the upper end of the inflation target range in the
following quarter, before reaching an average of approximately 5,2 per cent by the fourth
quarter of 2009. This deterioration in the inflation outlook is partly related to the higherthan-expected second-quarter inflation outcome and a revised administered price
assumption due to, inter alia, raised property taxes and higher petroleum prices.
Monetary Policy Review November 2007
South African Reserve Bank
Percentage points

Figure 18 Break-even inflation rates

Spread between R189 and R153 bonds

Spread between R197 and R186 bonds
There are nevertheless still a number of risks to the inflation outlook. Since the August
MPC meeting, international oil prices have increased sharply from around US$68 per
barrel to above US$88 per barrel in October 2007. The recent appreciation of the rand
against the dollar, when combined with the possible moderation of global growth, could
alleviate some of the pressure from dollar-denominated oil prices. Due to adverse
domestic supply conditions and some international developments, including the impact
of biofuel demand, food prices have increased significantly over the past two years and
still pose a risk to future inflation. The recent deterioration in inflation expectations and
associated higher average levels of wage settlements, if not offset by higher rates of
labour productivity growth, also present a risk to the inflation outlook. However, there are
tentative signs of moderation in household consumption expenditure and output growth,
which should have a dampening effect on inflationary pressures.
Assessment and conclusion
The past six months have been challenging from a monetary policy perspective. Over
this period the inflation outlook deteriorated somewhat despite the tighter monetary
policy stance adopted in 2006. Initially, the impetus to the higher inflation trend came
from exogenous factors such as food and petrol prices, although there were warning
South African Reserve Bank

Monetary Policy Review November 2007
Per cent

Figure 19 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).

signals from the elevated rates of credit extension and household consumption
expenditure. More recently there has been evidence of generalised inflation pressures
which have impacted adversely on inflation outcomes and the inflation outlook.
The international outlook remains uncertain. The full implications of the international
financial market turbulence are still to be seen. Some slowdown in growth is expected,
particularly in the US. However, continued dynamism in the Asian economies is likely to
underpin global growth in general, and commodity prices in particular. Despite higher
international oil and food prices, global inflation is expected to remain contained.
Monetary policy in South Africa will remain focused on bringing inflation back to within
the inflation target range. Recently there have been some signs of moderation in
consumption expenditure. The outlook for monetary policy will depend to a significant
degree on whether these signs of moderation are sustained and sufficient to bring about
the desired inflation outcome.
Monetary Policy Review November 2007
South African Reserve Bank