MONETARY POLICY
REVIEW
October 2002
South African Reserve Bank
MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
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ISSN: 1609-3194
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Contents
Monetary Policy Review


MONETARY POLICY REVIEW October 2002
Monetary Policy Review
Introduction
Over the past few months inflation pressures in South Africa continued to increase
unabatedly. Initially these pressures emanated from the sharp depreciation of the
exchange rate of the rand in the second half of 2001. This fed through primarily to food
prices. Earlier on in the year, therefore, the debate around monetary policy focused on
the efficacy of higher interest rates in dealing with external shocks. The view of the
Reserve Bank was that the main role of monetary policy under such circumstances was
to guard against possible second-round effects, and to prevent the higher food price
inflation from influencing inflation expectations and other wage and price decisions.
During the course of the year, it became clear that inflationary expectations were
becoming increasingly entrenched and that wage settlements were trending higher.
Equally disturbing was the fact that the higher inflation was no longer a food price
phenomenon, and was becoming more generalised. Despite indications that the
inflation environment was becoming more favourable in June, these expectations were
subsequently dashed as the CPIX continued to increase, the production price index
resumed its upward trend in July after a dip in June, and the exchange rate again
became vulnerable. Furthermore, the threat of a United States attack on Iraq has
contributed to continued high oil prices.
The result of these developments has been that since the publication of the previous
Monetary Policy Review in April 2002, the repo rate has been increased further in June
and September, on both occasions by 100 basis points. This has brought the
cumulative increase for the year to 400 basis points, and demonstrates the resolve of
the Bank to bring the inflation rate back within the target range for CPIX. Despite these
actions, and although the forecasts show that the target for 2003 can be attained,
there are nevertheless a number of factors which impart a significant upside risk to the
achievement of the target.
The Monetary Policy Review provides an overview of recent inflation trends, as well
as the factors that have impacted on inflation. This is followed by a discussion of
recent monetary policy decisions, as well as a review of inflation expectations. Finally,
the results of the Bank’s forecasts are presented. As usual there are a number of
boxes highlighting topical issues. The first box briefly touches on the question of how
inflation affects different income groups. In line with the Bank’s commitment to
greater transparency, the second box describes the Monetary Policy Committee’s
decision-making process, and the third box describes the issues and process
involved in setting the inflation targets.
Recent developments in inflation
This section analyses recent trends in the main inflation indices, and reviews the
developments in the main determinants of inflation in the South African economy.
The evolution of indicators of inflation
Since the April 2002 issue of the Monetary Policy Review, the main inflation indices
have continued to rise. The depreciation in the exchange rate of the rand in the
second half of 2001 and the related surge in food prices have continued to affect the
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MONETARY POLICY REVIEW October 2002

MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
various measures of year-on-year inflation in 2002. Although the impact of these
initial shocks on inflation is expected to abate in the near future, there is some
evidence that the pressures underlying inflation are now more broadly based than
had originally been thought.
Figure 1 shows the twelve-month percentage change in the consumer price index
excluding mortgage interest cost for metropolitan and urban areas (CPIX) and the
headline consumer price index for metropolitan areas (CPI). From September 2001,
CPIX inflation has trended upwards from 5,8 per cent to 9,9 per cent in July and 10,8
per cent in August 2002. The eight-month average rate of increase for CPIX in 2002
is 8,9 per cent.
The magnitude of the increase in headline CPI inflation over the period has been
slightly greater than for CPIX, as this measure incorporates the mortgage cost effect
of the three 100-basis-point interest rate increases in January, March and June
2002. As Figure 1 shows, CPI inflation rose from 4,0 per cent in October 2001 to
10,6 per cent in July 2002 and 11,6 per cent in August 2002. The July increase was
the first double-digit inflation figure since June 1995.
As noted above, food prices have continued to make a significant contribution to the
increase in the year-on-year CPIX inflation rate in 2002. Figure 2 shows that food
prices contributed 0,7 percentage points to the total CPIX inflation of 6,4 per cent in
June 2001, rising strongly to a 4,8 percentage point contribution to total CPIX
inflation of 10,8 per cent in August 2002.
Figure 1
Consumer price inflation: CPIX and CPI
Percentage change over twelve months

CPIX
CPI
Source: Statistics South Africa

SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
The prices of most items in the food category have increased considerably. Products
traded on international markets (such as grain products, fish and other seafood,
sugar, and sunflower oil) whose prices were adversely affected by the sharp
depreciation of the currency in 2001, serve as input factors in the production chain.
The resultant knock-on effect has impacted strongly on the economy’s food-pricing
mechanism, and ultimately on consumers. Given the relatively higher weighting that
food has in the budgets of lower income households, these developments in food
prices have been a particularly severe setback to the poor. Box 1 provides a
discussion of how recent inflation trends have affected the different income groups.
Besides food prices, the contributions made to CPIX inflation by transport costs,
housing, and medical care and health expenses have all increased recently. After aiding
the deceleration in CPIX inflation late in 2001, the contribution of transport costs rose
again in 2002, fuelled by rising Brent crude oil prices which caused the inland pump
price of petrol to increase from R3,75 per litre in October 2001 to R4,32 per litre in May
2002, before settling at R4,00 per litre in July and August and R4,09 per litre in
September. Transport costs contributed 1,1 percentage points to the CPIX inflation rate
in August 2002. The contribution of the housing component of CPIX increased from
1,3 percentage points in January and February 2002 to 1,8 percentage points in June
and July, and to 1,9 percentage points in August. Medical care and health expenses,
which contributed a constant 0,8 percentage points between April 2001 and February
2002, then increased to contribute 0,9 percentage points in the following three months
before increasing again to contribute 1 percentage point from June to August 2002.
Figure 2
Contributions to CPIX inflation
Percentage points

Food
Housing
Transport
Medical care and health expenses
Other
Contribution of:
Source: Statistics South Africa and SARB calculations

MONETARY POLICY REVIEW October 2002
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Box 1
Does inflation hurt the poor more?
There is often a presumption that inflation hurts the poor more than the rich. Conversely, there is a
belief that monetary policy, in trying to reduce inflation, increases unemployment and therefore
poverty. This box briefly outlines some of the redistributive and differential effects of inflation.
It cannot be assumed a priori that the poor will be hardest hit by inflation. To a significant degree this
will depend on the different weights in the consumption basket, and how the relative prices in the
basket change. It is also determined by the extent to which the poor can hedge against inflation.
In South Africa, Statistics SA calculates the consumption weights and inflation rates facing five
different expenditure groups, namely very low (up to R8 070 per annum); low (R8 071 – R12 263);
middle (R12 264 – R24 365); high (R24 366 – R55 159) and very high (R55 160 and more). Each
group represents 20 per cent of the population. The weights for selected expenditure items for the
different groups are shown in Table A1. As would be expected, the lower income groups have a
higher weighting for food in their consumption basket. The low-income group has a weighting of 51,2
per cent for food in its consumption basket, whereas the food weighting for the high-income group
is 16,7 per cent.
The inflation rate facing the poor will depend on relative price movements. When food prices rise
more than the average, the poor will be relatively more disadvantaged. Figure A1 shows that since
late 2001 the inflation rate faced by the very low income groups has been significantly higher than
that of the very high income group. Since 2000 the average inflation rate facing the very poor has
been 8,2 per cent whereas that facing the very high expenditure group has been 7,5 per cent. This
would of course differ from consumer to consumer in these groups, depending on individual
preferences.
The fact that food prices have responded so quickly and significantly to exchange rate changes also
emphasises the fact that it is no longer true that exchange rate changes only have an impact on the
high-income groups. Since the liberalisation of agriculture, food has increasingly become a true
tradeable good, subject to international prices.
Table A1
Weights: Expenditure patterns for metropolitan and other
urban areas
Expenditure group category
Total
Very low
Low
Middle
High
Very
high

Medical care and health expenses ....

Source: Statistics South Africa

SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
Although it is not necessarily the case that the poor are most affected by inflation, there are good
reasons why the poor are more vulnerable to inflation, particularly in South Africa. It is generally
accepted that if inflation is anticipated, and if people have the means to protect themselves from
inflation, then the impact of inflation is limited.
The wealthy often have assets that can more easily be protected against an expected inflation, and
are better able to hedge against inflation. The ability of the working poor to protect themselves will
depend on their wage-bargaining power. The non-working poor are dependent on the degree to
which any social welfare benefits that they may be receiving are linked to inflation.
An important point to note is that even if the price index facing the poor does not rise significantly faster
than that of other groups, the poor are more likely to suffer greater hardship than the more wealthy
groups. This is because necessities typically comprise a large share of the poorer households’ budgets,
and they are already on or below the breadline. Consequently, the poor are less able to soften the impact
of higher prices on their normal consumption purchases by either substituting lower price and lower
quality items, or entirely foregoing certain types of purchases. For people living on the breadline, this is of
great concern as substitution to lower quality items, or foregoing certain items can have important
negative long-term dietary and health implications. In addition, the poor are less likely to have savings
which will help them offset these effects.
The question about the effect of inflation on the poor must be distinguished from the related issue
of whether the poor pay more in absolute terms for similar goods and services. A number of studies
conducted internationally have shown that there is evidence that the poor do pay more. For example
the lack of competition and high transport costs in rural areas result in higher prices paid by the rural
poor. However, there is no necessary reason for the prices paid by the poor to rise faster than prices
paid by the better-off.
Figure A1
CPIX inflation rate for various expenditure groups
Percentage change over twelve months

Very low
Middle
Very high
Source: Statistics South Africa

MONETARY POLICY REVIEW October 2002
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To highlight the role that food and energy prices have played in determining the trend
of CPIX inflation, Figure 3 shows the effects of excluding these prices from the main
index. As expected, the exclusion of food prices lowers the recent path of CPIX inflation
significantly. However, CPIX excluding food prices increased from 5,4 per cent in
December 2001 to 7,8 per cent in June and July and to 8,4 per cent in August 2002,
demonstrating that pressures are coming from other sources too. Excluding energy
prices, by contrast, has little impact on the path and level of recent CPIX inflation.
Figure 4 provides a breakdown of CPIX inflation into the more aggregated ‘goods’
and ‘services’ categories. Broadly speaking, the goods component of the CPIX
comprises a relatively larger proportion of the tradeable items that are significantly
affected by the rand’s exchange rate and foreign competition, than the services
component which contains a significant proportion of non-tradeables (primarily
affected by internal factors such as wage-cost factors). An examination of
developments in these two components in Figure 4 reveals that inflation in the goods
component increased sharply from 4,7 per cent in September 2001 to 11,4 per cent
in August 2002, which was the expected response of traded goods to the exchange
rate shock experienced in 2001. Potentially more important, however, is the response
of inflation in the services component. This has followed but lagged the upward trend
of goods-component inflation. After hovering just above 7 per cent in the first quarter
of 2002, the inflation rate for this component rose to 9,7 per cent in August.
Administered prices carry a weight of 24,55 per cent in the CPIX, and therefore play
an important role in determining the level of prices in South Africa. As Figure 5 shows,
this sector of the economy recorded double-digit inflation rates until March 2001,
Figure 3
The effect of food and energy prices on CPIX inflation
Percentage change over twelve months

CPIX
CPIX excluding energy prices
CPIX excluding food prices
Source: Statistics South Africa

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MONETARY POLICY REVIEW October 2002
Figure 4
CPIX: Goods and services inflation
Percentage change over twelve months

Services
Goods
Source: Statistics South Africa

Figure 5
CPIX and administered prices
Percentage change over twelve months

API
API excluding petrol and diesel
CPIX
Source: Statistics South Africa and SARB calculations

MONETARY POLICY REVIEW October 2002
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before gradually declining to the level of overall CPIX in December 2001. More
recently, as the impact of the exchange rate and food shocks have impacted on the
tradeables in the CPIX, inflation in the index of administered prices (API) has been
slightly below that for CPIX, although still at high rates. In August 2002 the inflation
rate for the API was 7,8 per cent.
The contributions of the various components to the inflation rate of the API are
shown in Figure 6. Significant contributions to the overall inflation rate of 7,8 per cent
in August 2002 were made by medical health services (1,7 percentage points) and
education (1,3 percentage points). The contribution of petrol and diesel prices
declined from 2,4 percentage points in May 2002 to 0,4 percentage points in July,
before increasing once more to 1,6 percentage points in August as a result of base
effects from August 2001 price decreases.
Developments in year-on-year production price inflation are shown in Figure 7. After
signs of a peak in the rate of increase in the overall production price index (PPI),
when inflation declined from 14,9 per cent in May to 14,4 per cent in June 2002, PPI
inflation rose to 15,2 per cent in July and to 15,4 per cent in August.
As Figure 7 shows, the imported and domestic components of the PPI both trended
upward in 2002. The imported component of PPI increased at a faster rate, with
inflation rising steeply from 7,4 per cent in November 2001 to 17,4 per cent in
Figure 6
Contributions to the administered price index
Percentage points and percentage change over twelve months

Petrol and diesel
Education services
Other administered prices
Medical health services
Contribution of:
Administered price index
Source: Statistics South Africa and SARB calculations
-2

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MONETARY POLICY REVIEW October 2002
April 2002, before declining to 15,6 per cent in August. The inflation rate for the
domestic component of the PPI, which has a weighting of 73 per cent in the overall
index, rose from 7,1 per cent in September 2001 to 14,1 per cent in May 2002,
before slowing to 13,9 per cent in June. Inflation in this component of the PPI then
rose once more, reaching 15,3 per cent in August.
Factors affecting inflation
Recent developments in some of the main drivers of inflation are reviewed in this
section. These include domestic and international factors. In a later section the
outlook for these variables and, therefore, for inflation, is presented.
International economic developments
At the beginning of 2002 the global economy was emerging from what many analysts
viewed as one of the shortest and most moderate downturns of the post-war era.
According to the International Monetary Fund (IMF), the moderating factors included
the general pre-emptive and aggressive response of policy-makers to the downturn,
and the progress made with reducing vulnerabilities and the strengthening of
economic fundamentals in advanced and in developing countries. The recent
revisions to the US national accounts, however, show that the recession of 2001 was
worse than originally estimated, and that there was in fact a contraction during the
first three quarters of the year.
Figure 7
Production price inflation
Percentage change over twelve months

Production price index (PPI)
Imported component of PPI
Domestically produced component of PPI
Source: Statistics South Africa

MONETARY POLICY REVIEW October 2002
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In the first quarter of 2002 there were indications that a recovery had begun. Firstquarter growth in the United States was 5 per cent and there were expectations that
the upswing would be even stronger than many had anticipated. The US stock
markets also responded positively and there were signs that the recovery was
spreading to the rest of the world. However, these hopes were dashed with the
succession of corporate accounting scandals which shook the US markets and,
ultimately, the major markets around the world as well.
Second-quarter growth in the US declined considerably to 1,1 per cent and the IMF
estimates that output growth for 2002 will be 2,2 per cent (Table 1). The decline in
growth reflected in part a decline in consumer expenditure growth, probably as a result
of the weaker stock markets. Consumer expenditure, which had held up well during
the recession, increased by 1,9 per cent in the second quarter, compared with 3,1 per
cent in the first quarter. The weakness in the US markets also resulted in a decline in
capital inflows, leading to a significant weakening of the US dollar since May.
The weaker second-quarter performance in the United States led to generalised
downward revisions of growth forecasts, not only in the United States but also in
many other regions. In the euro area, the initial recovery in the first quarter was not as
strong as in the US but there were signs that the downturn had bottomed out. Real
gross domestic product (GDP) in the euro area increased at an annualised rate of 1,2
per cent in the first quarter and 1,4 per cent in the second quarter. This followed a
contraction of 1,0 per cent in the final quarter of 2001. However, at the recent
meeting of European Union finance ministers in Copenhagen, growth estimates for
the second half of 2002 were halved by the European Commission to 0,3 per cent,
and growth for the year is not expected to exceed 1,0 per cent in line with the IMF
estimate of 0,9 per cent (Table 1).
The Japanese economy remains weak. The revisions to the method of calculating
GDP in Japan meant that the economy contracted by 0,1 per cent in the first quarter
as against initial estimates of 5,7 per cent positive growth, though second-quarter
growth recovered to 2,6 per cent. However, the weaker performance of the US and
Table 1
Annual percentage change in real gross domestic product and
inflation rates
Per cent
Real GDP
Inflation rates

(estimate)
(estimate)

Source: IMF World Economic Outlook, September 2002

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MONETARY POLICY REVIEW October 2002
European economies is already beginning to affect Japanese exports. The East
Asian economies had more robust performances during the first half of the year,
buoyed by increased exports and higher consumer expenditure.
Not all emerging markets followed the Asian recovery. Crises in a number of Latin
American countries resulted in uncertainty and increased risk perceptions. Argentina
continues to be in one of its deepest recessions, and the contagion effects of this on
the region have impacted on Uruguay and Ecuador in particular. The Brazilian economy
has been faced with increased uncertainty in the run up to its October elections,
although recent IMF assistance has helped to stabilise the situation. Nevertheless, the
volatile situation in Latin America has been negative for emerging-market risk in general.
Despite the downturn in 2002 and the weak recovery, South Africa managed to
avoid a significant decline in growth. Although export volume growth declined in the
second half of 2001, the depreciation in the external value of the rand in the second
half of 2001 helped reverse this trend in the first half of 2002. However, the weaker
pace of recovery could adversely affect exports as well as commodity prices.
The slower pace of global recovery has meant that inflation has not been a major
cause for concern in most countries. Lower real growth rates meant that firms still
had limited pricing power. As Table 1 shows, it is estimated that world inflation will
average 3,6 per cent in 2002 compared with 4,3 per cent in 2001.
Oil prices
International oil prices have remained relatively high since the second quarter of this year,
despite lower-than-anticipated demand. During the course of the year, the Organisation
of Petroleum Exporting Countries (OPEC) has maintained quotas at the lower levels
introduced in January. Since April, the monthly average Brent price has been above the

Figure 8 Brent crude oil price and rand/US dollar exchange rate

South African rand/US$
Brent US dollar price
Brent rand price
Index 2 July 2001=100

MONETARY POLICY REVIEW October 2002
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level of US$25 per barrel (apart from June when it was marginally lower). More
recently, oil prices moved sharply higher amid concerns of a possible US-led
attack on Iraq. OPEC has recently reaffirmed its commitment to maintain the
benchmark price within a range of US$22 and US$28 per barrel for a basket of
crude oil. The price of the OPEC basket has remained marginally below the ceiling
of US$28 per barrel.
World interest rates
The delayed recovery in the world economy has resulted in differing monetary policy
stances in advanced economies. Some countries have pursued tighter policies and
others have left them unchanged since the end of 2001 (Table 2). Canada, Sweden,
Australia and New Zealand have tightened monetary policy between May and July
in response to stronger growth and inflationary pressures, whereas the United
States, the euro area, Denmark and the United Kingdom, for example, have left
monetary policy unchanged since the end of last year. Initially, it was widely
expected that most economies would be adopting a tighter monetary policy stance
during the course of this year. Such increases are now expected to be delayed, and
some expect that US rates could decline even further. Several emerging markets
including Thailand, Brazil, Mexico, Indonesia, and Chile have eased their monetary
policy stances since the beginning of the year. South Korea moved against this trend
with an increase in May.
Table 2
Key central bank interest rates
Per cent
Countries
1 January
26 September
Latest change

(Percentage points)
1,75
1,75
11 Dec 2001
(-0,25)
0,00
0,00
19 Mar 2001
(-0,15)
3,25
3,25
8 Nov 2001
(-0,50)
4,00
4,00
8 Nov 2001
(-0,50)
2,25
2,75
16 Jul 2002
(+0,25)
3,25
3,25
9 Nov 2001
(-0,50)
3,75
4,25
2 May 2002
(+0,25)
1,25–2,25
0,25–1,25
26 Jul 2002
(-0,50)
4,25
4,75
5 Jun 2002
(+0,25)
4,75
5,75
3 Jul 2002
(+0,25)
3,80
9,10
24 Jun 2002
(+2,00)
3,25
3,25
12 Dec 2001
(-0,25)
17,62
13,50
12 Jun–18 Sep 2002
(-1,66)
5,00
5,00
20 Sep 2001
(-0,50)
4,00
4,25
7 May 2002
(+0,25)
2,13
1,88
27 Jun 2002
(-0,25)
2,25
2,00
21 Jan 2002
(-0,25)
6,50
6,50
22 Oct 2001
(-0,50)
19,00
18,00
17 Jul 2002
(-0,50)
6,50
3,00
8 Aug 2002
(-0,25)
4,75
3,00
26 Jul 2002
(-0,75)
9,75
9,50
8 Jul 2002
(+0,50)
11,50
8,00
29 Aug 2002
(-0,50)
25,00
21,00
7 Aug 2002
(-2,00)
Source: National central banks

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MONETARY POLICY REVIEW October 2002
Exchange rate developments
Despite losing ground after May, the rand has remained one of the better performing
currencies this year. Following the 37 per cent depreciation against the US dollar in
2001, it went through a period of consolidation in January and early February,
followed by a strong rally from February to mid-June 2002. During April it
appreciated sharply from R11,28 per US dollar to reach R9,74 per US dollar at the
end of May. Part of the appreciation can be ascribed to exporters’ repatriation of
export earnings, declining pressure on emerging-market currencies, the weakening
of the US dollar following the corporate governance and accounting scandals in the
US, and the gold price rally accompanied by an improved outlook for commodities.
The latter factor led to a general strengthening of the currencies of commodityproducing countries, including Australia, as shown in Figure 9.
Since June the rand has come under increased pressure and followed a weaker
trend. By late September it was around R10,60 per US dollar. Factors contributing
to this decline were the disappointing inflation figures; the increasingly uncertain
outlook for the global economy and commodities; deteriorating political and
economic developments in the region, particularly in Zimbabwe; emerging-market
jitters stemming from the crisis in Argentina and the threat of debt default in Brazil;
and what was probably most significant, the leaking of the draft mining charter.
Despite reassurances by government that this did not reflect government policy,
large-scale selling of bonds and equities by non-residents at times pushed the rand
to levels close to R11 per US dollar. In July and August, non-residents reduced their
holdings of domestic securities by almost R12 billion.
Figure 9
US dollar per rand, euro, Australian and New Zealand dollar
Index: 2 January 2002=100

Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
US dollar per euro
US dollar per Australia dollar
US dollar per New Zealand dollar
US dollar per rand

MONETARY POLICY REVIEW October 2002
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Labour markets
The labour market developments detailed in Figure 10 reveal that increases in
economy-wide unit labour cost (i.e. wage increases adjusted for productivity
changes in the formal non-agricultural sector), have risen to levels above the
targeted inflation rate for the economy. The year-on-year growth in unit labour cost
accelerated from 2,4 per cent in the second quarter of 2001 to 7,0 per cent in the
fourth quarter, before moderating to 6,4 per cent in the first quarter of 2002. Growth
in unit labour cost for the manufacturing sector alone was well below these levels,
measuring 3,6 per cent in the first quarter of 2002 largely as a result of improved
growth in labour productivity.
As Figure 10 shows, the increase in unit labour cost in the formal non-agricultural
sectors of the economy was the result of rising rates of increase in nominal
remuneration per worker and the continued downward trend in the measured
growth in labour productivity per worker. The annual increase in remuneration per
worker rose from 7,0 per cent in the second quarter of 2001 to 10,7 per cent in the
final quarter, while growth in labour productivity per worker declined from 4,5 per
cent in the second quarter of 2001 to 3,4 per cent in the third quarter, before
levelling off to 3,5 per cent in the last quarter of the year. In the first quarter of 2002,
the growth in labour productivity per worker declined once more to 3,0 per cent, but
the impact of this on growth in unit labour cost was more than offset by the
moderation in the rate of increase in remuneration per worker to 9,6 per cent.
Figure 10
Remuneration per worker, labour productivity and unit labour
cost in the formal non-agricultural sectors
Percentage change over four quarters

Remuneration per worker
Labour productivity
Nominal unit labour cost
Source: Statistics South Africa

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MONETARY POLICY REVIEW October 2002
Demand and output
The South African economy continues to perform relatively well in a global context.
Table 3 shows that real GDP grew at a modest 2,2 per cent in the first quarter of
2002, before accelerating to 3,1 per cent in the second quarter. A wide range of
productive sectors played a role in increasing output growth in the second quarter,
including a strong contribution from export-oriented sectors which show signs of
having benefited from the exchange rate depreciation in 2001 despite fairly weak
global growth.
As Table 3 shows, there was solid growth in aggregate final demand in 2002. Final
consumption expenditure by households and by government was buoyant, and
fixed capital formation increased relatively strongly. A sharp slowdown in the rate of
inventory accumulation, however, resulted in a decline in real gross domestic
expenditure by 0,9 per cent in the second quarter.
Fiscal policy
Although a mildly expansionary budget was announced for the 2002/03 fiscal year,
the fiscal accounts for the first quarter of the year show that the deficit before
borrowing and debt repayment shrank on a year-on-year basis. The surplus of
revenue over expenditure for the non-financial public sector for the first three months
of fiscal 2002/03 amounted to R2,9 billion (1,1 per cent of GDP), compared with the
R1,3 billion recorded in the same period in fiscal 2001/02 (0,5 per cent). This
increase in the surplus in government accounts has been largely the result of
exceptionally high government revenue growth. Government revenue of
R66,7 billion was collected in the first quarter (25,0 per cent of GDP), an increase of
25,8 per cent on the same quarter of 2001/02 and well above the 7,1 per cent
forecast for 2002/03 as a whole. Higher revenue receipts were recorded across-theboard, including increased corporate tax payments arising from the depreciation of
the rand and better collection of domestic taxes on goods and services.
Government expenditure, by contrast, grew by 11,8 per cent year on year to
R68,3 billion (25,6 per cent of GDP).
Table 3
Growth in real gross domestic product and expenditure components
Per cent

Q3
Q4
Year
Q1
Q2

Quarterly data refer to quarter-on-quarter growth at annual rates of seasonally adjusted data

MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
Monetary conditions
The year-on-year rates of increase in all of the monetary aggregates in Table 5 have
been disturbingly high in 2002. To the extent that these aggregates represent
sources of funding for future expenditure on goods and services, they are an
indication of possible spending that may exceed the economy’s production
potential, and hence of inflationary pressures in the economy.
The broad M3 monetary aggregate increased by 17,4 per cent in July 2002.
Although the trend in this aggregate appears to be downward from the 20,6 per cent
growth recorded in May, the decline is largely due to increased tax collections, which
transferred a portion of the private sector’s deposits in M3 to government deposits
which are not included in M3. The growth in the more narrowly defined aggregates
slowed noticeably from the first to the second quarter of 2002, but nevertheless
remained stubbornly high.
Credit extension to the private sector, which had risen sharply to a three-year high
of 15,6 per cent in January 2002, has since declined steadily to 11,7 per cent in July.
This reduction was mainly the result of reversals in the leads and lags associated
with foreign transactions, with earlier borrowing in this regard apparently being
Table 4
Public finance: ratios to gross domestic product (fiscal years)
Per cent
1999/2000 2000/01
2001/02

2002/03
2003/04 2004/05
April to June
Medium-term estimates
National government

Source: SARB and National Treasury, Budget Review 2002
* PSBR: Public-sector borrowing requirement
Table 5
Percentage change in monetary aggregates
Twelve-month change
M1A
M1
M2
M3


SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
repaid as the currency strengthened in the first five months of the year. The
corporate sector was affected most by this trend, and the share of households in
total credit extended to the private sector duly increased over the period.
Monetary policy
Monetary policy continues to be dominated by the response to the sharp
depreciation of the rand in November and December 2001. The Monetary Policy
Committee decision-making process is described in Box 2, and Box 3 discusses
issues relating to the setting of the targets.
Box 2
Making monetary policy decisions
One of the questions often raised in the context of monetary policy regards the monetary policy
decision-making process. This box describes the practical aspects of this process.
The Monetary Policy Committee (MPC) was reconstituted at the beginning of 2002 and currently
comprises seven members: the Governor, two deputy governors and four senior officials of the Reserve
Bank. The MPC will increase to eight members when the vacant position of deputy governor is filled.
Previously, meetings were held every six to eight weeks, but since the beginning of this year quarterly
meetings have been scheduled to coincide with the release of key quarterly data. However, provision
is made for unscheduled meetings if the need arises, as was the case with the unscheduled meeting
in January 2002.
Although the meetings are held quarterly, there is an almost continuous monitoring of economic
developments, particularly those that impact on inflation and monetary policy. Members receive briefing
updates and analysis and research output from various units in the Bank, as well as material from
various external domestic and international sources, including financial institutions, academic
economists, and international organisations such as the IMF and the Bank for International Settlements.
The MPC cycle begins in earnest approximately two to three weeks prior to the scheduled meeting,
when members meet with the Macro Models Unit. By then the modellers will have consulted various
other units regarding the assumptions made about the exogenous variables of the models. The
assumptions are presented to the committee and, in the ensuing discussions, changes may be
suggested to the assumptions or requests made for alternative scenarios to be considered during the
forecasting process. This process ensures that there is ‘ownership’ of the forecast by the committee.
The first day of the scheduled MPC meeting starts with presentations on special items of topical
interest that are prepared on an ad hoc basis, usually at the prior request of the MPC. In the past,
such topics have included analyses of food prices, international oil prices and the role of monetary
aggregates in the inflation process. This is followed by a review of economic developments which
entails presentations on different aspects of the economy, prepared by various departments in the
Bank and presented by the respective unit or departmental heads. The members of the committee
will have received a full set of documentation the previous week. The standard agenda for the
economic developments is as follows:
-
International economic conditions: prepared by the International Economy Unit of the Research
Department.
-
International financial markets: prepared by the International Banking Department.
-
Domestic money and capital markets: prepared by the Money and Capital Market Department.
-
Financial and fiscal developments: prepared by the Financial Analysis and Public Finance Unit
of the Research Department.
-
National economic conditions: prepared by the National Economy Unit of the Research
Department.
-
Economic projections: the forecasts of the various Bank econometric models as developed by
the Macro Models Unit of the Research Department are presented, along with surveys of inflation
expectations.
Each presentation is followed by a discussion. These presentations usually continue until late
afternoon, and up to that point the monetary policy stance is not discussed. In the evening there is
a working dinner where some of the issues raised during the course of the day are discussed further,
with a focus on the implications for the monetary policy stance.

MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
Following the 100-basis-point increase in the repo rate at the unscheduled meeting in
January 2002, monetary policy was tightened further in the subsequent three meetings
of the Monetary Policy Committee. In all cases the repurchase rate was increased by a
further 100 basis points (Figure 11). By March it was clear that inflation expectations had
been adversely affected by the depreciation, and that the impact of the depreciation on
prices would not be limited to a one-off unavoidable first-round effect. In addition, there
was concern about the continued high rate of growth in the money supply and credit
extension, the state of the balance of payments, and the beginning of an acceleration
in unit labour cost. This was against the backdrop of a world economy recovering from
the downturn, with anticipated acceleration in the recovery. It was felt that tightening
monetary policy at that stage, if successful in dampening wage and price increases,
would avert the need for more drastic increases in the future.
By June, the upward trends of inflation and inflation expectations had maintained
their momentum, and unit labour cost trends and money supply developments
remained unfavourable. By that time, CPIX inflation had moved above the 9 per cent
level and PPI inflation had reached almost 15 per cent. There were, however, some
positive indications that could have signalled a reduction in pressure on inflation, and
that appeared to signal the peak of the interest rate cycle at the time. These included
the partial recovery of the rand from its lows in December, the surplus on both the
current and financial accounts of the balance of payments, the continued low level of
capacity utilisation and the fact that fiscal discipline was being maintained.
The following morning begins with a summary of the discussion of the previous evening. A discussion of
the monetary policy stance ensues. Committee members are then asked in turn to express their views
on the appropriate monetary policy stance and on any interest rate changes that may be deemed
appropriate. In general, decisions are made by consensus or with a majority view, without a formal vote
being taken.
Once the decision is taken, the statement to be issued is finalised. To ensure that the embargo on the
release of the decision is not broken, the statement is released to the press at the same time that the
Governor reads the statement live on national television at 15:00.
An important implication of the introduction of inflation targeting is that monetary policy has become more
forward looking. Monetary policy decisions are made on the basis of current and expected developments
in a number of variables, which are also the main drivers of the Bank’s forecasting models. As described
above, the MPC monitors a number of factors that influence inflation, including money supply and credit
extension; changes in wages and productivity and unit labour cost; the output gap; exchange rate
developments and import prices, oil prices and other administered prices. There is no target for any of
these variables other than for CPIX, which is the benchmark for monetary policy decisions.
This implies that greater emphasis is given to the forecast than in the past. However, it is important to
stress that there is not a mechanical relationship between the forecast and monetary policy decisions.
Because of the uncertainties inherent in the forecast (as illustrated in the fan chart), the models and
forecasts are aids to policy-making, but the final decision has to be a judgement call based not only on
the forecast but also on other information.
Although output is not specifically targeted, it is an important factor in monetary policy decisions as it
enters the model through the output gap. The future path of output can determine the extent of expected
inflationary pressures. Similarly, although there is no specific target for the exchange rate, the expected
future path of the exchange rate could have an important impact on monetary policy decisions.
The explicit forward-looking nature of monetary policy has resulted in far greater stability in the real and
nominal interest rates. This is reflected in the less vigorous response to events such as the oil price shock
in 2000, the exchange rate developments in 2000 and 2001 and the money supply developments in the
second half of 2001. Excessive focus on or targeting of these variables would probably have resulted in
greater variability in interest rates.

SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
This relatively positive outlook appeared to be confirmed with the release of the PPI
figures for June, which showed that production price inflation had declined. It was
hoped that this would mark the turning point of the PPI and feed in with a lag to the
CPIX. This appeared to bode well for the inflation outlook. Unfortunately, as discussed
earlier, in the subsequent month production prices resumed their upward trend. Apart
from this setback, a number of factors contributed to the increasingly negative
outlook for inflation when the MPC met in September.
At the September meeting, the MPC had to take cognisance of the fact that not only
was inflation rising at a faster rate than expected, but inflation pressures were also
becoming more broadly based. It was no longer a case of rising food prices but, as
seen earlier in the Review, the price increases were becoming more generalised and
had also spread to services. Furthermore, quarter-on-quarter CPIX inflation was
even more pronounced. Apart from this, the oil price was keeping petrol prices high,
and the risk of an attack on Iraq by the United States is likely to keep these prices
at higher levels, with a risk of further acceleration. The weaker exchange rate since
June has also clouded the inflation outlook. The leaking of the draft mining charter
contributed to substantial net sales of securities in the bond and equity markets.
Inflation expectations (discussed more fully below) remained high, and there was
increasing evidence that wage settlements were significantly higher in the third
quarter than had been the case in the first half of the year. However, there is
evidence that an inflation spiral is not anticipated, and that inflation will begin to trend
downwards later this year.
The MPC also had to consider the fact that despite the previous increases in interest
rates, growth in the monetary aggregates and credit extension had remained
stubbornly high. On the positive side, despite fairly robust growth in demand, it was
acknowledged that there was no sign of excess spending or production capacity
Figure 11
The repo, prime and real prime interest rates*
Per cent, interest rates measured at end of period

Repo rate
Prime overdraft rate
Real prime rate
* The real prime overdraft rate is measured ex post using the CPIX inflation rate, and is
available only to August 2002 (i.e. this excludes the September rate increases)

MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
constraints. Although inflation was being driven primarily by cost-push factors, it was
felt that this, combined with accommodating monetary developments, required a
monetary policy response from the Bank.
Although the cumulative rate increases have amounted to 400 basis points for the
year, the banks’ real prime overdraft rate measured ex post deflating by the CPIX
inflation rate, will be similar to that prevailing at the end of 2001 (Figure 11). On the
basis of expected inflation, it can be argued that real rates have risen somewhat.
However, monetary policy responses to inflation shocks do require increases in real
interest rates. In addition, the increase should be seen in conjunction with the stimulus
given to the economy from the depreciation in the real exchange rate of the rand over
the past year. Considered in this way, monetary conditions are not as tight as
suggested by looking solely at the level of interest rates. Growth and expenditure levels
have remained relatively robust. The MPC is aware of the fact that excessively high real
interest rates will have a negative effect on the economy. The challenge facing the
Bank is to increase real rates sufficiently to achieve its inflation objectives at a minimum
cost to the real economy. Such costs, however, cannot be avoided over the short
term, and are necessary in order to reap the longer-term benefit of lower inflation.
Box 3
How are inflation targets determined?
A number of countries have adopted inflation targeting in situations where their inflation rates were
significantly above the long-run targeted level. In such situations, deciding on the rate and path of
disinflation becomes critical. According to a study by Mahadeva and Stern, most countries in such
instances have used the introduction of inflation targeting as part of the disinflation mechanism. This
makes the inflation target endogenous to the inflation outcome. As these authors suggest, “...during
disinflation it is difficult to separate decisions about target-setting from implementation. Short-term
targets on a disinflation path may be more akin to conditional forecasts than policy rules, but their
publication may nevertheless increase transparency and hence help policymakers to achieve lower
inflation.” (Mahadeva and Stern, 2001:1)
The setting of inflation targets in South Africa can be seen in this context – that the introduction of
inflation targeting would help with the process of bringing down inflation to its long-run level, by
increasing the credibility of the Bank’s anti-inflation objectives and commitment. To initiate this
process, the first target had to be below the prevailing CPIX inflation rate of around 7 per cent.
However, it also had to be feasible or achievable, and credible. Because of lags in monetary policy,
it also had to have a reasonable time horizon, i.e. it had to have a time horizon of longer than about
eighteen months, as this is the estimated lag between a change in interest rates and its full impact
on inflation. (Using a time horizon that is too short is likely to result in frequent misses of the inflation
target even when monetary policy is being conducted optimally.) The result was that the target range
was set in February 2000 at 3-6 per cent, to be achieved on average for 2002.
Subsequent to the introduction of the inflation-targeting framework, a joint Treasury/Reserve Bank
Inflation Targeting Technical Committee was established to maintain regular contact and to consult
on technical issues relating to the framework. This is an advisory committee and the final decisions
are taken by the Minister of Finance and the Governor. Decisions relating to the implementation of
monetary policy remain the preserve of the Reserve Bank. In other words, full instrument
independence is maintained.
An important decision that had to be taken in deciding on subsequent targets was whether a target
for one year should be announced, or whether a multi-year path should be specified. Specifying a
path has the advantage of allowing for better forward planning in wage and price setting by the
private sector. It also helps with the process of disinflation by providing credibility and transparency.
An alternative approach is to continue to announce only one medium-term annual inflation target.
This could be accompanied by an announcement of a long-run target which in turn may or may not
have a specified target date for its achievement.

SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
The outlook for inflation
The outlook, risk and uncertainties relating to some of the factors that determine the
outlook for inflation and that are embodied in the forecast, are presented in this section.
The international context
At the time of publication of the previous Monetary Policy Review, there were
positive signs that the recovery in the United States was progressing well.
Nevertheless, there was uncertainty about the strength and duration of the recovery,
while some commentators were predicting a double dip recession. Since then, there
has been a slew of bad news from the international markets. It has become
increasingly clear that if a general recovery does take place, it will not be as strong
as many had originally predicted. This includes the IMF which, in its recent World
Economic Outlook, has downgraded its projections for the second half of 2002 and
2003, with the risks of the outlook primarily on the downside. As can be seen in
Table 6 world growth projections for 2003 have been revised downward from 4,0 per
cent to 3,7 per cent. Most significantly, US growth has been revised down to 2,6 per
cent from 3,4 per cent.
Private-sector forecasters have also engaged in continuous downward revisions of
the strength of the world recovery. The widely held view is that, although the
recovery will continue, there is a likelihood of a prolonged period of low world
growth. The weakness in international stock markets, led by the United States, has
negative implications for consumer expenditure growth, which had underpinned the
initial recovery in the US and which had mitigated the extent of the recession in
2001. As US corporations and households rebuild their balance sheets, real growth
is expected to be subdued.
The advantage of not announcing the full path is that it does allow for some flexibility if there are
problems with attaining the target, i.e. an annual target can leave more room to absorb short-run
inflationary shocks and dampen output fluctuations.
On the one hand, announcing a disinflation path may influence inflation expectations more than the
announcement of only a short-term target would. On the other hand, if the detailed path is missed,
credibility may be undermined. The decision taken in South Africa was to have some combination of
the two, where the full path has not been specified, but the annual targets for 2003-2005 have been.
The basis for the decision was that South Africa would want a reduction in the inflation rate at a speed
which would not unduly affect the real sector of the economy. The decision was based on what the
forecasts indicated was feasible, given the monetary policy stance. The objective remains the reduction of
inflation but implicit in this is a recognition that an excessively fast reduction in inflation will have high costs.
At the time when the new targets were set, there was a general belief that the targets for 2002 would
be attained. For example in September 2001, at the time that the targets were being decided upon,
the Reuters consensus forecast for CPIX average for 2002 was 5,8 per cent and 5,4 per cent for
2003. In October the consensus forecast for 2002 was 5,7 per cent and 5,4 per cent in 2003. The
Reserve Bank and Treasury forecasts were in line with these forecasts.
Ultimately, the Bank’s objective is to bring the inflation rate down to the level of its major trading
partners. No time frame has been set at this stage, nor has the exact long-term target level for inflation.
Reference
Mahadeva, L. and Sterne, G. 2001. Inflation Targets as a Stabilisation Device.
Bank of England Mimeograph.

MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
Growth in the euro area has also been lower than anticipated, and is expected to
continue on a weaker path. The outlook in Germany in particular has deteriorated as
negative consumer and producer sentiment persists. A number of forecasters have
recently downgraded their forecasts for the euro area, and the IMF projection for
2003 has been revised downward to 2,3 per cent from 2,9 per cent in April.
Although the Japanese economy showed promising signs of a strong recovery
earlier in the year, these hopes appear to have been premature as the stronger yen
and faltering recovery in the US and Europe have negatively affected Japanese
growth prospects. The continued recovery in the rest of Asia, however, could help
support Japanese growth over the coming months. Although lower world growth
and higher oil prices will undermine growth in Asia, domestic demand is expected
to maintain a steady growth momentum.
The Latin American region is expected to remain turbulent during the coming
months. Although prospects in Brazil have improved following IMF assistance, the
uncertainties surrounding the upcoming elections continue to influence the
perceptions of risk in the region. This is compounded by continued and unresolved
problems, particularly in Argentina.
In March it appeared that the world had seen the end of the downward trend in the
interest rate cycle and there was an expectation of an imminent reversal of that trend.
Not only has this reversal been put on hold, but there are expectations of a renewed
round of rate cuts, especially in the US, and cuts are not ruled out in the euro area and
the United Kingdom, particularly as the outlook for the real economy is becoming
increasingly negative. Given the current low levels of rates, the scope for aggressive
cutting is more limited than in 2001. However, macroeconomic policy in general is likely
to remain supportive of a global recovery. Interest rates in the industrialised countries
are therefore likely to remain stable or decline. International inflation pressures have
become even more subdued, and some analysts have been forecasting deflation in the
United States. Therefore, an increase in world inflation is unlikely.
The international oil price remains a threat to the domestic inflation environment.
Despite the higher oil price in recent months, OPEC has not bowed to the pressure
to increase the output quotas. There does, however, seem to be a commitment to
Table 6
IMF projections of world growth and inflation for 2003
Real GDP
Inflation
April
September
April
September

Source: IMF World Economic Outlook, September 2002.

SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
maintaining the oil price within the OPEC range of US$22-28 per barrel. Although
the bottom of the range has been successfully defended in the past, the resolve to
prevent prices from breaching the top of the range has yet to be tested.
A major factor clouding the oil market is the continued threat of a US attack on Iraq.
This has kept the oil price at high levels. If an attack does occur, a further spike in
the price would be likely. However, a number of factors could keep prices from rising
excessively. Firstly, the tepid recovery in the US and the euro area would moderate
demand for oil. Secondly, as prices rise, non-OPEC oil output is expected to
increase, reducing OPEC market share. This could result in more pressure from
within OPEC to increase quotas. Overall, however, it is expected that the risks to the
oil price remain on the upside.
Apart from oil, the international maize price has been rising since mid-July and this
is likely to start filtering through to domestic production and consumer prices.
Outlook for domestic demand and supply
The deteriorating outlook for the global economy is likely to have a negative impact
on South African exports. Although this will be mitigated somewhat by a favourable
competitive position as a result of a depreciated real exchange rate of the rand,
lower demand for exports, less favourable commodity prices, and higher emergingmarket risk aversion than originally expected will make the outlook on this front less
favourable for South Africa.
The less favourable export performance could be detrimental to the current
account of the balance of payments, and, if imports do not decline, the currentaccount surplus could decline significantly and move into deficit as there is unlikely
to be a substantial fall in dividend outflows. To the extent that domestic economic
growth persists at current levels, imports are unlikely to decline significantly.
However, higher interest rates are expected to influence expenditure, including
imports. Although the second-quarter GDP growth was encouraging, it is not clear
whether it can be sustained at those levels. Domestic investment growth has been
rising at a healthy rate and consumption expenditure has remained buoyant. As
the global recovery falters, the growth outlook is likely to be less optimistic as
export demands are curtailed. Capacity constraints are not expected to be a
problem, although the higher expected wage demands could start putting upward
pressure on unit labour cost.
The exchange rate of the rand continues to be undervalued but, as seen in the past,
such a situation may persist for extended periods. As the global economy is weaker
than anticipated, the rand is not expected to make a strong recovery in the near
future. With rising uncertainty about the world economy, emerging-market risk
premiums could rise and reduce flows to emerging markets, and the foreign
exchange markets could be characterised by increased volatility. In the South
African region, developments in Zimbabwe continue to affect foreign perceptions
negatively.
Indicators of inflation expectations
The findings of the inflation expectations survey undertaken in the third quarter of
2002 by the Bureau for Economic Research (BER) at the University of Stellenbosch,
are reported in Table 7. The table shows that in the third quarter of 2002, the average

MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
expectation for CPIX inflation in 2002 was 8,5 per cent. Financial analysts’
expectations were the highest at 9,2 per cent and those of trade union officials the
lowest at 7,9 per cent. Looking further ahead, the average expectation was that
CPIX inflation would decline to 7,6 per cent in 2003 and to 7,0 per cent in 2004.
When these results are compared with those from the survey undertaken in the
second quarter of 2002 (Table 7) it is clear that the increase in inflation expectations
relates largely to 2002 (expected 2002 CPIX inflation averaged 8,2 per cent in the
second quarter and 8,5 per cent in the third). For 2003 and 2004, the average
expectations are roughly unchanged from the previous survey. The BER contrasts
this with the second-quarter survey that reported large increases in expected
inflation in all forecast years, and argues that this indicates that the increase in
inflation expectations may be slowing down. Although the results show that the
Reserve Bank is expected at this stage to miss its inflation targets in the coming
years, the BER interprets these results as suggesting that the increase in CPIX
inflation expectations may be slowing down and that the jump in inflation
expectations which followed the exchange rate depreciation and surge in food
prices, may have been contained.
The consensus CPIX forecasts produced from the Reuters August survey of longterm forecasts for the South African economy reveal that inflation is expected to
average 9,4 per cent in 2002 (this is the mean of 11 individual forecasts ranging
between 8,8 per cent and 9,7 per cent). CPIX inflation is then expected to decline
to 6,9 per cent in 2003 and 5,4 per cent in 2004. An analysis of the Reuters
consensus forecasts over time confirms the BER’s finding that most of the increase
in inflation expectations has been restricted to the 2002 forecast, which rose from
5,7 per cent in October 2001 to 9,4 per cent in August 2002. The increase in the
mean 2003 forecast was initially moderate (from 5,4 per cent in October 2001 to
6,2 per cent in June 2002), although it then rose to 6,9 per cent in August 2002 –
perhaps as expectations of a later turning point in the inflation surge took hold. By
contrast, the average forecast for CPIX inflation in 2004 has declined from
5,7 per cent in the December 2001 survey to 5,4 per cent in August 2002.
Another indicator of trends in longer-term inflation expectations may be obtained
from the spread between the yields on South African CPI inflation-linked bonds and
conventional nominal bonds of similar maturity. Disregarding the risk premium
associated with future inflation and differences in the liquidity of the bonds and their
payments patterns, these spreads or break-even inflation rates provide an indication
of expected inflation over the period until the bond matures. Figure 12 reveals that
inflation expectations obtained in this way from the R189 (maturing 2013) and
Table 7
BER survey of CPIX inflation expectations: 3rd quarter 2002*
Per cent


Source: Bureau for Economic Research, University of Stellenbosch
* Second-quarter results in parentheses

SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
R197 (maturing 2023) inflation-linked bonds resumed their downward trend at the
end of March 2002 after increasing sharply since December 2001. More recently
there appears to have been a slight reversal of this downward trend.
The Reserve Bank inflation forecast
The Reserve Bank’s latest projection for CPIX inflation over the forecast period from
the third quarter of 2002 to the end of 2003 is presented in Figure 13. The forecast
again employs the fan chart technique to indicate the uncertainties surrounding the
central projection (the March 2001 Monetary Policy Review provides a discussion of
this technique). The forecast incorporates the projected effects of the 100-basispoint increase in the repo rate announced on 12 September 2002.
Figure 13 shows that the central projection for the CPIX inflation rate is forecast to
peak at over 10 per cent in the fourth quarter of 2002 before declining to within the
6 per cent upper limit of the target range in the second half of 2003. As is always
the case with forecasts, risks were foreseen which could result in the actual inflation
outcome missing the central projection on either side. Factors that may be
detrimental in this regard include the possibility that the oil price will increase
substantially as a result of the current tensions surrounding Iraq, causing the oil price
to be higher than was assumed when compiling the forecast, and that administered
prices and unit labour cost may rise at rates which are not consistent with the
inflation targets. A stronger or weaker than expected performance of the exchange
rate would also add to the risk that the actual CPIX inflation outcome may be below
or above the central projection.
Figure 12
Breakeven inflation rates

Spread between R189 and R153 bonds
Spread between R197 and R186 bonds
Percentage points

MONETARY POLICY REVIEW October 2002
SA RESERVE BANK
Assessment and conclusion
Over the past few months the Bank has shown its determination to prevent the
external shocks that have hit South Africa from turning into an uncontrolled inflation
spiral. It is recognised that the action taken so far has been unpopular in some
quarters where it is argued that monetary policy has little role to play in dealing with
temporary external shocks. However, as seen above, the impact of the shocks has
not been temporary, and far from being isolated to limited categories, price
increases have become more generalised, and have also influenced inflation
expectations. In such circumstances the monetary authorities have no option but to
react. It has often been stressed in the past that failure to act sooner would result in
more drastic action later.
The next few months will be critical for the monetary policy outlook. As seen above,
despite the actions of the Reserve Bank, there are a number of factors which impart
upside risk to the achievement of the inflation target in 2003. On the international
front, the pace and extent of the global recovery will have an important effect on the
prospects for the rand. Also of importance will be developments between the United
States and Iraq. Not only would this conflict affect the oil price, but it could have a
significant impact on the speed of the global recovery. Clearly these events are not
something that monetary policy can counter directly, but their effects on inflation
cannot be ignored.
Figure 13
CPIX forecast
Per cent

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).

SA RESERVE BANK
MONETARY POLICY REVIEW October 2002
Domestically, what will be critical is the extent to which prices begin to react to the
monetary policy actions taken during the course of the year. It is well known that
monetary policy has a lagged effect, and steps taken earlier in the year should begin
to show results. The Bank’s forecasts, along with those of most other private-sector
forecasters, indicate that the turning point in the inflation rate is expected at some
time during the last quarter of 2002. Should this indeed occur, the previous actions
combined with base effects should culminate in a consistent downward trend in the
inflation rate. The sooner this happens, the quicker the reversal in negative inflation
expectations is likely to occur. The longer the postponement of this turning point, the
greater the difficulty in reducing inflation, and monetary policy may have to adjust
accordingly.