Monetary Policy
Review


May 2005
Monetary Policy
Review
May 2005
South African Reserve Bank
Monetary Policy Review May 2005
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ISSN: 1609-3194
South African Reserve Bank
Monetary Policy Review May 2005
Contents
Monetary Policy Review


Monetary Policy Review
Introduction
Despite increased uncertainty in the global environment since the publication of the
previous Monetary Policy Review in November 2004, the inflation outlook remains
favourable. Inflation has remained within the target range for the past 19 months, there
has been a significant decline in inflation expectations, and it is generally expected that
inflation will remain within the target range for the next two years. Primarily as a result of
these favourable developments, the repurchase rate was lowered by 50 basis points at
the April meeting of the Monetary Policy Committee (MPC).
The global environment has been characterised by uncertainties in recent months which
require consideration. Developments in international oil markets have been of particular
concern, as oil prices have reached record highs notwithstanding increases in output
levels, and market conditions seem destined to be tight for some time. These higher oil
prices have duly resulted in forecasts of global growth being revised downward. The
imbalances in the United States (US) economy also remain, as does the uncertainty
regarding the future path of the US dollar exchange rate.
Domestically, strong economic growth has been supported by robust domestic
expenditure and accompanied by a welcome expansion in formal non-agricultural
sector employment. However, some evidence of an exchange-rate related slowing in
activity has emerged in the mining and manufacturing sectors. The view of the MPC in
this regard is that a competitive and stable exchange rate is desirable for sustainable
economic growth.
As usual, the Monetary Policy Review analyses inflation developments and the factors
that have impacted on inflation, followed by an assessment of recent monetary policy
developments and a discussion of the outlook for inflation. Three topical issues are
focused on in the boxes. The first box discusses the long-term prospects for the
international oil market, while the second reviews developments in house prices in South
Africa and internationally. The final box looks at the objectives of monetary policy in
inflation-targeting monetary policy frameworks.
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
Figure 1 shows that the year-on-year increase in the consumer price index excluding
mortgage interest cost for metropolitan and other urban areas (CPIX), the measure
targeted by the Reserve Bank, extended its stay within the 3 to 6 per cent target range
to 19 consecutive months in March 2005. Since the publication of the previous
Monetary Policy Review in November 2004, when the available rate was 3,7 per cent for
September, CPIX inflation initially rose to 4,6 per cent in November 2004 before slowing
to 3,1 per cent in February 2005. In March, the rate increased once more to 3,6 per cent.
The analysis presented in this section suggests that these fluctuations have been largely
the result of movements in petrol and diesel prices.
South African Reserve Bank

Monetary Policy Review May 2005

Monetary Policy Review May 2005
For the calendar year 2004, average CPIX inflation was 4,3 per cent. Quarterly CPIX
inflation (measured as the annualised quarter-on-quarter rate of increase in the seasonally
adjusted data) accelerated from 2,7 per cent in the third quarter of 2004 to 5,0 per cent
in the final quarter, and then slowed to 2,1 per cent in the first quarter of 2005.
Inflation measured year on year in terms of the headline consumer price index (CPI) for
metropolitan areas increased from 1,3 per cent in September 2004 to 3,7 per cent in
November 2004, before slowing to 2,6 per cent in February 2005. In March, it rose to
3,0 per cent. On a seasonally adjusted and annualised basis, the quarter-on-quarter rate
of increase in the CPI accelerated from 2,5 per cent in the third quarter of 2004 to 4,9 per
cent in the fourth quarter, before declining to 2,3 per cent in the first quarter of 2005.
Table 1 shows the weighted contributions of the main components of the CPIX to the
year-on-year percentage changes discussed above. As can be seen, the recent
movements in the CPIX inflation rate are largely attributable to developments in the
transport component of the index. The contribution of this component increased from
0,6 percentage points in September 2004 to 1,1 percentage points in November, and
then declined to 0,2 percentage points in February 2005 before rising once more to
0,5 percentage points in March. The corresponding movements in the inland pump
price of unleaded petrol saw an increase from R4,54 per litre in September 2004 to
R4,85 per litre in November, followed by a cumulative 65-cent decline to R4,20 a litre in
February 2005 and increases to R4,62 per litre in March and R5,02 per litre in April (the
latter includes the increase of 5 cents per litre in the Fuel Levy and 5 cents per litre in
the Road Accident Fund Levy announced by the Minister of Finance in his Budget
Speech in February).
The contributions of the other main components of the index remained relatively
constant over the period under review. The food component contributed between
0,4 and 0,5 percentage points to overall CPIX inflation, while the contribution of the
housing component increased from 0,8 percentage points during October and
South African Reserve Bank
Percentage change over twelve months

CPI

CPIX
Figure 1
Consumer price inflation: CPIX and CPI
Source: Statistics South Africa
South African Reserve Bank
November 2004 to 0,9 percentage points during the following three months before
declining once more to 0,8 percentage points in March. Finally, the contribution of the
medical and health care component decreased from 0,7 percentage points in
September 2004 to 0,5 percentage points in January 2005 before rising once more to
0,7 percentage points in March.
Figure 2 illustrates the effect of excluding energy and food prices from the CPIX inflation
measure. Energy prices have been the dominant factor determining the observed
fluctuations in CPIX inflation in the period under review. Once energy prices are excluded
from the overall CPIX, the rate of increase in the remaining prices increased slightly from
3,4 per cent in September 2004 to 3,7 per cent during November 2004 before declining
to 3,3 per cent in March 2005. Food prices, by contrast, continued to have a moderating
effect on the overall CPIX inflation rate. Excluding this component, CPIX inflation
increased from 4,2 per cent in September 2004 to 5,5 per cent in November 2004
before recording 3,8 per cent in February 2005 and 4,3 per cent in March.

Monetary Policy Review May 2005
Table 1
Contributions to year-on-year CPIX inflation
Percentage change over twelve months* and percentage points
Component
Sep
Oct
Nov
Dec
Jan
Feb
Mar


Of which:

Medical care and health expenses....

Source: Statistics South Africa
Percentage change over twelve months

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


Figure 2
The effect of food and energy prices on CPIX


inflation

Monetary Policy Review May 2005
The inflation rates for the goods and services categories of CPIX are presented in Figure 3.
As the graph shows, services price inflation trended downward throughout 2004 and into
2005, declining to below the upper end of the inflation target range in January 2005 for the
first time since the introduction of inflation targeting. The year-on-year inflation rate for
services prices increased from 6,3 per cent in September to 6,6 per cent in November 2004
before receding to 5,6 per cent in February 2005. In March, the services price inflation rate
was 5,9 per cent. Goods prices, by comparison, rose by 3,6 per cent over the twelve
months to November 2004 before decelerating to 2,3 per cent by March 2005.
As the construction of the official index of administered prices by Statistics South Africa
is still under way, the index of administered prices calculated by the Reserve Bank is
presented in Figure 4 (Box 1 in the April 2002 Monetary Policy Review provides details).
Since petrol has a weight of 20,7 per cent in this calculation (5,08 per cent in the CPIX
basket), the recent fluctuations in petrol prices have had a significant influence on the
index. The year-on-year inflation rate for the administered price index increased from
6,8 per cent in August 2004 to 10,0 per cent in November 2004, with petrol prices
contributing 4,4 percentage points to this total. The rate then declined to reach 5,6 per
cent in February 2005 before rising to 6,9 per cent in March (petrol prices contributing
0,5 and 1,8 percentage points, respectively). Excluding the petrol component, therefore,
the inflation rate for the remaining administered prices continued the downward trend
began in mid-2003, reaching 6,3 per cent in March 2005.
The overall production price index (PPI) inflation rate began to rise in May 2004 but
production price inflation has since remained low (Figure 5). Twelve-month PPI inflation
increased to 2,5 per cent in November 2004 before declining to 1,4 per cent and
1,2 per cent during January and February 2005, respectively. In March, an inflation rate
of 1,9 per cent was recorded. This subdued performance can be attributed mainly to the
impact of the stronger exchange rate of the rand and low inflation rates in South Africa’s
main trading partners on the production prices of imported goods. Figure 5 shows that
prices of these goods increased by 0,3 per cent in January, declined by 0,7 per cent in
South African Reserve Bank
Percentage change over twelve months

Goods
Services
CPIX

Figure 3
CPIX: Goods and services inflation
Source: Statistics South Africa
February, and rose by 0,7 per cent in March 2005. The year-on-year inflation rate for
domestically produced goods has also been relatively subdued, increasing from 2,4 per
cent in September 2004 to 3,4 per cent in November before slowing to 2,3 per cent in
March 2005. Excluding energy prices, production prices have declined on a year-onyear basis in each month since October 2004.
South African Reserve Bank

Monetary Policy Review May 2005
Percentage change over twelve months

Administered price index (API)

API excluding petrol

CPIX
Source: Statistics South Africa and SARB calculations

Figure 4
CPIX and administered prices
Percentage points* and percentage change over twelve months

-5

Contribution of:


Imported component*


Domestically produced component*

Production price index (PPI)

PPI excluding energy prices
Source: Statistics South Africa
Figure 5
Production price inflation

Monetary Policy Review May 2005
Measured as the annualised quarter-on-quarter rate of increase in the seasonally
adjusted data, PPI inflation slowed from 1,5 per cent in the third quarter of 2004 to
0,9 per cent in the final quarter, and then declined by 0,5 per cent in the first quarter
of 2005.
Factors affecting inflation
Recent developments in some of the main drivers of inflation are reviewed in this section,
including domestic and international factors. In a later section the outlook for these
variables and, therefore, for inflation, is presented.
International economic developments
After growing strongly in late 2003 and early 2004, global growth has moderated partly
as a result of higher international oil prices. A growth rate of 5,1 per cent, the highest for
the world economy in nearly 30 years, was nevertheless reported by the International
Monetary Fund (IMF) for 2004 (Table 2). The expansion has, however, tended to become
less balanced, although the inflation environment remained for the most part benign,
with little evidence of second-round effects from higher oil prices.
Table 2
Annual percentage change in real gross domestic product and
consumer prices
Real GDP
Consumer prices


Source: IMF World Economic Outlook, April 2005
Growth of 3,4 per cent in the advanced economies in 2004 was aided by a strongerthan-expected expansion in the US which offset disappointing growth in Europe and
Japan. In the US, real gross domestic product (GDP) growth accelerated from 3,0 per
cent in 2003 to 4,4 per cent in 2004, although third and fourth-quarter annualised
growth rates moderated to 4,0 and 3,8 per cent, respectively. The United Kingdom (UK)
economy also slowed gradually through the year, as the Bank of England’s Monetary
Policy Committee raised the cost of borrowing by a quarter percentage point on five
occasions between November 2003 and August 2004. However, growth remained
robust at 3,1 per cent for 2004.
South African Reserve Bank
In the euro area, GDP growth for 2004 as a whole was 2,0 per cent, compared with
0,5 per cent in 2003, while growth in Japan has continued to be uneven. The growth
performance was very strong from mid-2003 to early 2004, but a sharp slowdown was
recorded in the latter part of last year. Consequently, although 2,6 per cent growth was
recorded for 2004 as a whole, the Japanese economy registered approximately zero
expansion in the last three quarters of the year.
Developing Asia generated considerable economic momentum in 2004 when GDP
growth averaged 8,2 per cent, the fastest growth rate since the 1997-98 Asian financial
crisis. This was aided by China’s real GDP growth of 9,5 per cent, despite efforts by the
Chinese government to slow the economy in 2004. India also grew strongly at 7,3 per
cent. In spite of the terrible humanitarian cost of the tsunami resulting from the
earthquake that occurred off the northwest coast of Sumatra on 26 December 2004, the
impact of the catastrophe on growth in the region is expected to be limited.
In Latin America growth exceeded expectations in 2004, with Brazil growing at 5,2 per
cent, while Central and Eastern Europe experienced their strongest growth since the
beginning of the transition to more market-oriented economic systems. In the
Commonwealth of Independent States higher-than-expected growth was driven largely
by buoyant domestic demand and high energy and metals prices. Robust growth of
5,5 per cent was also recorded in 2004 by the oil-exporting countries of the Middle East.
Sub-Saharan Africa posted its highest GDP increase in a decade as strong global demand and
prices for commodity exports, better macroeconomic policies and structural reforms in a
number of countries in the region provided an encouraging boost to the poverty-reduction
efforts of these countries. Economic growth in sub-Saharan Africa amounted to 5,1 per cent
in 2004, with particularly impressive growth being recorded by the oil-producing countries.
Oil prices
The strong global economic recovery has contributed to upward pressure on commodity
prices and especially to a sharp increase in international crude oil prices during 2004.
Excess capacity in the Organization of the Petroleum Exporting Countries (OPEC) has
reached record low levels and actual oil production exceeded current output quotas
during the past two years. The discussion in Box 1 suggests that conditions in the
international oil market may indeed remain tight in the longer term.
The price of Brent crude oil increased significantly from around US$30 per barrel at the
beginning of 2004 to US$52 per barrel in October before falling to below US$37 per
barrel in early December (Figure 6). Crude oil prices began to increase once more in
December after OPEC requested member countries to reduce actual production by
1 million barrels per day from January 2005 to meet the previously agreed output quota
of 27 million barrels per day. OPEC decided in January to maintain the agreed output
quotas but announced that the price band mechanism would be temporarily
suspended, pending the completion of further studies on the subject. Crude oil prices
continued to be highly volatile and reached levels of around US$47 per barrel towards
the end of January before dropping below US$44 per barrel in early February after the
elections in Iraq passed without disruptions to oil production.
Crude oil prices started to increase towards the end of February and accelerated further
during March after the International Energy Agency (IEA) increased its estimate for global
oil demand in 2005 for the third consecutive month. The IEA projected in December 2004
that global oil demand would increase to 83,7 million barrels per day in 2005. However,
South African Reserve Bank

Monetary Policy Review May 2005

Monetary Policy Review May 2005
the March 2005 IEA projections showed oil demand in 2005 increasing to 84,3 million
barrels per day. OPEC countries decided in March to increase output quotas
immediately by 500 000 barrels per day and pledged an additional 500 000 barrels per
day should oil prices not decline. The price of Brent crude oil, however, increased further
to levels around US$55 per barrel as markets feared that global oil production might fail
to keep pace with rising demand.
Crude oil prices again declined to around US$50 per barrel towards the end of March
but increased above US$55 per barrel in early April following a research report released
by Goldman Sachs that revised its “superspike range” to US$50 – US$105 per barrel in
the next several years. Crude oil prices have since declined to levels around
US$50 per barrel due to favourable pronouncements regarding production levels in
OPEC countries. The IEA also lowered its forecasts for global oil demand marginally by
50 000 barrels per day in its April 2005 montly report.
South African Reserve Bank
Box 1
Prospects for the world oil market
The long-term prospects for the international oil market appear to have taken a turn for the worse.
Although current prices are well below the levels reached in the 1970s when measured in real terms,
and the magnitude of the recent increases is limited relative to those experienced at that time, the
longer-run outlook for the oil market suggests that there is a significant risk that conditions may
remain tight. This is the view of the IMF 1, for example, whose analysis appears qualitatively consistent with that of other relevant institutions such as the International Energy Agency (IEA), the OPEC
Secretariat and US Department of Energy (DoE). This box discusses these recent projections for the
international oil market.
Although nominal oil prices have reached record highs in recent months, it is important to keep in
mind the historical perspective provided by Figure B1.1. As the graph shows, and as a number of
commentators have stressed, prices measured in real US dollar terms are far below the levels
reached in the late 1970s and early 1980s. It is also clear from the graph that the price increases
experienced in recent months are not nearly as severe as those of 1974 and 1979.
US dollars per barrel

Source: Bloomberg
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Figure 6
Price of Brent crude oil

The discussion of this view
is based on Chapter 4 of the
World Economic Outlook, April
2005 and "Oil Market Developments and Issues", Policy
Development and Review Department, IMF, 1 March 2005.
South African Reserve Bank

Monetary Policy Review May 2005
A fundamental determinant of oil prices now and in the future is the balance between supply and
demand for oil in the various markets. In the shorter term, when temporarily higher demand (e.g. as
a result of a cold winter) or supply disruptions cause market conditions to tighten, the risk of price
spikes increases. Provided the longer-term prospects for oil prices remain favourable, as they
generally have in the 1985-2000 period, the impact of these increases on investment decisions and
growth tends to be limited. When the likely evolution of the supply-demand balance over a longer
horizon suggests that conditions will remain tight, however, these increases are likely to have a more
significant impact on expectations and growth.
The balance between supply and demand in the oil market in the longer term is influenced by a
complex set of factors which tend to act with long lags. Current oil prices are an important factor,
for example. On the one hand, higher oil prices tend to encourage economies to reduce their
dependence on oil, and also provide an incentive for producers to expand their production capacity
and to facilitate the use of unconventional sources. As Federal Reserve Chairman Alan Greenspan
recently said, “... if history is any guide, should higher prices persist, energy use will over time
continue to decline, relative to GDP” 2. The dependence of OECD economies on oil has undoubtedly
declined over time, largely in response to the earlier oil price shocks of the 1970s and 1980s,
although developing countries remain more energy-intensive in production. On the other hand, low
current prices discourage energy conservation and investment in future production capacity.
Regarding the latter, it is interesting that following the lower oil price environment of 1985-2000,
OPEC’s current production capacity is estimated by the IMF to be below the level of 1978.
Increases in supply are of course ultimately limited by the extent of unexploited reserves and the cost
of exploiting these reserves. The distribution of reserves between the OPEC and non-OPEC countries
is also a factor which will influence developments in the global oil industry. The IMF suggests that the
responsiveness of non-OPEC oil supply is the key unknown in its projection of the supply-demand
balance. If, as the IMF believes, supply from these countries will peak by 2010, then the importance
of OPEC supply in meeting additional demand will increase after this date.
Taking these factors into account, then, what are the projections for demand and supply in the
coming years? In line with the discussion of non-OPEC supply in the preceding paragraph, the
baseline price path in the IMF’s World Economic Outlook forecast is for the real price of oil (a simple
average of West Texas Intermediate, Brent and Dubai prices) to decline from US$44,70 in 2005 to
US$33,70 a barrel in 2010, and then to remain at this level until 2030. Table B1.1 shows the projected
oil demand, non-OPEC supply and the residual “call on OPEC”3 for the period 2010 to 2030.

Remarks by Chairman Alan
Greenspan before the National
Petrochemical and Refiners
Association Conference, San
Antonia, Texas, 5 April 2005.

This is the hypothetical
amount that OPEC would need
to produce to meet the shortfall
between total demand and nonOPEC supply in the market.
US$ per barrel

Figure B1.1
Brent crude oil prices

UK Brent (constant 2000 prices)

UK Brent (nominal)
Source: IMF, International Financial Statistics

Monetary Policy Review May 2005
Key central bank interest rates
Table 3 presents the most recent interest rate changes made by central banks around the
world. The US Federal Open Market Committee (FOMC) increased the target for the
Federal Funds Rate in May 2005 to 3,0 per cent, the eighth consecutive 25-basis-point
increase since the record low level of 1,0 per cent in June 2003. The FOMC noted that
output was continuing to grow at a solid pace and that inflationary pressures had
South African Reserve Bank
As can be seen, the IMF’s baseline projection is for global oil demand to increase to 92 million
barrels per day in 2010, 113,5 million barrels per day in 2020 and eventually to 138,5 million barrels
per day by 2030. Lower and upper boundaries are then provided for growth in non-OPEC supply,
with the lower bound showing no increase in supply after 2020. The call on OPEC in order to meet
projected demand therefore varies according to the path followed by non-OPEC supply. If this is at
the lower bound, for example, the call on OPEC increases (according to the upper bound in the
table) to 32,7 million barrels per day in 2010, 49,2 million barrels per day in 2020 and to 74,4 million
barrels per day by 2030. The table also presents alternative oil demand projections by other
agencies and corresponding estimates of the call on OPEC for comparison purposes.
The call on OPEC is projected to grow significantly over the coming years in the baseline projections
presented by the IMF. After initially remaining approximately unchanged at around 32 million barrels
per day until 2010, it then doubles to 61 – 74 million barrels per day in 2030. Significant investment
spending will be required to meet this increase in demand, and concerns in this regard have been
voiced. Since proved oil reserves are concentrated in its member countries, OPEC’s response to
the increase in demand will be the key determinant of future developments in the supply-demand
balance and oil prices.
Although projections such as these provide important insights regarding the factors which are likely
to influence the oil market, the IMF correctly stresses that long-run forecasts for oil supply and
demand are subject to substantial uncertainties. Besides assumptions regarding the rate of global
growth in future and the rate of growth of non-OPEC supply, more fundamental factors such as the
manner in which technological progress will impact on the projections need to be considered. While
this means that the risks to the projections are necessarily large, the importance of developments
in the energy markets for policy-makers makes the exercise useful.
Table B1.1
Projections: Oil demand, non-OPEC supply and call
on OPEC
Millions of barrels per day

Actual Estimate

Non-OPEC supply

Call on OPEC

Memorandum:
Oil demand projection by agency

Call on OPEC by agency

Source: Reproduced from IMF World Economic Outlook, April 2005, p 170
increased in recent months. The committee wanted to keep the upside and downside
risks to sustainable growth and price stability equal, and believed that the existing
monetary policy accommodation could be removed at a measured pace.
Table 3
Key central bank interest rates
Per cent
Countries
1 Jan
3 May
Latest change

(percentage points)
1,00
3,00
3 May 2005
(+0,25)
0,00
0,00
19 Mar 2001
(-0,15)
2,00
2,00
6 Jun 2003
(-0,50)
3,75
4,75
5 Aug 2004
(+0,25)
2,75
2,50
19 Oct 2004
(+0,25)
2,00
2,00
6 Jun 2003
(-0,50)
2,75
2,00
7 Apr 2004
(-0,50)
0 – 0,75
0,25 – 1,25
16 Sep 2004
(+0,25)
5,25
5,50
2 Mar 2005
(+0,25)
5,00
6,75
10 Mar 2005
(+0,25)
4,80
3,50
1 Feb 2005
(-0,20)
5,31
5,58
29 Oct 2004
(+0,27)
2,50
4,25
23 Mar 2005
(+0,25)
8,31
7,70
20 Apr 2005
(+0,17)
,**
2,70
23 Apr 2004**
3,75
3,25
11 Nov 2004
(-0,25)
1,38
1,88
24 Mar 2005
(+0,13)
1,25
2,25
2 Mar 2005
(+0,25)
4,50
5,00
28 Apr 2005
(+0,25)
16,50
19,50
20 Apr 2005
(+0,25)
2,25
3,00
7 Apr 2005
(+0,25)
2,00
1,75
29 Apr 2005
(-0,25)
12,50
7,50
26 Apr 2005
(-0,25)
5,25
5,50
27 Apr 2005
(-0,50)
16,00
13,00
15 Jun 2004
(-1,00)
*
Japan eased monetary policy several times during 2003 and again in January 2004 by increasing the target range for the
outstanding balance on reserve accounts at the Bank of Japan
**
The central bank of Malaysia introduced a new interest rate framework on 23 April 2004
Source: National central banks
The Bank of England (BOE) raised its repo rate by 25 basis points in August 2004 to
4,75 per cent, following three similar moves earlier in 2004 to keep inflation on track and
meet the inflation target in the medium term. The BOE has since left interest rates
unchanged, although some members of its Monetary Policy Committee are in favour of
higher interest rates due to high growth in demand in the UK economy.
The European Central Bank (ECB) has kept its official interest rate unchanged at 2 per cent
since June 2003 and is satisfied that there is no significant evidence of underlying domestic
inflationary pressures building up in the euro area. However, the ECB will continue to
monitor the medium-term upside risks to price stability given the high level of international
oil prices. Although the Bank of Japan has maintained its policy interest rate near zero
since 2001, it has eased monetary policy several times during 2003 and again in January
2004 by increasing the target range for the outstanding balance on reserve accounts held
by private financial institutions at the Bank of Japan. The monetary authority is currently
willing to provide sufficient liquidity to the markets until the year-on-year rate of change
in core consumer prices registers zero per cent or higher on a sustainable basis.
South African Reserve Bank

Monetary Policy Review May 2005

Monetary Policy Review May 2005
After having kept monetary policy unchanged since the end of 2003, the Reserve Bank
of Australia increased its cash rate by 25 basis points to 5,5 per cent in March 2005.
This increase was considered necessary due to a gradual increase in underlying inflation
and limited spare capacity in the economy. The Reserve Bank of New Zealand has
increased its official cash rate by a cumulative 175 basis points to 6,75 per cent since
the beginning of 2004 as inflationary pressures remained strong.
Brazil’s central bank raised its benchmark lending rate to 19,50 per cent in April 2005
following evidence of inflationary pressures and the increase in oil prices. The year-onyear increase of 7,5 per cent in Brazil’s consumer prices in March is still higher than the
inflation target of 5,1 per cent for 2005. The central bank of Chile increased its key
interest rate by 25 basis points to 3,0 per cent in April 2005 due to robust domestic
expenditure and a gradual increase in core inflation.
The pronounced disinflationary trends in the Czech Republic, Hungary and Poland
provided the opportunity for the respective central banks to reduce their interest rates
further in April 2005. The Bank of Israel also lowered its short-term interest rate by
40 basis points during January and February 2005.
China tightened monetary policy for the first time in nine years in October 2004 due to
concerns about the overheating of its economy. Interest rates in China were increased
by 27 basis points to 5,58 per cent. The Bank of Thailand increased its 14-day
repurchase rate by a cumulative 75 basis points in 2004 and a further 25 basis points
in March 2005 to 2,25 per cent. The Bank of Thailand expects strong economic growth
in the coming months as the negative impact of the tsunami disaster has been less
severe than previously anticipated, although the impact of higher oil prices is expected
to start feeding through to inflation. Taiwan also raised interest rates in March 2005 to
1,88 per cent. By contrast, the Bank of Korea lowered the target for the overnight call
rate by a cumulative 50 basis points to 3,25 per cent during 2004 due to a slowdown
in the pace of recovery and subdued consumer demand.
Exchange rate developments
The exchange rate of the rand measured against a basket of currencies is currently
around its average level for the past 10 months. As the graphs in Figure 7 show, the
nominal effective exchange rate of the rand appreciated in the period between August
and December 2004 partly as a result of US dollar weakness, and then trended
downward once more in 2005. As usual, the performance of the rand in the period since
the publication of the previous Monetary Policy Review in November 2004 has been
influenced by both international and domestic factors.
Movements in the exchange rate of the US dollar against a broad spectrum of
currencies have been an important factor affecting the rand in this period. The dollar
initially strengthened from the end of 2004 to mid-February 2005 as a result of
favourable pronouncements and economic data releases, and the 25-basis-point
increase in the Federal Funds Rate on 2 February. The currency then weakened on
international markets until early March, influenced by continued concerns about the
increasing US trade deficit and speculation about possible central bank diversification of
foreign exchange reserves from US dollars into alternative currencies. Subsequently,
however, the dollar strengthened once more, supported by a further 25-basis-point
increase in the Federal Funds Rate on 23 March and positive consumer and producer
data released for February.
South African Reserve Bank
Various other factors have also contributed to the recent performance of the rand.
International perceptions of South Africa’s economic fundamentals continued to improve,
influenced by factors such as a more favourable growth performance, an improved foreignexchange reserve position, continued sound fiscal management and better inflation
performance. A ratings upgrade was consequently received from Moody’s Investor Services
in January 2005. The period under review also saw a significant inflow of capital. The last
quarter of 2004 saw net purchases of about R24 billion worth of bonds and equities by
foreign investors, followed by a further R7,8 billion from January to March 2005. Partly
absorbing these flows, the deficit on the current account of the balance of payments
widened once more in the fourth quarter of 2004 as increases in the value of imports and
net service and income payments more than offset the growth in export values.
Reserve accumulation
Figure 8 reveals that the South African Reserve Bank has continued to purchase foreign
exchange in order to build up reserves in a gradual manner. The Bank’s gross reserves
increased from US$12,4 billion at the end of September 2004 to US$15,9 billion at the
end of March 2005, while the international liquidity position (net reserves) improved from
US$9,0 billion to US$12,4 billion over the same period.
South African Reserve Bank

Monetary Policy Review May 2005
Index: 2000=100 (foreign currency per rand)
Rand per euro
Rand per US dollar
Figure 7
Exchange rates of the rand
Jan
Mar
May

Jul
Sep
Nov
Jan
Mar

Nominal effective exchange rate of the rand (NEER)

Rand per US dollar

Rand per euro (right-hand scale)

Monetary Policy Review May 2005
Unit labour cost
Developments in unit labour cost, measured as the ratio of remuneration per worker to
output per worker in the formal non-agricultural sector of the economy (Figure 9), require
careful consideration in the period under review. Revisions to the Survey of Employment
and Earnings by Statistics South Africa now show nominal remuneration per worker
South African Reserve Bank
US$ millions
-5000

10000
15000
20000

Gross reserves

International liquidity position


Figure 8
Official reserve position of the South African

Reserve Bank
Percentage change over four quarters

Figure 9
Renumeration per worker, labour productivity

and unit labour cost in the formal

non-agricultural sector

Nominal unit labour cost

Remuneration per worker

Labour productivity
Source: Statistics South Africa

growing by 7,3 and 10,5 per cent year on year in the third and fourth quarters of 2004,
respectively, although the latter increase in particular is well above the annual average
results obtained from surveys of wage settlements. Average nominal wage settlements
are reported by Andrew Levy Employment Publications to be 6,8 per cent for 2004, and
6 per cent in the first quarter of 2005. With the downward trend in labour productivity
growth continuing, year-on-year unit labour cost duly increased by 6,6 per cent in the
third quarter and by 10,1 per cent in the fourth quarter of 2004.
The growth in labour productivity has declined continuously from 5,2 per cent in the third
quarter of 2003 to 0,4 per cent in the final quarter of 2004. Measured here as the ratio of
real value added to employment in the formal non-agricultural sector, this decline is largely
attributable to increases in employment more than offsetting increases in real value added.
Demand and output
Since the November 2004 Monetary Policy Review, Statistics South Africa and the
South African Reserve Bank have published a revised set of national accounts data for
the post-1997 period. The exercise resulted in level adjustments to the data and also
involved changing the base year from 1995 to the year 2000. Table 4 examines the
recent growth in real GDP using these data.
Table 4
Growth in real gross domestic product and expenditure
components
Per cent

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

Final consumption expenditure

Quarterly data refer to quarter-on-quarter growth at annual rates of seasonally adjusted data
*
Constant 2000 prices
Buoyed by sustained strong growth in domestic demand, the growth rate of real GDP
accelerated to 5,7 per cent in the third quarter of 2004 before easing to 4,0 per cent in
the final quarter of the year. For 2004 as a whole, real GDP growth increased to 3,7 per
cent from 2,8 per cent in 2003.
Domestic spending has generally been the main driver of this expansion, supported by
growth in disposable income, buoyant real-estate and securities markets, and a
favourable interest rate environment. Despite slowing to 2,6 per cent in the third quarter
of 2004 largely as a result of weak final consumption expenditure by government, real
domestic expenditure increased by 4,4 per cent in the fourth quarter and by 6,3 per cent
overall in 2004. The three main components of real final demand all contributed strongly
in this regard. Final consumption expenditure by private households and general
South African Reserve Bank

Monetary Policy Review May 2005

Monetary Policy Review May 2005
government increased by 6,1 per cent and 7,2 per cent, respectively, in 2004 and
growth in gross fixed capital formation was even higher at 9,4 per cent. The increase in
domestic demand coupled with the stronger exchange rate also stimulated growth in
expenditure on imports of goods and services, which after slowing to 0,5 per cent in the
third quarter jumped to 23,3 per cent in the final quarter, contributing to overall growth
of 12,9 per cent for the year. Exports of goods and services, having contracted in 2003
and in the first quarter of 2004, increased once more in the last three quarters of the year
to record growth of 2,9 per cent overall.
Real output growth tended to be strongest in those sectors primarily oriented towards
the domestic market in response to the expansion in expenditure. The slower growth
recorded in the final quarter of the year was mainly the result of weakness in the primary
and secondary sectors, and especially in the mining and manufacturing sectors which
are most exposed to the effects of the stronger currency. However, in 2004 as a whole,
the primary sector was able to expand real value added by 3,3 per cent, the secondary
sector by 2,9 per cent, and the tertiary sector by 4,1 per cent.
Real-estate and equity prices
Robust growth has been a striking feature of the South African real-estate market in
recent years, although house price increases have slowed in recent months. Figure 10
presents the year-on-year increases in house prices measured by the Absa house price
index. This index records the total purchase price of houses in the 80 – 400 m2 size
category which are priced at less than R2,2 million and for which loan applications were
approved by Absa. After peaking at just over 35 per cent in September 2004, growth in
nominal house prices declined to reach 26,9 per cent in March 2005. In real terms, the
corresponding rates are 33,7 per cent in September 2004 and 23,2 per cent in March
2005. Box 2 provides an international perspective on these developments.
South African Reserve Bank
Percentage change over twelve months

Absa house price index (nominal)

Absa house price index (real)
Source: Absa
Figure 10
House prices
A factor which may help explain the slower growth in house prices is the impact of
buoyant market conditions on the affordability of houses. Figure 11 presents two indices
which serve as proxies of affordability. In both cases an increase in the index represents
a decline in affordability. The first (PDI) is simply the ratio of the indices of Absa nominal
house prices to per capita disposable income. This broad measure shows that
affordability has been deteriorating since 1997 as house prices have risen faster than
increases in disposable income. The second measure (RDI), which is calculated as the
ratio of mortgage repayments on an average priced house to per capita disposable
income suggests, however, that there has been limited deterioration in affordability in
recent years. Since this measure takes into account both house prices and the mortgage
interest rate, increases in house prices which exceed increases in disposable income may
be offset by lower interest cost.
The values of building plans passed and completed are important indicators of realestate sector activity. Table 5 shows that the values of both building plans approved and
completed remain strong, particularly in the residential real-estate sector. The growth in
the real value of buildings completed increased from 6,8 per cent in 2003 to 22,5 per
cent in 2004, while the real value of building plans passed, a measure of future
construction activity, increased by 33,0 per cent in 2004 compared with 11,3 per cent
in 2003. The increases recorded in January – February 2005 relative to the corresponding months of 2004 were 9,9 per cent for the real value of building plans passed,
and 20,4 per cent for the real value of buildings completed.
South African Reserve Bank

Monetary Policy Review May 2005
Indices: 2000=100

Figure 11
Housing affordability indices

PDI

RDI
Source: Absa and SARB calculations
Note: A down payment of 20 per cent is assumed in the calculation of RDI. The
mortgage rate is proxied by the predominant rate of banks for dwelling units, and
the monthly repayment is calculated over a period of 20 years.

Monetary Policy Review May 2005
South African Reserve Bank
South African Reserve Bank

Case K E, J M Quigley and
R J Shiller. 2001. "Comparing
Wealth Effects: The Stock
Market Versus the Housing
Market", Cowles Foundation
Discussion Paper No. 1335,
Yale University, October.

For example Tsatsaronis K
and H Zhu. 2004. "What drives
housing price dynamics: crosscountry evidence". BIS Quarterly
Review, March; and Sutton G D.
2002. "Explaining changes in
house prices". BIS Quarterly
Review, September.
Box 2
Housing price dynamics: An international perspective
The behaviour of house prices is attracting attention in the media and from policy-makers in a
number of countries around the world, in part due to the growing realisation of their importance for
both monetary policy and financial stability in general. This box briefly discusses why house prices
may matter, and reviews developments in these prices in South Africa and internationally. An analysis
of trends in inflation-adjusted house prices in the post-1980 period is presented, and the factors
which drive these trends are considered.
Why are developments in house prices important?
A house is typically the most valuable asset a household owns. For financial intermediaries, the
mortgages raised to finance the ownership of residential real estate constitute a significant portion of
their portfolios. Fluctuations in house prices are therefore important to both groups, and by extension
to the wider economy. Research suggests that changes in housing wealth influences consumption
behaviour, for example1, and that house prices play a potentially important role in the transmission of
monetary policy via wealth and balance sheet effects (see Box 3, May 2004 Monetary Policy Review).
In addition, the importance of mortgages in the asset-backed finance portfolios of banks and other
financial intermediaries means that house prices also influence the performance of these institutions
and of the financial system itself.
Trends in house prices
Figure B2.1 presents inflation-adjusted house price indices for South Africa, Australia, the United
Kingdom, Ireland, Canada and the United States. Although these indices may not be fully comparable
between countries, given differences in measurement, they do provide a sense of the general trends –
the long swings which are evident in the prices. Consistent with the findings of other studies2, two
periods of rapid growth can be observed in the graphs. The first of these is in the 1980s, followed first
by a slowdown in the early 1990s as the global economy slowed, and then by a second period of
growth which is most notable from the mid-1990s.
These broad trends disregard important differences in the experiences of the countries, however.
Growth in house prices in Canada and the US, for example, has tended to be less volatile than in the
other countries in Figure B2.1, although real house prices are nevertheless at historic highs in the US
at present. Also, the more recent upswing appears to have begun earlier in the UK, Australia and the
US than in South Africa, where prices accelerated late in the decade.
What drives house prices?
House prices, like other prices, are determined by demand and supply factors. Tsatsaronis and Zhu
(2004), for example, distinguish between factors that operate in the longer term, and those that
impact on the shorter-term dynamics of house prices. Furthermore, differences in the characteristics
of national housing markets mean that these factors may affect house prices differently in different
countries. In fact, this is the case even within countries.
In the longer term, the demand for housing would tend to be positively related to household income
and wealth (both current and expected). Moreover, since a house is a long-lived asset that provides
services over an extended period, the current and future interest rates used to discount this stream
of services is an important determinant of its price. It follows, therefore, that a shift to a lower inflation
environment that reduces these interest rates would tend to boost house prices. Shifts in
demographics (e.g. population movements or changes in the age profile which impacts on the
number of potential new buyers), amendments to the tax system that favour home ownership or
changes in the financial service markets that promote ownership would also impact on demand. The
supply of housing is influenced in the longer term by factors such as the availability of land, the
existing stock of housing and the cost of adding to this housing stock.
Supply factors tend to be relatively inflexible in the shorter term, while the planning and construction
phases involved in expanding the housing stock occur. Consequently, movements in house prices at
this horizon may be attributed largely to demand factors. Demand factors which have received
attention in the literature include the prevailing conditions relating to the financing of house
purchases, the transaction cost framework and the general level of confidence in the housing market
(which may remain low, e.g. following a period of volatility; Tsatsaronis and Zhu, 2004).
South African Reserve Bank

Monetary Policy Review May 2005
Even though houses are not physically transferable, factors such as stronger global growth and the
structural shift to lower inflation and interest rates in the 1990s are universal drivers of rising house prices.
To the extent that the various demand and supply factors are national in character, however, the
dynamics of house prices may differ across countries. In South Africa, declines in inflation and interest
rates have been bolstered by a number of idiosyncratic factors which have supported the positive
momentum in housing demand. There have been gradual reductions in both personal income taxes and
transfer costs, and the growing economy has generated not only increases in income but has begun to
modify its distribution. Greater access to the mainstream housing markets by previously excluded
communities has contributed to the increased demand for housing. South Africa has also seen changes
in the financial sector that have impacted on the dynamics of house prices, such as the emergence of
securitisation of mortgage assets and the extension of the duration of mortgages. Collectively, these
global and national factors explain the recent trends in house prices in South Africa.
United States
Figure B2.1
Inflation-adjusted house prices*
Indices: 1995=100
United Kingdom
Indices: 1995=100
Canada
Indices: 1995=100
Australia
Indices: 1995=100
* Deflated using CPI data. For Ireland, quarterly house price data for the period 1980–98 are derived from annual data using the quadratic match
average interpolation method.
Sources: Bloomberg, Absa, Nationwide, Irish Department of Environment and Local Government, Office of Federal Housing Enterprise Oversight
and IFS.
Ireland
Indices: 1995=100
South Africa
Indices: 1995=100

Monetary Policy Review May 2005
South African Reserve Bank
Table 5
The real value of building plans passed and buildings completed
Percentage change

2005*
Building plans passed

Buildings completed

These figures are for January – February 2005 compared to the corresponding months of 2004
Source: Statistics South Africa
The lower domestic inflation and interest rate environment, good corporate performance,
high international commodity prices and stronger global equity markets provided support to
equity prices on the JSE Securities Exchange SA (JSE) until mid-March 2005. The closing
level of the daily all-share price index as depicted in Figure 12 shows a continued upward
trend in share prices from mid-2004, reaching a record high of 13 761 on 17 March 2005.
The index then fell to below 12 500 at the end of April as world markets weakened. The
resources index, which performed sluggishly between October and mid-December 2004,
in part due to the strengthening of the exchange rate, then rose to reach a historic high level
of 12 473 on 17 March 2005, before declining to around 10 650 at the end of April.
Fiscal policy
Government’s fiscal policies remain supportive of monetary policy. The Budget
presented on 23 February 2005 estimates total revenue for the 2005/06 fiscal year at
R369,9 billion and makes provision for total expenditure of R417,8 billion, resulting in an
Indices


FTSE/JSE all-share index
FTSE/JSE resources index
Figure 12
Share price indices
South African Reserve Bank

Monetary Policy Review May 2005
estimated budget deficit of R48,0 billion (Table 6). This represents 3,1 per cent of GDP.
The budget deficit as a proportion of GDP is projected to decline to 3,0 and 2,7 per cent,
respectively, in the subsequent two fiscal years.
Table 6
Public finance data
2002/03 2003/04
2004/05 2004/05 2005/06 2006/07 2007/08
Actual
Actual
MTBPS
Revised
Medium-term
Oct 2004
estimates
estimates
National government (R billions)

As a percentage of GDP:

PSBR: Public-sector borrowing requirement
Source: National Treasury Budget Review 2005 and Medium Term Budget Policy Statement 2004
The deficit to GDP ratio for 2004/05 has been revised to 2,3 per cent in the 2005/06 Budget
Review from the 3,2 per cent envisaged in the 2004 Medium Term Budget Policy Statement
(MTBPS). This is a consequence of revisions to historical GDP data, an increase in revenue
collection and a slightly lower revised expenditure estimate. Indeed, higher than expected
tax revenues suggest that the actual deficit for 2004/05 may be even lower than the revised
2,3 per cent of GDP.
The public-sector borrowing requirement (PSBR) for 2004/05 has also been revised
downward from the 4,1 per cent of GDP presented in the 2004 MTBPS to 2,8 per cent
in the 2005/06 Budget Review. The PSBR is estimated at 3,9 per cent of GDP in the
fiscal year 2005/06, declining slightly to 3,8 per cent in the medium term.
Monetary conditions
Monetary aggregates have grown at a brisk rate in 2004 and early 2005 (Table 7), in line
with the growth in domestic expenditure. The average monthly year-on-year growth rate
in 2004 for the broad monetary aggregate, M3, was 13,3 per cent, although the rate
decelerated from a high of 14,9 per cent in October to 11,9 per cent in March 2005. The
movements in the year-on-year growth in the narrower aggregates were more
pronounced than those in M3, with M1A and M1 growing at 16,6 per cent and 15,2 per
cent, respectively, in 2004. Measured from quarter to quarter and at an annualised rate,
M3 increased by 17,6 per cent in the final quarter of 2004 and by 6,0 per cent in the first
quarter of 2005.
The total loans and advances credit aggregate accelerated in the period under review,
driven mainly by growth in asset-backed finance (mortgage advances, leasing finance
and instalment sale credit). On a year-on-year basis, the rate of increase in total loans
and advances accelerated from 8,8 per cent in June 2004 to 17,8 per cent in March
2005, with growth in asset-backed finance increasing from 17,7 per cent to 22,9 per
cent over the same period. Growth in mortgage advances recorded 24,2 per cent in
March, while leasing finance and instalment sales credit grew by 15,2 and 21,0 per cent,
respectively. Quarter-on-quarter annualised growth in total loans and advances

Monetary Policy Review May 2005
South African Reserve Bank
accelerated from 10,1 per cent in the second quarter of 2004 to 27,0 per cent in the
fourth quarter, before slowing to 20,0 per cent in the first quarter of 2005.
Table 7
Percentage change in monetary and credit aggregates
Per cent
Period
M1A
M1
M2
M3
Total loans and
advances **
Quarterly change*


Twelve-month change


Average


Quarter-on-quarter growth at annual rates of seasonally adjusted data
**
Total loans and advances to the domestic private sector excluding investments and bills discounted
Monetary policy
Since the publication of the previous Monetary Policy Review there have been three
meetings of the MPC. At the December 2004 and February 2005 meetings the monetary
policy stance was left unchanged. At the April meeting, the MPC decided to reduce the
repo rate by 50 basis points (Figure 13) in view of an improvement in inflation
expectations and a favourable expected inflation outcome in the next two years.
Developments in the international oil markets and associated uncertainty dominated
discussions not only of the threat to domestic inflation but also to world inflation and
growth. However, despite the threat that looms over the market, the actual impact on
world and domestic inflation has been far less marked than was the case during previous
oil crises.
An important factor in determining the stance of monetary policy is the forecast
generated by the Bank’s macroeconomic models. As has been explained in previous
South African Reserve Bank

Monetary Policy Review May 2005
Monetary Policy Reviews, monetary policy is not set mechanistically according to the
outcome of the central forecast. Some judgement is required as well. But the model
does attempt to incorporate in a systematic way the combined impact of the different
inflation determinants on the inflation outcome. In addition, forecasts presented at
different meetings are subject to change, either because of a change in the assumptions
about the exogenous variables (for example the international oil price) or forecast errors.
In addition, the forecast is constructed on the assumption of an unchanged monetary
policy stance. If the stance changes one would expect to see a change in the forecast.
The forecasts presented to the MPC in October 2004 showed that inflation was
expected to peak at around 5,8 per cent in the third quarter of 2005 and then decline
moderately. Since then the forecasts have predicted more benign inflation outcomes. In
February 2005, the central forecast showed that inflation was expected to peak in the
first quarter of 2006 at a level slightly above 5 per cent and to then decline towards the
mid-point of the target. In April, the forecasts showed a similar pattern, although a
slightly lower inflation path was predicted as a result of the unexpectedly low inflation
outcome in the first month of this year. This was despite higher oil price assumptions
factored into the forecast. The forecast presented to the MPC in April is reproduced later
in this Review. The MPC’s views on the outlook for some of the determinants of inflation
are highlighted below.
A theme that dominated all three meetings was the developments in international oil
prices. At the time of the December 2004 meeting, oil prices had receded from their
October highs of over US$52 per barrel following the Iraqi elections. In November Brent
crude oil averaged US$43,45, although the MPC acknowledged that the daily
fluctuations clearly illustrated the nervousness in the market. By February 2005 the
average oil price had risen slightly, although the combination of the lower prices in
November and December, combined with a firm rand, resulted in a lowering of domestic
petrol prices in January and February. Since then, international prices have resumed
their upward movement, averaging just below US$55 per barrel in the two weeks before
the April MPC meeting. The implications for domestic prices were a reversal of the petrol
Per cent, interest rates measured at end of period

Figure 13
The repo and short-term interest rates

Prime rate

Repo rate

3-month NCD rate

Monetary Policy Review May 2005
South African Reserve Bank
price reductions seen in previous months, and the likelihood that these increases would
ensure that the 3,1 per cent CPIX inflation measured in February would represent the low
point of the inflation outcomes for the time being.
At the time of the April meeting, uncertainty regarding the future course of the oil price had
increased, with suggestions of high upside risk. However, the MPC had to consider a
number of issues. First, although there is no doubt that higher oil prices do impact
negatively on measured inflation, it is generally accepted that monetary policy should not
respond to these first-round effects. In any event, as mentioned above, the forecasts
showed that despite the higher oil price assumptions, inflation should remain well
contained. In the event of an unexpectedly high “superspike”, monetary policy would have
to remain vigilant of the second-round effects. Furthermore, in such an event, the impact
on the real economy is likely to be contractionary, which could offset in part the impact of
the higher oil prices on inflation. Precipitate tightening of monetary policy under such
circumstances could intensify this contractionary effect. Second, there is the impact of
higher oil prices on the international economy. Although there has been a significant
increase in prices, the impact has been far more muted than in previous rounds of price
increases. Despite the higher prices, the IMF still forecasts inflation to be well contained,
and the latest World Economic Outlook projects world inflation to be marginally lower in
2005 than in 2004. This continued subdued world inflation has been one of the
considerations in the setting of domestic monetary policy. The higher oil prices have,
however, resulted in a downward revision of world economic growth of about 0,5 per cent.
Developments in wage settlements and unit labour cost were also closely monitored by
the MPC. In February 2005, the committee commented on the favourable unit labour
cost data, which showed that in the third quarter of 2004 unit labour cost had increased
by 4,9 per cent compared to the third quarter of the previous year. At the time of the
subsequent meeting, this figure had been revised up to 6,6 per cent, and the figure for
the fourth quarter was 10,1 per cent. These figures appear to be a threat to the inflation
outlook. However, the surveys on wage settlements continue to reflect a downward
trend, with the latest figures for the first quarter of 2005 indicating settlements averaging
6 per cent. The MPC has in the past commented on the fact that wages tend to be set
on the basis of past inflation, and therefore these settlements are likely to lag, but
eventually follow, the downward trend in inflation. This pattern appears to be continuing,
but the committee did raise a cautionary note.
Domestic expenditure trends continued to be carefully analysed in these meetings. As
seen earlier, domestic expenditure remained robust and was sustained by higher
consumer confidence, the stronger rand, lower interest rates, higher real incomes and
high asset prices. There was, however, evidence that the rate of increase in house
prices was slowing. Nevertheless, the strong consumer demand continued over the
period but there was little evidence of inflationary pressure emanating from this. The
strong domestic pressure was also reflected in the money supply and credit extension
figures. Although M3 money supply growth has remained fairly stable at around 12 per
cent on a year-on-year basis, credit extension has been growing at a much faster rate.
Much of this was related to mortgage loans, reflecting the buoyant conditions in the
property market, and the purchase of new motor vehicles which have reached near
record highs.
Although output was also relatively robust it declined moderately in the fourth quarter of
2004 in line with the expectations of the MPC. In the April 2005 meeting, the committee
was concerned about the slackening pace of growth in a number of sectors, in particular
the manufacturing and gold-mining sectors. The outlook for growth in these sectors
would be affected by world economic growth as well as the rand exchange rate.
South African Reserve Bank

Monetary Policy Review May 2005
The MPC also noted the fact that the current-account deficit has been increasing as a
result of the higher levels of imported goods. In 2004 the current-account deficit as a
percentage of GDP averaged 3,2 per cent for the year, and around 4 per cent in the
fourth quarter. The MPC was, however, confident that deficits around these levels would
continue to be financed comfortably through capital inflows.
The rand exchange rate, which has had an important impact on the inflation outcome in
South Africa, has been a source of uncertainty. At the time of the December 2004
meeting, the rand had strengthened mainly as a result of dollar weakness, but
subsequently the dollar recovered somewhat as US monetary policy was tightened.
However, the continued imbalances in the US economy implied that the outlook for the
US dollar, and therefore for the rand exchange rate, remained uncertain.
In the April meeting the MPC expressed concern about the fact that since the middle of
2004 the rand had been in a trading range significantly higher than was the case since
the beginning of 2003. This was not only true against the US dollar. The average
effective (trade-weighted) exchange rate index was approximately 10 per cent higher
than its level between the beginning of 2003 and mid-2004. The MPC expressed
concern regarding the impact of this development on certain sectors of the economy
which were beginning to show signs of stress in the face of the stronger rand.
This concern has been interpreted in some quarters as a signal that there has been a
change in the objective of monetary policy. However, it should be emphasised that
achieving the inflation target remains the primary and overriding objective of monetary
policy. The purpose of achieving this objective is not to achieve low inflation for its own
sake, but to provide a stable platform for sustainable economic growth. When inflation is
comfortably within the inflation target range, monetary policy has a greater degree of
freedom to focus on other factors as well. Being concerned with the impact of
developments in the rand exchange rate on the growth prospects of the economy is
therefore entirely consistent with the inflation-targeting framework, where the control of
inflation remains the overriding objective. These issues are discussed further in Box 3.
In the December meeting the committee noted that the increase in the price of
consumer services had remained consistently above the upper level of the inflation
target. By the April meeting, however, this measure had fallen below the 6-per-cent level
for two consecutive months, measuring 5,6 per cent in February 2005. This was viewed
as a positive development, as these prices are generally less affected by exchange rate
developments than are goods prices. This reflected in part progress made by the public
authorities in the containment of administered price increases. Fiscal policy also
continued, and is expected to continue, to be supportive of monetary policy during this
period, with the MPC highlighting the lower-than-expected budget deficit outturn for the
2004/05 fiscal year.
Other favourable developments over the period included the continued low levels of
production price inflation, which indicate few pressures coming through on consumer
prices in the short term and continued low levels of food price increases.
Finally, a further important positive development has been the evolution of inflationary
expectations which are discussed in more detail later in this Review. All the recent
surveys showed a progressive decline in inflation expectations. The results of the latest
survey by the Bureau for Economic Research (BER) showed that all categories of
respondents expected CPIX inflation to remain in the target range over the next three
years. These improved expectations are seen as an illustration of the improved credibility
of monetary policy and an important signal that low inflation is sustainable.

Monetary Policy Review May 2005
South African Reserve Bank
From the discussion above it is clear that the MPC was cognisant of the risks to the
inflation forecast. However it was felt that, on balance, and given the favourable inflation
outcome and expected outcomes, the factors supporting a further rate reduction
outweighed the risks. Accordingly, the MPC decided at its April meeting that a further
50-basis-point reduction in the repo rate was justified. This brought the repo rate down
to 7 per cent. Although this is low in nominal terms, real rates remain in line with those
in a number of other countries including Australia, New Zealand and the UK, and are still
significantly higher than those in the US and the euro area (Figure 14).
Per cent
Figure 14
Real money-market interest rates in April 2005
Argentina
US
Euro
Area
Japan
Korea
India
UK
Australia
South
Africa
New
Zealand
Turkey
Brazil
-5

* December 2004
** Calculated using CPIX inflation
3-month money-market interest rates adjusted using latest 12-month inflation in
consumer prices
Source: Bloomberg and The Economist

Box 3
Inflation targeting and the objectives of monetary policy
Within an inflation-targeting framework, achieving and maintaining inflation at or around the target
is the primary objective of monetary policy. The question that is often raised is whether or not
monetary policy should have or does have other objectives as well. In South Africa, when interest
rates were raised in 2002 in response to exchange rate developments, the Bank was accused of
being indifferent to economic growth and of having exchange rate targets. More recently, the
Bank’s decision to lower interest rates has been met with criticism that the Bank is now targeting
output and/or the exchange rate. Maintaining the inflation rate within the 3-6 per cent target range
remains the overriding objective of monetary policy. However, to suggest that monetary policy
does not take other developments into consideration in reaching a decision on interest rate
changes is to misunderstand the nature of the inflation-targeting framework.
There are three main reasons for wanting to achieve low inflation. Firstly, there are good
distributional and efficiency reasons. It is generally the case that the poor are affected most by
inflation as they are least able to hedge against the ravages of high inflation. In addition, inflation
can result in a misallocation of resources across sectors of the economy. Secondly, low inflation
South African Reserve Bank

Monetary Policy Review May 2005
or price stability provides an anchor for inflation expectations. If inflation expectations are well
anchored, this makes price stability easier to maintain in the long term. Finally, low inflation
makes an important contribution to growth by providing a stable environment for sustainable
economic growth. This is in line with the constitutional mandate of the Bank to protect the value
of the currency in the interest of balanced and sustainable economic growth. In the long run,
therefore, low inflation contributes to economic growth by providing a stable macroeconomic
environment. This does not, however, imply that there is a long-run trade-off between growth
and inflation. The Bank does not believe that higher long-run growth can be achieved through
higher inflation. On the contrary, it believes that higher long-run growth will be achieved against
a background of low inflation. Low inflation brings about lower interest rate variability and lower
nominal interest rates on a sustainable basis which contribute to growth. More recently, with
inflation remaining well contained within the inflation target range, higher levels of economic
growth have been achieved on a sustainable basis which is indeed the reason monetary policy
is directed at maintaining low inflation.
Achieving low inflation may incur short-run real costs, and there may be a trade-off between
inflation variability and output variability in the short run. It is perhaps instructive to distinguish here
between what is usually referred to as strict and flexible inflation targeting. Strict inflation targeting
is when only inflation enters the central bank’s objective function, while flexible inflation targeting
is when other variables, such as output, have a positive weight in the objective function. The fact
that most central banks to some extent have secondary objectives means that flexible inflation
targeting is the general case.
The question then becomes how flexible inflation targeting is applied, or what weight is assigned
to output? It is often the case that in the early phase of inflation targeting, a greater weight is
assigned to inflation as credibility is built up. Monetary policy characterised by strict inflation
targeting will try to hit the target as quickly as possible under all circumstances. Under flexible
targeting, monetary policy will gradually push inflation towards the target. Most inflation-targeting
models show that the stricter inflation targeting is, the more variable output will be. Too narrow a
focus on inflation will result in interest rate and output instability. By contrast, too much of a focus
on the cyclical growth issues will result in greater inflation variability and lower credibility for the
whole inflation-targeting framework. The issue then is the appropriate trade-off between rigid
adherence to the inflation target on the one hand and a steady path of output on the other, bearing
in mind credibility considerations.
Even if a central bank does not have output variability or the size of the output gap as a specific
objective of monetary policy, it is the case that in most models of inflation, the output gap is one
of the determinants of inflation. A widening output gap (i.e. lower current or expected growth)
implies less pressure on inflation, and therefore room for further monetary accommodation.
Conversely, as the output gap closes, a tighter monetary policy stance is more likely.
Similarly, current or expected exchange rate developments will feed into the monetary policy
decision-making process. An appreciating currency will be reflected in a more benign inflation
forecast because of the direct price effect of import prices on domestic prices. Furthermore, an
appreciating currency results in a contraction in output and an effective tightening of monetary
conditions, and this impact on economic growth could be offset by lower interest rates.
Furthermore, although monetary policy does not target the exchange rate, the valuation of the
exchange rate could be cause for concern.
This does not mean that responses to exchange rate or output developments happen
mechanically, i.e. that every time the exchange rate appreciates or output declines there will be an
easing of monetary policy. The inflation outlook is impacted on by a number of concurrent and
often contradictory forces, and the forecasting model will take this into account. In addition, the
MPC will have to use its judgement as to the likely evolution of these variables. As long as the
inflation target remains the overriding objective of monetary policy, it is appropriate that monetary
policy takes cognisance of other variables that impact on inflation.

Monetary Policy Review May 2005
The outlook for inflation
The outlook, risk and uncertainties relating to some of the factors that determine the
outlook for inflation and that are embodied in the forecast, are presented in this section.
International outlook
Having moderated as 2004 progressed, global growth looks set to continue at
sustainable, though still robust, rates in 2005 and 2006. The IMF projects world growth
at 4,3 per cent in 2005 and at 4,4 per cent in 2006 (Table 8). Global inflation is expected
to remain subdued at 3,6 and 3,1 per cent in 2005 and 2006, respectively. Although
macroeconomic policies and financial conditions remain generally supportive of growth,
there are a number of threats and challenges to this outlook.
Table 8
IMF projections of world growth and inflation for 2005
and 2006
Per cent
Real GDP
Inflation rates


Other emerging-market and developing countries

Source: IMF World Economic Outlook, April 2005
The projections in Table 8 indicate that US GDP will grow by 3,6 per cent in both 2005
and 2006. Inflationary pressures remain relatively benign as inflation is projected to slow
from 2,7 per cent in 2005 to 2,4 per cent in 2006. However, uncertainties regarding the
large deficits in the US and the future path of the US dollar exchange rate, which
increase the risk associated with global imbalances, suggest that there are threats to
these projections. The US budget proposals for the fiscal year 2006, which aim to halve
the budget deficit in 4 years, will be an important step towards sustainability.
The euro area and Japan, which together account for nearly one quarter of global
output, have performed disappointingly recently. Given strong economic ties, economic
developments in these countries have a significant impact on growth prospects for
South Africa. Growth in the euro area is projected at 1,6 per cent for 2005 improving to
2,3 per cent for 2006, and in Japan at 0,8 and 1,9 per cent for 2005 and 2006,
respectively. The projections for inflation in Table 8 suggest that inflationary pressures are
well contained in both cases. The UK economy is projected to grow by 2,6 per cent in
both 2005 and 2006, with inflation rates of 1,7 and 2,0 per cent, respectively.
South African Reserve Bank
In Developing Asia growth is expected to be slightly slower in 2005 and 2006 at 7,4 and
7,1 per cent, respectively, compared with the 8,2 per cent growth rate achieved in 2004.
China’s economy grew by more than 9 per cent for the second straight year in 2004,
and is expected to slow only slightly to 8,5 per cent in 2005 and 8,0 per cent in 2006.
Despite slowing markedly in recent months, inflation in China remains a concern. The
consumer price index registered a 3,9-per-cent increase in 2004, although this is
projected to slow in 2005 and 2006. Latin America is expected to grow robustly this
year, as is the oil-rich Middle East region, and prospects for growth in sub-Saharan
Africa remain generally favourable.
Solid global growth is therefore expected in 2005 and 2006. However, there are important
risks to the outlook which are perhaps tilted slightly to the downside. Some of the key
risks cited by the IMF are the increasingly unbalanced nature of the global expansion, the
possibility of a sudden tightening of financial conditions and further sharp increases in the
oil price. The IMF forecasts are based on the assumption of an average price of oil of
US$46,50 per barrel in 2005, and US$43,75 per barrel in 2006 (a simple average of the
spot prices of UK Brent, Dubai, and West Texas Intermediate crude oil).
Outlook for domestic demand and supply
The domestic economy looks set to sustain the growth momentum which was
established in 2004. The latest Reuters consensus forecast, based on surveys
undertaken in late March 2005, is for real GDP growth of 4,1 per cent in 2005 and
3,8 per cent in 2006. The forecasts are the means of 13 individual forecasts ranging
between 3,7 and 4,6 per cent for 2005, and between 3,4 and 4,5 per cent for 2006.
Domestic demand is likely to remain the most important force behind economic growth
in 2005. Consumer confidence remains high, as is borne out by the near-record levels of
the First National Bank/BER consumer confidence index in the first quarter of 2005. The
improvement in this index in recent quarters has been broad-based as confidence
increased across all population and income groups. The factors that pushed consumer
confidence higher last year remained in place, including the lowest nominal interest rates
in over two decades, low inflation, a surge in house and share prices, favourable personal
tax rates, increased social grants and a moderate improvement in employment.
Economic activity on the supply side has also shown signs of expansion. The tertiary
sector has contributed substantially to economic growth and remains resilient, and the
extended period of growth in domestic demand has helped to offset the adverse impact
of the exchange rate and disappointing export growth of the secondary sector. There is
evidence, however, of a slackening of activity in parts of the manufacturing and primary
sectors which is related to the stronger external value of the rand in the past six months.
Many companies have seen their profits soar, with the First National Bank/BER business
confidence index recording a recent high in March 2005. Businesses also deemed this
year’s Budget and the amendment to the company tax rate as complementing the
present favourable financial environment and ensuring continued momentum for
medium-term economic growth. The South African Chamber of Business (Sacob)
business confidence index registered 127,5 in March 2005, its highest level since
reaching a record level of 130,9 in September 2004. However, the Standard
Bank/Sacob Trade Conditions Survey, which appraises overall trading conditions in
South Africa on a monthly basis, indicated that trade conditions had been slightly weaker
in the first three months of 2005. The medium-term (six months ahead) outlook
nevertheless continues to be quite optimistic according to the trade expectations index
for March.
South African Reserve Bank

Monetary Policy Review May 2005

Monetary Policy Review May 2005
Indicators of inflation expectations
Expectations for CPIX inflation in 2005 have declined to the midpoint of the target range,
according to the results of the most recent BER quarterly survey of inflation expectations
for South Africa. The latest survey of financial analysts, business executives and
representatives of the trade union movement was conducted early in March 2005. Table
9 shows that the average expectation for 2005 regarding the CPIX inflation measure
targeted by the Reserve Bank is 4,5 per cent, rising slightly to 4,8 per cent for 2006 and
to 5,0 per cent for 2007. Since the survey undertaken in the fourth quarter of 2004, the
average expectations for CPIX inflation in 2005 and 2006 have declined by a full
percentage point in each case.
Table 9
BER survey of CPIX inflation expectations: 1st quarter 2005*
Per cent


Fourth-quarter 2004 results in parentheses
Source: Bureau for Economic Research, University of Stellenbosch
The decline in overall CPIX inflation expectations between the fourth quarter of 2004 and
first quarter of 2005 was primarily the result of a downward shift in the expectations of
business executives. Their expectation for inflation in 2005 declined by 1,6 percentage
points and for inflation in 2006 by 1,5 percentage points. By contrast, labour representatives’ expectations for 2005 and 2006 declined by 0,8 and 1,1 percentage points, and
those financial analysts by 0,7 and 0,5 percentage points, respectively.
The Reuters survey of economists based in South Africa, the UK and the US published on
7 April reports a similar trend in consensus forecasts for 2005-07. CPIX inflation is
expected to average 4,1 per cent in 2005, representing the mean of 15 individual forecasts
ranging from 3,4 to 4,7 per cent. The expectation is that CPIX inflation will then rise to
average 4,8 per cent in 2006, and 5,0 per cent in 2007. The consensus forecast for 2006
is the mean of 16 forecasts ranging between 3,6 and 5,8 per cent, and for 2007 it is the
mean of 10 forecasts ranging between 4,1 and 6,0 per cent.
Evidence of inflation expectations being anchored in the target range is also provided by the
breakeven inflation rates, measured by the spreads between the yields on South African CPI
inflation-linked bonds and conventional nominal bonds of similar maturity. These spreads
provide an indication of expected inflation over the period until the bond matures, assuming
no changes to the risk premium associated with future inflation and differences in the
liquidity of the bonds and their payment patterns. As Figure 15 shows, these breakeven
inflation rates declined steadily between mid-2004 and the end of February 2005, rose
slightly in March, and then declined once more in April. The inflation expectations obtained
from the R197 (maturing 2023), R189 (maturing 2013) and R198 (maturing 2008) inflationlinked bonds have remained within the target range since mid-2004 and were around 4 per
cent at the end of April 2005.
South African Reserve Bank
The Reserve Bank inflation forecast
Figure 16 reproduces the Reserve Bank’s quarterly forecast for CPIX inflation presented at
the MPC meeting on 13 and 14 April 2005. The latest observed value for CPIX was for the
fourth quarter of 2004, although January 2005 data were incorporated in the forecast for
South African Reserve Bank

Monetary Policy Review May 2005
Percentage points

Figure 15
Breakeven inflation rates

Spread between R189 and R153 bonds

Spread between R197 and R186 bonds

Spread between R198 and R194 bonds
Per cent

Figure 16
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).

Monetary Policy Review May 2005
the first quarter of 2005. The forecast is based on the assumption of an unchanged repo
rate at 7,5 per cent over the forecast period, which runs from the first quarter of 2005
to the final quarter of 2006.
The central projection of the forecast is for the CPIX inflation rate to reach a lower turning
point in the first quarter of 2005 and then to increase to 5,2 per cent in the first quarter
of 2006, before gradually declining to around 4,5 per cent by the end of the forecast
period. The probability distribution for this forecast suggests that there is approximately
an 80 per cent probability that the CPIX inflation rate will be between 3 and 6 per cent
in the final quarter of 2006.
With regard to the risks to the forecast, there are a number of factors that increase the
possibility of outcomes that deviate from the central projection. Important among these
is the threat of international crude oil price spikes, which would increase the upside risks
associated with the forecast. Additional factors such as high rates of growth in assetbacked credit extension and administered price increases above the upper limit of the
target range are also relevant in this regard. The low rates of production price inflation
and agricultural futures suggest that future pressure from these sources will be limited.
Overall, the balance of risks associated with the forecast is deemed to be neutral.
Assessment and conclusion
Against a background of an uncertain international economic environment, monetary
policy in South Africa has contributed to maintaining inflation within the inflation target of
3 – 6 per cent. Although the inflation rate appears to have reached a lower turning point
in February, the increase in March to a year-on-year rate of 3,6 per cent was attributable
mainly to the higher international oil prices. Of significance is the fact that despite the
higher oil prices, inflation is expected to remain comfortably within the target range over
the forecast period of two years. This view is confirmed not only by the Bank’s forecasts,
but also by the fact that inflation expectations have continued to improve considerably
over time.
The lower actual and forecasted inflation resulted in more room for the Bank to reduce
interest rates at the April meeting of the MPC. This move was justified not only on the
basis of the improved inflation outlook but also on the basis of evidence of a slackening
of activity in some sectors of the economy. These sectors have been negatively affected
by the continued strength of the exchange rate which has in effect resulted in an
involuntary tightening of monetary conditions. On a weighted basis, the rand has been
trading over the past few months at a range higher than for the main part of 2004.
Monetary policy will continue to be forward looking and will remain focused on the
expected trend of inflation. As usual, there are a number of upside and downside risks
and uncertainties relating to the determinants of the inflation trend. On the international
front, there are the oil prices and their impact on global growth and prices, as well as the
uncertain outlook for the US dollar which has implications for the exchange rate of the
rand. Domestically, monetary policy will have to take cognisance of the risks and
uncertainties relating inter alia to the continued high levels of expenditure, the outlook for
the output gap and trends in wage settlements. Monetary policy will be guided by the
MPC’s assessment of the future developments in these and other variables, and their
expected impact on the outlook for inflation.
South African Reserve Bank