Monetary Policy
Review
May 2004
Monetary Policy
Review
May 2004
South African Reserve Bank
Monetary Policy Review May 2004
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ISSN: 1609-3194
Monetary Policy Review May 2004
South African Reserve Bank
Contents
Monetary Policy Review


Monetary Policy Review
Introduction
In September 2003 the inflation rate as measured by the consumer price inflation
excluding mortgage interest cost for metropolitan and urban areas (CPIX) moved to
within the inflation target of 3 – 6 per cent, and it has remained within the range since
then. CPIX inflation continued its downward trend until December 2003 when it reached
a low of 4 per cent, before turning moderately upwards in subsequent months. This rate
was 4,8 per cent in February 2004 before declining to 4,4 per cent in March. The
turnaround in the inflation trend since December 2003 was not unexpected, as a
combination of base effects and exogenous factors such as higher food and energy
prices were expected to push the measured inflation rate higher. Despite the upturn in
inflation, the twelve-month rate of increase in the CPIX is expected to remain within the
target range over the forecast period. This positive outlook is due in part to the sustained
recovery in the exchange rate of the rand.
The monetary policy response to the improvement in the inflation outlook was reflected
in a significant decline in short-term interest rates during the second half of 2003. By the
time of the publication of the Monetary Policy Review in November of 2003, the
repurchase (repo) rate had been reduced by a total of 500 basis points. At the December
Monetary Policy Committee (MPC) meeting, the repo rate was lowered by a further
50 basis points and no further adjustment has occurred since then.
An important development in the inflation-targeting framework was the announcement
by the Minister of Finance that the specification of the target range would be changed
from an annual average to a continuous target. Previously the target had been specified
as having CPIX inflation between 3 and 6 per cent on average for a calendar year. The
target remains 3 – 6 per cent for year-on-year CPIX inflation, but it is now required that
this be achieved continuously.
In this Monetary Policy Review an analysis of recent price developments, the factors that
affect inflation as well as the outlook for inflation, is provided. In addition, three focus
topics are presented in boxes. In the first box, the implications of the change in the
specification of the inflation target are discussed. The second box presents an
international comparison of inflation targeting practices, and the third box analyses the
monetary policy transmission mechanism.
South African Reserve Bank
Monetary Policy Review May 2004

Box 1
Respecifying the inflation target
When inflation targeting was introduced in South Africa, the first target was specified as a calendar
year average (for 2002) for CPIX inflation. Subsequent targets were also specified in terms of an
average for a particular calendar year. In November 2003 the Minister of Finance announced that
the calendar-year averaging would fall away and that the target would apply continuously. At the
same time the Minister announced a change to the “escape clause”, which now becomes an
“explanation clause”, whereby some flexibility is given to the Bank in the conduct of monetary policy
within the new definition of the target. This box discusses some of the problems of the original
specification, the rationale for the new specification, and then considers the question of whether a
continuous target necessarily implies a stricter monetary policy.
South African Reserve Bank

Monetary Policy Review May 2004
Policy time horizons
In the conduct of monetary policy it is useful to distinguish between the control horizon and the
target (or policy) horizon. The control horizon reflects the lag between a change in monetary policy
and its full impact on inflation. This is determined by the structure of the economy. The target
horizon is the horizon over which the policy-makers decide to focus their policy, or it is the period
after which the central bank expects inflation to return to target after being hit by a shock. The
target horizon is determined by the central bank. Generally the target horizon should not be
shorter than the control horizon. For example, it would not be feasible to try to achieve a new
target within 6 months (the target horizon) if monetary policy has a lag of say 18 months (the
control horizon).
Most central banks specify a target horizon in line with their control horizon. Monetary policy
should be forward looking, in line with the lag in transmission and should aim at the period over
which it does have control. Although it is generally accepted that monetary policy should have a
fairly constant target horizon, this could be made more flexible if circumstances require. For
example, the Bank of Norway specifies the inflation target of 2,5 per cent over time: “A substantial
share of the effects on inflation of an interest rate change will occur within two years. Two years
is therefore a reasonable time horizon for achieving the inflation target of 2.1⁄2 per cent ... If
extraordinary circumstances induce the Norges Bank to apply a different time horizon than two
years, the Bank will provide an assessment of this”.
In South Africa the control horizon is estimated to be between 18 and 24 months. That is, the full
effect of a monetary policy change is felt after this time. It should be noted however that this does
not mean that the effects are only felt at the end of the period. It is estimated that about half the
impact on inflation is felt after about nine months. Therefore the focus of policy is not only on the
end point, but on the expected trend of inflation in future.
Why respecify the target?
The main problem with specifying the target as a calendar year average is that it introduces a
variable target horizon and excessive variability of interest rates (and output) can be the result. As
a particular calendar year-end gets closer, the target horizon in effect gets shorter, and there is
more pressure to act in order to achieve the target for that particular calendar year. Eventually the
target horizon gets shorter than the control horizon, and it is clear that monetary policy can no
longer impact on a particular calendar year and has to look beyond it. A rolling average or a
continuous target is more forward looking and allows monetary policy to focus on the control
period of 18 – 24 months over which monetary policy operates.
It should be noted that the Bank did not in fact operate with a variable target horizon, but the
calendar year average target complicated communication. For example, in the middle of 2001,
the Bank’s forecasts showed that the target should be achieved on average for 2002. By
September of 2001 CPIX inflation had fallen to 5,8 per cent. However soon thereafter, the rand
depreciated precipitously, and it became clear that the inflationary response to this would result in
the target being missed in 2002. However, given the lags in monetary policy, by this time monetary
policy was in fact already aiming at 2003.
Ex post and ex ante assessment of monetary policy
There is a distinction between ex ante and ex post assessment of monetary policy. Current
inflation is a reflection of past policies and exogenous factors. Whether or not current inflation is
inside the target is a (ex post) test of the success of past policies, as there is little that monetary
policy can do about current inflation. (With calendar year averaging, the assessment is even more
backward looking or delayed.) Thus in the specification of the target as being continuous, it
implies that where current inflation is relative to the target, is an ex post assessment of policy,
rather than an assessment of the appropriateness of the current monetary policy stance.
In assessing the appropriateness of the stance of monetary policy ex ante, we need to consider
whether the current stance is consistent with maintaining the inflation rate within the inflation
Monetary Policy Review May 2004

South African Reserve Bank
target range over the coming two years or so. In other words, is the forecast inflation trend within
the inflation target band? In principle, the inflation targeting policy rule suggests that interest rates
should be set on the basis of the divergence of the central forecast from the inflation target. In
reality, although this rule does guide policy formulation, the MPC does not follow it in a mechanical
way. The models and the forecast are an important part of the process, but not the overriding
consideration. As conditions in the economy change and as expectations change, the
assumptions of the forecast will be continually changing, so the forecasts themselves are
continuously reassessed. The further into the future, the more uncertain things are. Uncertainty will
always be greatest around the end of the forecast period. This makes it impossible to apply the
rule mechanistically.
What does this mean for actual implementation?
Does this mean that monetary policy has to be tightened every time the measured inflation rate
moves out of the target or that the new specification implies a stricter monetary policy? As argued
above, if the measured inflation moves out of the target range, the important consideration is what
the future trend of inflation is expected to be. If inflation is observed to be out of the target today,
then it implies that monetary policy in the past has failed to achieve the target. Because it is outside
the control period, there is little monetary policy can do, other than to ensure that the current stance
of monetary policy is appropriate for achieving the target over the coming control period.
Under these circumstances, if the overall inflation trend is expected to remain out of the target for
an extended period of time, the MPC will be expected to react. (Indeed, unless the move outside
the target was totally unexpected, the MPC is likely to have reacted already.) However, if the
expectations are that the inflation rate will return to the target range within a short period of time,
then the MPC will not necessarily act. In this case it implies that monetary policy is appropriate on
a forward-looking basis. It goes without saying that if the inflation rate is expected to be outside
the target and to remain there, then monetary policy will need to react.
Whether or not the movement outside the target should be seen as a failure of monetary policy
will depend to a large extent on the causes of the deviation from the target range. If the deviation
is caused by a supply-side shock, for example an oil price increase with only first-round effects,
monetary policy cannot be blamed. It is only if this increase is generalised in what are called
“second-round effects”, and where inflation expectations are affected, that monetary policy should
have reacted. It is not always easy to determine when a shock will indeed lead to generalised
inflation. This is a judgement call for the monetary authorities.
The “explanation clause” as set out by the Minister of Finance gives the Bank some flexibility in
reacting to current and expected supply-side shocks. As is set out in the November 2003
Medium Term Budget Policy Statement, “When the economy is buffeted by a supply side shock
similar to those envisaged by the original escape clause that will take inflation outside the target
range (e.g. an oil price shock, a drought, a natural disaster, or financial contagion affecting the
currency), at the subsequent meeting of the Monetary Policy Committee, the SARB will fully
inform the public of the nature of the ‘shock’, the anticipated impact on CPIX inflation and the
monetary policy response to ensure that inflation returns to the target and the time frame over
which this will occur.”
Conclusion
Although in principle a fixed calendar year target could lead to overactivism or undue complacency
at times because of the variable time horizon it entails, this is not how the MPC behaved. Monetary
policy has been consistently forward looking, but the averaging complicated the communication of
monetary policy and the effective management of expectations. Although the new specification
does appear to be a stricter requirement there is sufficient flexibility built into the system to
accommodate this. The changes adopted in the inflation-targeting framework bring South Africa in
line with international practice. Box 2 in this Review shows that most inflation-targeting countries
have either adopted continuous targets or rolling averages over a number of quarters.
Recent developments in inflation
The evolution of indicators of inflation
After trending downward from the last quarter of 2002 to late in 2003, the main
indicators of inflation appear to have started moving upwards. Figure 1 presents the
twelve-month percentage changes in CPIX, the official measure for inflation targeting
purposes, and in the headline consumer price index for metropolitan areas (CPI).
The CPIX inflation rate slowed from a peak of 11,3 per cent in October and November
2002 to 4,0 per cent in December 2003, before increasing to 4,8 per cent in February
2004. In March, CPIX inflation declined to 4,4 per cent, helped by base effects in the
measurement of transport costs, a lower-than-expected increase in the education
category and new favourable survey data on domestic workers’ wages. In terms of the
new continuous specification for the inflation target announced in November 2003, CPIX
entered the 3 to 6 per cent inflation target in September 2003 (the new specification of
the target is discussed in Box 1). Measured from quarter to quarter at seasonally
adjusted and annualised rates, CPIX inflation fell from 13,0 per cent in the second
quarter of 2002 to 1,1 per cent in the fourth quarter of 2003, and then rose to 7,5 per
cent in the first quarter of 2004. The annual average CPIX inflation rate fell from 9,3 per
cent in 2002 to 6,8 per cent in 2003.
Figure 1 shows that the CPI inflation rate fluctuated more than that of CPIX in the period
under review, as a result of the monetary policy-induced interest rate changes included in
the former index. The repo rate was increased by 400 basis points in the course of 2002,
before being reduced by a total of 550 basis points in 2003. CPI inflation fell from 13,0 per
cent in October 2002 to a low of 0,2 per cent in January 2004, before rising slightly to
0,7 per cent in February. The CPI inflation rate then declined to 0,4 per cent in March.
Measured from quarter to quarter, the seasonally adjusted and annualised CPI inflation rate
declined sharply from 14,2 per cent in the fourth quarter of 2002 to -2,1 per cent in the
same quarter of 2003, and then increased to 2,0 per cent in the first quarter of 2004.
South African Reserve Bank

Monetary Policy Review May 2004
Figure 1
Consumer price inflation: CPIX and CPI
Percentage change over twelve months

CPI

CPIX
Source: Statistics South Africa
Monetary Policy Review May 2004

South African Reserve Bank
The inflation rates for some of the main components of the CPIX are shown in Figure 2
(food, housing, transport, medical care and health expenses are depicted). It is well
documented that food prices, which have a weight of 25,7 per cent in the CPIX, have
contributed significantly to recent trends in consumer price inflation. To date, developments in this component have largely reflected the influence of the appreciating
exchange rate of the rand on import prices, overshadowing the influence of lower than
normal rainfall over parts of the country in 2003 and concerns regarding shortfalls in
agricultural production. In October 2002, food price inflation peaked at 20,8 per cent,
contributing 5,3 percentage points to the overall CPIX inflation rate of 11,3 per cent. The
inflation rate for this component has since fallen to a low of 1,9 per cent in December
2003 before rising to 2,5 per cent in March 2004.
The fluctuations in the inflation rate for the transport cost component of CPIX, which
comprises 15,3 per cent of the index, have also been associated with developments in
the foreign exchange rate of the rand, a prime determinant of the level of the domestic
crude oil price and the domestic petrol and diesel pump prices. Inflation for this
component measured 9,6 per cent in December 2002, before declining to -0,5 per cent
in June 2003. Subsequently it has oscillated between 2,9 and -1,1 per cent.
The inflation rates of the other components of CPIX inflation were relatively more stable.
Recent inflation for the housing cost component ranged between 8,1 and 11,3 per cent,
while that for medical care and health expenses declined from 13,5 per cent in
November and December 2002 to 8 per cent in the corresponding months of 2003,
before rising to 10,2 per cent in March 2004.
Figure 3 shows the effect of excluding energy and food prices from the CPIX measure of
inflation. These components have been relatively volatile in recent times, and excluding
them from the overall measure provides an indication of the underlying trends in inflation.
The exclusion of energy prices from the CPIX has had little impact on the trend of inflation,
Figure 2
Inflation rates for components of the CPIX
Percentage change over twelve months

-5

Food
Housing
Medical care and health expenses

Transport
Source: Statistics South Africa
South African Reserve Bank

Monetary Policy Review May 2004
although these prices had a moderating effect on inflation in 2003. The twelve-month
rate of increase in CPIX excluding energy prices fell from 10,7 per cent in December
2002 to 4,5 per cent in January 2004, before rising to 4,7 per cent in March. An
examination of the inflation rate for the CPIX excluding food prices, by contrast,
reveals the significant temporary effect that developments in food prices had on CPIX
inflation. When food prices are excluded, CPIX inflation measured over twelve months
peaked at 8,3 per cent in November 2002, compared with an 11,3 per cent peak for
the overall index, before declining to 4,2 per cent in December 2003. The inflation
rates for the overall index and for the indices measured after excluding energy and
food prices have converged early in 2004, measuring 4,4, 4,7 and 4,6 per cent,
respectively, in March.
A further decomposition of inflation performance considers the goods and services
components of the CPIX separately. Figure 4 shows that goods inflation, which has a
larger imported component and therefore is more affected by exchange rate changes,
fluctuated significantly more than services inflation, declining from a year-on-year level
of 13,5 per cent in October 2002 to 2,1 per cent in December 2003. Prices of
services, by contrast, have been fairly sticky, and the services’ price inflation rate has
exceeded the upper limit of the inflation target, although it has moderated recently.
The inflation rate for this component of the index increased from 6,2 per cent in March
2002 to 8,6 per cent in September 2003, before slowing to 7,8 per cent in March
2004. Factors which have contributed to these above-target inflation rates include
relatively high wage increases for domestic workers following the implementation of
minimum wage legislation for domestic workers in September 2003, although this has
moderated in March, and the performance of certain administered prices included in
the services index.
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 and SARB calculations
Monetary Policy Review May 2004

Administered prices have a significant weight in the CPIX, and their role in determining
the inflation rate needs to be considered. Figure 5 reveals that increases in these prices
have been relatively stable once petrol and diesel prices are accounted for, although they
remain well above the upper limit of the inflation target. The year-on-year inflation rate
for an index of administered prices excluding petrol and diesel declined from 8,4 per
cent in July 2003 to 7,4 per cent in March 2004.
South African Reserve Bank
Figure 4
CPIX: Goods and services inflation
Percentage change over twelve months

Goods

Services
Source: Statistics South Africa
Figure 5
CPIX and administered prices
Percentage change over twelve months

Administered price index (API)

API excluding petrol and diesel

CPIX
Source: Statistics South Africa and SARB calculations
South African Reserve Bank

Monetary Policy Review May 2004
The inflation rate measured in terms of the production price index (PPI) has been negative
since September 2003. The rate of decline in the index slowed from -2,5 per cent in
November 2003 to -1,0 per cent in February 2004 before rising slightly to -1,2 per cent
in March. As Figure 6 shows, the decline in production prices has mainly been the result
of developments in the prices of the imported component of the PPI. Influenced by the
recovery in the external value of the rand and the low inflation rates of South Africa’s main
trading-partner countries, the inflation rate for this component fell below zero in April 2003
and has remained negative. It fell from 15,2 per cent in November 2002 to -9,6 per cent
in November 2003, and has fluctuated between -8,0 and -8,9 per cent since then. The
corresponding rate of inflation for the domestic component, by contrast, declined from
6,9 per cent in March 2003 to 0,2 per cent in November 2003, and then rose once more,
recording 1,5 per cent in March 2004.
The PPI inflation rate measured quarterly on a seasonally adjusted and annualised basis
declined from 1,6 per cent in the third quarter of 2003 to -3,8 per cent in the final quarter
of the year, and then showed no growth in the first quarter of 2004. The rate of decline
for the imported component of the index slowed from -10,3 per cent in the second
quarter to -7,0 per cent in the fourth quarter of 2003, before increasing again to -8,4 per
cent in the first quarter of 2004.
Factors affecting inflation
Recent developments in some of the main drivers of inflation in South Africa are
reviewed in this section. These include the external environment and the exchange rate,
as well as domestic demand and output, fiscal policy and monetary conditions. The
outlook for these variables, and their likely impact on inflation, are discussed later.
Figure 6
Production price inflation
Percentage change over twelve months

-10
-5

Production price index (PPI)
Imported component of PPI
Domestically produced component of PPI
Source: Statistics South Africa
Monetary Policy Review May 2004

International economic developments1
According to official data, the United States of America (US) economy has been in
recovery from its mild 2001 recession since late in that year. However, until mid-2003 it
was the weakest economic recovery recorded, with output growing at an annual rate of
only 2,6 per cent in the period, less than half the usual recovery pace. Productivity
growth was nevertheless surprisingly strong throughout this period, at 5 per cent per
year according to the latest reading. The combination of these factors ensured that
employment fell in each month from February to July 2003, a disappointing labour
market performance that led many to question the sustainability of the US recovery.
This scenario changed from mid-2003, with the second half of the year being
characterised by a significant resurgence in economic growth in the US, fuelled by the
cumulative effects of low interest rates, three large tax cuts, a falling exchange rate and the
resumption in capital spending. Real gross domestic product (GDP) increased at an annual
rate of 8,2 per cent in the third quarter of 2003, by 4,1 per cent in the fourth quarter and
by 4,2 per cent in the first quarter of 2004. For the year 2003, real GDP increased by
3,1 per cent, compared with 2,2 per cent in 2002.
In the euro area, the recovery has been muted and economic growth in the fourth quarter
of 2003 was weaker than expected. In addition, business and consumer confidence
declined somewhat. The recovery has so far been mainly export driven, despite the
appreciation of the euro, but domestic conditions are becoming more supportive. Output
growth for 2003 as a whole was 0,4 per cent, below the 0,9 per cent recorded in 2002.
In contrast to the continued hesitant recovery in the euro zone, the UK recorded
2,3 per cent growth in 2003, and 2,4 per cent in the first quarter of 2004, and
experienced significant employment growth. Consequently, British unemployment is
the lowest of any Group of Seven country at 4,8 per cent, compared with 5,6 per cent
in the US and an average of 8 per cent within the European Union. However, the
biggest threat to Britain’s long-term competitiveness is the fact that its productivity
South African Reserve Bank

The quarterly growth rates
referred to in this section are
based on seasonally adjusted
data.
Table 1
Annual percentage change in real gross domestic product and
inflation rates
Real GDP
Inflation rates


Source: IMF World Economic Outlook, April 2004
growth is lower than that of the US, Germany and France. Productivity growth in the
final quarter of 2003 was 1,8 per cent.
In Australia and New Zealand GDP growth remained strong throughout 2003. Australia
grew by 3 per cent in 2003, and delivered unexpectedly strong growth of 5,5 per cent
on an annualised basis in the fourth quarter. New Zealand’s economy grew by 3,5 per
cent in 2003, with final quarter year-on-year GDP growth of 2,4 per cent.
Most Latin American economies experienced improved growth in the latter part of 2003
as the region recovered from the recession of 2001 and 2002. Economic growth in Asia
improved markedly in the course of 2003. Japan in particular has recently been
performing better than at any time in the past decade. Japan’s real GDP increased at an
annualised rate of 6,4 per cent in the fourth quarter of 2003, the fastest quarterly growth
rate in the past 13 years. This was the result of strong growth in exports and improved
domestic demand as fixed capital formation rose sharply. The growth rate for 2003 as a
whole was 2,7 per cent.
The latest information suggests that many economies in the region performed more
strongly than anticipated. China, India, Thailand and Singapore showed robust growth.
Much of this is a result of stronger domestic demand, though export growth made a
significant contribution in most cases. China recorded real GDP growth of 9,1 per cent
in 2003, its highest growth rate since 1997.
Africa experienced surprisingly resilient growth during the past year that reflects,
among other things, improved macroeconomic policies in an increasing number of
African countries. The region grew by 4,1 per cent in 2003, up from the 3,5 per cent
recorded in 2002.
Oil prices
International oil prices measured in terms of the Organization of the Petroleum Exporting
Countries (OPEC) basket have risen from just above US$23 per barrel in April 2003 to
around US$34 per barrel early in May 2004 (Figure 7). In rand terms, the appreciation of
the domestic currency has meant that the increase over the same period has been
proportionately less, with a relatively flat trend and the price fluctuating in the R180 to
R230 per barrel range since April 2003. The domestic price of petrol changed broadly
in tandem with the price of imported crude oil: The pump price of 93 octane petrol in
Gauteng declined marginally from R3,84 to R3,78 per litre between October 2003 and
January 2004, but then increased to R4,08 in February and R4,17 in March. From 7 April
the price rose to R4,39 per litre, partly as a result of the increase of 10 cents per litre in
the fuel tax and the increase of 5 cents per litre in the Road Accident Fund levy
announced by the Minister of Finance in his Budget Speech in February 2004.
Although OPEC traditionally tightens supplies early in the year in anticipation of weaker
demand during the northern hemisphere summer months, most analysts had predicted
that the organisation would refrain from cutting output early in 2004 as oil prices had
remained above the group’s preferred range of US$22 – US$28 per barrel since
December 2003. At a meeting in Algiers in January 2004, OPEC energy ministers
nevertheless agreed to reduce oil production quotas by 1 million barrels per day, starting
in April 2004. Some OPEC members had been breaching quota limits and the cartel
ordered members in breach of their quotas to immediately cut output by 1,5 million
barrels a day. The two-stage cut will reduce OPEC’s oil output by a total of 2,5 million
barrels a day, or approximately 10 per cent of total OPEC production.
South African Reserve Bank

Monetary Policy Review May 2004
Monetary Policy Review May 2004

The OPEC decision as well as continued low levels of crude oil inventories in member
countries of the Organization for Economic Co-operation and Development (OECD),
delays in restoring Iraq’s oil production, and the US Energy Department’s ongoing
additions to their Strategic Petroleum Reserve contributed to crude prices increasing by
about 15 per cent from December 2003 to March 2004 to levels around US$34 per
barrel. The oil price has also strengthened on increased political uncertainties in the
Middle East, as well as concerns that the amount of proven reserves held by Western
oil companies would shrink as others follow the Royal Dutch/Shell Group’s lead in
restating numbers.
World interest rates
Most central banks maintained or eased their monetary policy stance during the first half
of 2003 as inflationary pressures remained subdued and economic growth failed to gather
momentum. Although expectations of a global monetary tightening began to build in the
second half of last year, Table 2 shows that countries are currently at differing stages of
their interest rate cycles. Official interest rates have been raised in certain countries, some
have lowered rates and still others have left them unchanged for the moment.
Monetary authorities in the UK and Australia cited the pick-up in the domestic
economy, rapid growth in household borrowing and the global economic recovery as
the main reasons for increasing their official interest rates in November and December
2003, respectively. Furthermore, as the world economic recovery became more
broadly based and output continued to grow above trend, the Bank of England’s
Monetary Policy Committee became concerned in February 2004 that inflationary
pressures might pick up over the next couple of years and raised its repo rate by
0,25 percentage points to 4,0 per cent. The Reserve Bank of New Zealand also raised
its official cash rate in the beginning of 2004 by 0,25 percentage points to 5,25 per cent,
and by a further 0,25 percentage points to 5,5 per cent on 29 April as inflationary
pressures remained strong.
South African Reserve Bank
Figure 7
OPEC* basket price of crude oil
US dollars per barrel

* Organization of the Petroleum Exporting Countries
Source: Bloomberg
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May
South African Reserve Bank

Monetary Policy Review May 2004
By contrast, a number of countries have recently lowered rates. The Bank of Canada
lowered its target for the overnight rate by 25 basis points respectively in January 2004,
in early March and again in April to reach a level of 2,00 per cent. Core inflation is
projected to fall below 1,5 per cent in early 2004 before gradually moving back towards
the 2 per cent target by the end of 2005. Lower domestic cost pressures and subdued
economic activity also resulted in interest rate reductions in Hungary, Israel, Sweden and
Brazil in recent months.
Finally, an important group of countries has left interest rates unchanged for the time
being. The US Federal Open Market Committee, after lowering the federal funds rate to
1,0 per cent in a series of steps that ended in June 2003, has opted to keep its policy
rate at this low level until the economy moves back towards higher levels of
employment. Although the US economy has strengthened over the past few quarters,
the labour market remains weak. The European Central Bank has also kept its policy
rate unchanged at 2,0 per cent since early June 2003 as a result of its inflation outlook
and its confidence that the current monetary policy stance provides sufficient support to
the economic recovery in the euro area. The Bank of Japan has maintained its policy
interest rate near zero, but 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.
Table 2
Key central bank interest rates
Per cent
Countries
1 Jan
4 May
Latest change

(percentage points)
1,25
1,00
25 Jun 2003
(-0,25)
0,00
0,00
19 Mar 2001
(-0,15)
2,75
2,00
6 Jun 2003
(-0,50)
4,00
4,00
5 Feb 2004
(+0,25)
2,75
2,00
13 Apr 2004
(-0,25)
2,75
2,00
6 Jun 2003
(-0,50)
3,75
2,00
1 Apr 2004
(-0,50)
0,25 – 1,25
0 – 0,75
6 Mar 2003
(-0,50)
4,75
5,25
3 Dec 2003
(+0,25)
5,75
5,50
29 Apr 2004
(+0,25)
8,90
4,10
1 Apr 2004
(-0,20)
2,75
2,50
26 Jun 2003
(-0,25)
12,93
7,42
25 Feb 2004
(-0,06)
5,00
4,50
21 May 2003
(-0,50)
4,25
3,75
10 Jul 2003
(-0,25)
1,63
1,38
26 Jun 2003
(-0,25)
1,75
1,25
27 Jun 2003
(-0,50)
6,25
6,00
29 Apr 2003
(-0,25)
25,00
16,00
14 Apr 2004
(-0,25)
3,00
1,75
8 Jan 2004
(-0,50)
2,75
2,00
1 Aug 2003
(-0,25)
8,50
11,50
3 May 2004
(-0,50)
6,75
5,25
25 Jun 2003
(-0,25)
21,00
14,00
15 Jan 2004
(-2,00)
Source: National central banks
Monetary Policy Review May 2004

South African Reserve Bank
Box 2
Inflation targets: A survey of international specifications
Following the pioneering example of New Zealand, several countries have in recent years adopted
inflation targeting as a framework for monetary policy. The choice of an inflation target presents a
number of challenges. What price index should be targeted? At what level should the inflation target
be set? Should the target be a point or a range? And what is the appropriate time horizon for
monetary policy? While there are other requirements for successful inflation targeting, such as
communication, institutional arrangements and so on, the cornerstone of the framework remains the
target itself. This box provides a survey of the inflation targets which are specified by a number of
inflation-targeting countries.
Table B2.1 conveys a sense of the variety of targets employed by inflation-targeting countries. In
general, countries target either CPI or some measure of core inflation, although some make use of
operational targets. In this case, CPI is sometimes retained as the officially targeted measure, mostly
for its comprehensiveness, while other core measures are employed as operational targets. Canada
and Sweden are examples of countries that use this arrangement.
Table B2.1
Selected economies with inflation-targeting frameworks
Country
Date adopted
Price index targeted
Current target
Horizon
Australia
April 1993
CPI1
2 – 3 per cent
Over the
(approximately)
business cycle
Brazil
June 1999
Broad Consumer
5,5 (2004) and
1 year ahead
Price Index (IPCA)
4,5 per cent
(2005) with a
2,5 per cent
tolerance level
Canada
February 1991
CPI2
1 – 3 per cent,
6 – 8 quarters
with a focus on
the 2 per cent
midpoint
Chile
September 1990
CPI
2 – 4 per cent,
2 years
centered on
3 per cent
Czech
December 1997
CPI3
3 per cent with
20 months
Republic
tolerance level of
1 per cent
Iceland
March 2001
CPI
2.1⁄2 per cent
with 1,5 per cent
tolerance level
Mexico
January 1999
CPI
3 per cent with a
variability interval of
1 per cent
New Zealand
March 1990
CPI1
1 – 3 per cent
Over the medium
term
Norway
March 2001
CPI
2,5 per cent
2 years
Philippines
January 2002
CPI4
4 – 5 per cent
2 years
Sweden
January 1993
CPI5
2 per cent with 1
4 – 8 quarters
percentage point
margin
South African Reserve Bank

Monetary Policy Review May 2004
Exchange rate developments
After the sharp depreciation experienced in 2001 and part of 2002, the exchange rate
of the rand appreciated strongly against a basket of currencies between September
2002 and the beginning of May 2004 (Figure 8). The nominal effective exchange rate of
the rand weakened in May – June 2003 and again in January 2004, but on each
occasion strengthened once more to the April 2003 level. This behaviour of the rand has
had a significant impact on the rate of inflation, as the earlier review of the main
indicators of inflation illustrated.
The levels of inflation which are targeted also vary between countries. This is perhaps not surprising
since the optimal level of inflation is not known with certainty. Mature inflation-targeting countries,
which have inflation rates in the region of their long run levels, tend to have targets centred around
2 per cent. Economies which are on disinflation paths, by contrast, initially tend to set their targets
in the neighbourhood of the inflation rates prevailing at the time of adopting inflation targeting and
then adjust them downward over time. Brazil and the Czech Republic are cases in point.
Some countries set their targets as points and others as ranges or bands. Target ranges, which allow
flexibility and acknowledge the uncertainty inherent in inflation forecast targeting explicitly, are
specified by New Zealand, Australia, Canada, Chile, Thailand and the Philippines. Point targets,
which may provide a more precise anchor for inflation expectations and a more specific target for
monetary policy-makers, are preferred by Norway and the UK.
There are two aspects to consider regarding the choice of a horizon for the inflation target. The first
concerns the length of time required for monetary policy to have its full impact on inflation, which is
an empirical question for which the answer can vary from country to country. As argued in Box 1,
the guiding principle should be that the target horizon cannot be shorter than the control horizon; if
interest rates take around two years to impact fully on inflation, then the inflation target horizon
should not be less than two years. The second aspect concerns the reaction function of the central
bank. If the bank places more emphasis on inflation in its reaction function, the target horizon will be
shorter. This forces the bank to act quickly if the target is threatened, and will result in larger output
losses than would have been the case with a longer horizon. By contrast, central banks which set
long horizons may be perceived to care “too much” about the output consequences of their policy
decisions, and therefore risk losing credibility.
This therefore suggests that country-specific factors and policy preferences will determine the choice
of target horizon. It is perhaps not surprising that in Table B2.1 countries on transition paths such as
Brazil and the Czech Republic have opted for short target horizons, and established inflation
targeters for multi-year horizons. The standard trade-off between credibility and flexibility suggests
that this would be the case.
Thailand
May 2000
Core CPI6
0 – 31⁄2 per cent
United
October 1992
CPI7
2 per cent with a
2 years
Kingdom
±1 per cent
deviation triggering
a public explanation

The RBA and RBNZ began using CPI instead of a core measure when mortgage interest cost was removed from CPI

Core CPI and CPIXFET are used as operational targets. Core CPI excludes the 8 most volatile components – fruit,
vegetables, gasoline, fuel oil, natural gas, intercity transportation, tobacco and mortgage interest costs – and changes in
indirect taxes from the CPI; and CPIXFET excludes food, energy and effects of indirect taxes

Previously used headline CPI excluding regulated prices and the direct impact of indirect taxes and subsidies

Core inflation is also considered when making monetary policy

Operational monetary policy is based on CPI excluding changes in indirect taxes, subsidies and house mortgage interest

CPI excluding raw food and energy prices

The EU Harmonised Index of Consumer Prices (HICP). Previously Retail Price Index excluding mortgage interest payments
Sources: Central bank websites, Pétursson, T G. 2004. “Formulation of inflation targeting around the world”, Central Bank of
Iceland, Monetary Bulletin, 2004/1
Besides the correction of the overshooting that occurred during the period of rand
weakness, a number of factors help to explain this performance of the exchange rate.
One reason for the appreciation of the rand is the continued weakness of the US dollar
against a range of currencies. Over the period reviewed in Figure 8, for example, the
rand strengthened significantly more against the US dollar than against the euro
(moving from around R10,60 to R6,25 against the US dollar, and from R10,40 to R7,55
against the euro).
A further explanatory factor is the performance of commodity prices on international
markets. Commodity prices, as measured by the Commodity Research Bureau (CRB)
Spot Market Price Index (Figure 9), rallied strongly in the second half of 2003 and early
2004 because of the pick-up in the pace of economic activity, particularly in the United
States and China, falling inventory levels for specific commodities, and the decline in
the US dollar against other major currencies. In Figure 8 the rand appreciated least
against the currencies of the commodity producers, Australia and New Zealand.
The rand’s sustained performance has also been supported by improved international
perceptions of the strength of South Africa’s economic fundamentals, as evidenced for
example by narrowing spreads on South African international bonds and improved credit
ratings by the international credit-rating agencies. Other factors which have contributed
to the continued strength of the rand include the positive, although narrowing, nominal
interest rate differential between South Africa and foreign economies, and the conversion
first of the negative net open foreign-currency position (NOFP) in May 2003 into a positive
position, and the closing out of the Reserve Bank’s oversold forward book during
February 2004. This was achieved mainly through limited purchases of dollars in the
market. Since February, these purchases have resulted in an increase in the foreign
exchange reserves, which is expected to reduce the volatility of the rand.
Monetary Policy Review May 2004

South African Reserve Bank
Figure 8
Rand per US dollar, euro, Australian and
New Zealand dollars and the nominal
effective exchange rate of the rand (NEER)
Indices: 2 September 2002=100

S
O
N
D
J
F
M A
J
F
M
M
A
M
J
J
A
S
O
N
D
Rand per US dollar
Rand per euro

Rand per New Zealand dollar

Rand per Australian dollar

NEER
Labour markets
One way of assessing inflationary pressure arising from the labour market is to examine
movements in nominal unit labour cost. Changes in unit labour cost are changes in
money wages adjusted for changes in productivity and are derived as a differential of
changes in nominal remuneration per worker and changes in output per worker. Labour
cost is a major component of firms’ total costs and have an important influence on
output prices.
There have been positive developments in unit labour cost in the first three quarters of
2003, although these were somewhat reversed in the last quarter of the year (Figure 10).
The change in unit labour cost measured year on year declined from a high of 6,4 per
cent in the first quarter of 2003 to 2,2 per cent in the third quarter, reflecting a high base
related to the timing of earlier salary increases. However, in the last quarter of 2003
growth in unit labour cost rose again, recording an increase of 5,2 per cent. This increase
was due to a sharp increase in remuneration per worker accompanied by a slowdown
in labour productivity growth. For the last three quarters of 2003, growth in unit labour
cost was contained within the inflation target range.
As seen in Figure 11, the average annual wage settlement in 2003 was 8,9 per cent. This
should maintain some upward pressure on unit labour cost. However, declining
profitability, especially in the export sector, the lower level of measured inflation and the
improved inflation outlook should moderate this year’s settlements.
It is important to note that inflation is just one of a number of variables in the wage
negotiation process. The strength of labour unions, skills shortages in some sectors and
productivity gains may result in above-inflation settlements notwithstanding declines in
inflation. Given its importance in the inflationary process, unit labour cost is monitored
closely for monetary policy purposes.
South African Reserve Bank

Monetary Policy Review May 2004
Figure 9
Commodity prices: Commodity Research

Bureau (CRB) Spot Market Price Index
US dollar index: 1995=100

Source: CRB

Monetary Policy Review May 2004

South African Reserve Bank
Figure 10
Remuneration per worker, labour productivity

and unit labour cost in the formal

non-agricultural sector
Percentage change over four quarters

Nominal unit labour cost

Remuneration per worker

Labour productivity
Source: Statistics South Africa
Figure 11
Average annual inflation and wage

settlements
Per cent

CPI

CPIX

Average wage settlements
Source: Andrew Levy Employment Publications and Statistics South Africa
South African Reserve Bank

Monetary Policy Review May 2004
Demand and output
After losing momentum in the first half of the year, growth in real GDP accelerated to
1,1 per cent in the third quarter and 1,3 per cent in the fourth quarter of 2003. Despite
this slightly improved growth performance in the third and fourth quarters of 2003, the
South African economy grew by only 1,9 per cent for 2003 as a whole, considerably
slower than the growth rate of 3,6 per cent attained in 2002 (Table 3).
The slowdown in overall real economic growth in 2003 was due to the significant
contraction in the value added by the agriculture and manufacturing sectors. The poor
performance of agricultural output resulted from the adverse weather conditions that
affected most of the country in 2003 and had a negative effect on both livestock and
field crop production. In the case of manufacturing output, the contraction was largely
due to the slow world recovery and the impact of the appreciation of the exchange rate
of the rand, particularly on export-oriented subsectors.
The significant negative growth in manufacturing and agricultural output during 2003
largely offset the relatively strong growth performance in the value added by mining,
construction, trade, accommodation, transport, communication, and community, social
and personal service sectors. The solid performance of the construction sector was
underpinned by strong demand for residential and non-residential buildings, while the
trade and accommodation sectors continued to benefit from strong consumer demand
for goods and services and buoyant tourism. Strength in the transport and
communication sectors was mostly due to land transport and communication services.
On a quarterly basis, aggregate real gross domestic expenditure continued accelerating
throughout 2003 and reached 7,2 per cent in the fourth quarter. Consequently, growth
in real gross domestic expenditure for 2003 as a whole amounted to 4,2 per cent, just
below the robust rate of 4,7 per cent attained in 2002.
The annual growth in real final consumption expenditure by households for 2003
amounted to 3 per cent, similar to the 3,2 per cent rate attained in 2002. The continued
expansion in consumption expenditure by households was underpinned by rising
consumer confidence and declining prices of various consumer items, tax reductions,
interest reductions, a declining ratio of debt servicing cost to disposable income and fairly
high real wage settlements. The year-to-year growth rate of total real gross fixed capital
formation accelerated from 6,1 per cent in 2002 to 8,4 per cent in 2003 due to increases
Table 3
Growth in real gross domestic product and expenditure
components
Per cent

1st qr 2nd qr 3rd qr 4th qr

Quarterly data refer to quarter-on-quarter growth at annual rates of seasonally adjusted data
Monetary Policy Review May 2004

in capital expenditure in the public sector in particular. Included here are Transnet’s taking
delivery of new aircraft and further expansion of the Coega development project. Real
final consumption expenditure by general government increased by 4,6 per cent in 2003,
a significant increase from the 3,7 per cent growth recorded in 2002. The ratio of final
consumption expenditure by general government to GDP accordingly edged up for 2003
as a whole to 19,1 per cent compared with 18,7 per cent in 2002.
In the external sector of the economy, the volume of exports of goods and services declined
by 0,5 per cent in 2003 while that of imports rose sharply by 9,7 per cent, reflecting the
effect of the appreciation of the exchange rate and buoyant domestic demand.
Fiscal policy
The Budget presented by the Minister of Finance in February this year is moderately
more expansionary than recent budgets, with the deficit projected to increase from
2,6 per cent of GDP in the 2003/04 fiscal year to 3,1 per cent in 2004/05 (Table 4). The
deficit is projected to decline to below 3 per cent by 2006/07, which suggests a
continued commitment to fiscal discipline and provides reassurance regarding the role
of the fiscal deficit as a potential source of inflationary pressure.
The increase in the budget deficit is attributable to a combination of a decline in tax
revenue and an increase in expenditure. The decline in tax revenue is a consequence of
rand appreciation and the lacklustre growth in the global economy that has lowered the
profitability of exporting firms. However, total revenue (tax revenue plus other receipts
less Southern African Customs Union payments) is expected to remain stable at
24,7 per cent of GDP over the medium term. On the expenditure side, government’s
attempt to raise the level of economic growth, reduce unemployment and alleviate
poverty has seen expenditure rising by 11,2 per cent to R368,9 billion in fiscal 2003/04.
Both revenue and expenditure as a percentage of GDP are presented in Table 4.
The increased budget deficit is also reflected in the larger public-sector borrowing
requirement (PSBR) of 3,2 per cent of GDP, declining to 2,7 per cent in the medium
term. The increase in the PSBR is due to the declining surpluses of non-financial public
enterprises. After four years at relatively low levels, the PSBR increased from 0,6 per
cent of GDP in 2003/04 to 3,1 per cent in the 2004/05 fiscal year, but is estimated to
decline to 2,7 per cent of GDP in 2006/07.
South African Reserve Bank
Table 4
Public finance: Ratios to gross domestic product (fiscal years)
Per cent

Actual
Budget
Medium-term
estimates
estimates
National government

PSBR: Public-sector borrowing requirement
Source: National Treasury Budget Review 2004
South African Reserve Bank

Monetary Policy Review May 2004
Monetary conditions2
The growth in the monetary aggregates has been relatively robust in 2003 and early
2004 (Table 5). The average twelve-month growth rate for M3 in 2003 was 13,0 per
cent, and the aggregate grew by 14,9 per cent in February 2004 before slowing slightly
to 14,0 per cent in March as increased government deposits counteracted increased
net foreign assets and claims on the private sector. Quarter-to-quarter, annualised
growth in seasonally adjusted M3 slowed from 19,8 per cent in the second quarter of
2003 to 6,6 per cent in the final quarter, and then rose to 18,9 per cent in the first
quarter of 2004. Growth in the M2 aggregate averaged 14,7 per cent in 2003, and
measured 15,0 per cent in March 2004. Measured quarterly on the same basis as M3,
growth slowed from 23,5 per cent in the second quarter of 2003 to 8,7 per cent in the
final quarter of the year, and then increased to 13,6 per cent in the first quarter of 2004.
The growth in the narrower monetary aggregates M1A and M1 picked up towards the
end of 2003, but nevertheless averaged 5,9 and 1,7 per cent on a year-on-year basis,
respectively, in 2003. In March 2004, growth for M1A was 14,9 per cent and for M1
13,8 per cent. On a quarterly basis, the growth rate for M1 amounted to 25,1 per cent
in the final quarter of 2003 and to 37,6 per cent in the first quarter of 2004. The growth
rate of M1A rose by 17,1 per cent and 40,7 per cent in the same quarters.
Table 5
Percentage change in monetary and credit aggregates
Per cent
Period
M1A
M1
M2
M3
Total loans and
advances **
Quarterly change*

Twelve-month change

Quarterly data refer to quarter-on-quarter growth at annual rates of seasonally adjusted data
**
Total loans and advances to the domestic private sector. Investments and bills discounted are excluded

Since the publication of the
previous Monetary Policy
Review, the Reserve Bank has
revised the values of the
monetary aggregates. Although
negotiable promissory notes
(NPNs) and negotiable
certificates of deposit (NCDs)
are close substitutes, the
Reserve Bank’s definitions of the
monetary aggregates included
the latter but not the former. To
allow for shifts that have recently
occurred between the two
instruments, NPNs have been
included in the revised monetary
aggregates. The assessment
presented in Table 5 is based on
the revised data, which are
explained in more detail in the
March 2004 Reserve Bank
Quarterly Bulletin.
Monetary Policy Review May 2004

Total loans and advances to the domestic private sector were bolstered by lower interest
rates, wealth effects related to rising property prices and higher real disposable income in
2003. The twelve-month rate of increase has been around 12 per cent since April 2003,
recording 12,3 per cent in March 2004. The quarter-on-quarter growth rate slowed,
however, from 22,3 per cent in the second quarter to 7,2 per cent in the final quarter of
2003, before increasing to 12,6 per cent in the first quarter of 2004.
Monetary policy
Three meetings of the MPC have been held since the publication of the November 2003
Monetary Policy Review. In contrast to the previous meetings when the repo rate was
reduced by a total of 500 basis points, the recent meetings have produced less movement
in rates. In the December meeting, the repo rate was reduced by 50 basis points to 8 per
cent, and since then the level of the repo rate has remained unchanged (Figure 12).
At the time of the December meeting, CPIX inflation had declined to 4,4 per cent (for
October) and there were expectations that this trend had not yet bottomed out. This
positive short-term outlook was due in part to the favourable developments in the PPI
where the inflation rate was negative. These developments, combined with positive base
effects, were expected to maintain the downward trend of CPIX inflation in the short run.
The longer-term outlook for inflation was also seen to be positive. The world economic
recovery was not expected to have an immediate or significant impact on world inflation,
and the strong international commodity price increases resulting from this recovery were
expected to have a positive impact on South Africa’s export earnings and the exchange
rate. There was, however, an expectation that the world interest rate cycle would begin
to trend higher. At that point oil prices did not appear to be a major concern, and in fact
the expectation was for a continued moderation in oil prices.
Most domestic indicators also pointed to a positive inflation outlook. The relatively low
output growth and the low level of manufacturing capacity utilisation confirmed that
South African Reserve Bank
Figure 12
The repo and prime interest rates
Per cent, interest rates measured at end of period

Prime rate
Repurchase rate
South African Reserve Bank

Monetary Policy Review May 2004
output was well below the country’s growth potential. Money supply growth remained
low, although credit extension was increasing at a rate of around 12 per cent per
annum. Fiscal policy was expected to remain disciplined and inflation expectations had
come down significantly.
Given this favourable background, there was a general expectation in the market that the
repo rate would be reduced by at least 100 basis points at the December 2003 meeting.
The MPC, however, felt that there were sufficient factors to justify a more modest reduction
of 50 basis points. The Bank’s inflation forecasting model indicated that inflation was
expected to edge up in the course of 2004, although it was expected to remain below the
upper limit of 6 per cent. This reversal in the expected inflation trend could be attributed to
the strong growth in domestic final demand, in part as a result of the previous repo rate
reductions. Other risk factors included a threat to food prices as a result of the continuing
drought, uncertainties related to the exchange rate of the rand, and the possible increase
in unit labour cost as a result of the high nominal wage settlements.
By the time of the February 2004 MPC meeting, the CPIX inflation rate was still below
the mid-point of the inflation target range, having fallen to 4,0 per cent in December
before rising to 4,2 per cent in January. As usual, however, the committee’s focus was
on the expected trend of inflation, which, as was the case in the previous meeting, was
expected to edge up towards the upper end of the target range. The decision not to
change the repo rate at this meeting was to ensure that the inflation rate would remain
within the target band over the next two years. At this point inflation was projected to
accelerate moderately during 2004 to close to the upper limit of the target, followed by
somewhat slower rates of increase during 2005.
Positive factors identified by the MPC were similar to those that prevailed in the previous
meeting, but in addition the low recommended tariff increases of some public utilities
were noted. On the negative side the continued drought was seen as a major threat to
the maize and grain crops, with negative implications for food prices in general. It was
also emphasised that even if the effect on food prices was small, it was unlikely that the
positive impact that food prices had on the lowering of the inflation rate during 2003
would occur again in 2004. Although money supply growth remained relatively subdued,
the MPC continued to monitor the growth in domestic demand, which was financed to
some extent by bank credit extension.
CPIX inflation had risen to 4,8 per cent (for February) by the April 2004 meeting of the
MPC. Although the inflation rate appeared to be on an upward trend, the move was in
fact slightly less than the Bank’s inflation projections. The inflation forecast presented to
the committee, which is reproduced later in this Review, was similar to that shown at the
previous meeting. The central projection of the forecast shows that CPIX inflation is likely
to approach the upper limit of the target, whereafter it is expected to moderate and
remain within the target range.
The pressures that can be expected on CPIX were seen to be mainly related to exogenous
developments, such as changes in energy prices, indirect taxes and food prices. These
pressures were similar to those prevailing at the previous meeting, although the threat from
food prices had dissipated somewhat. Widespread rains had improved the outlook for the
maize crop, leading to a fall in these prices. Conversely, oil prices were seen to be more of
a threat to inflation, although this was identified as a short-term risk only. It has been noted
in the past that monetary policy does not in general react to exogenous shocks. However,
if these effects result in a more generalised impact on inflation, some reaction would be
called for. Any monetary policy response to these exogenous factors would depend on
Monetary Policy Review May 2004

how the MPC viewed the possible second-round effects. At the April meeting, the view
was that the second-round effects of these increases are expected to be small.
Other factors identified by the committee as contributing to the favourable inflation
outlook included the negative PPI inflation, low expected world inflation, and low levels
of capacity utilisation. Utilisation of productive capacity in manufacturing was 79,6 per
cent in the fourth quarter of 2003. Particularly noteworthy was the reported decline in
inflation expectations, as evidenced in the latest Bureau for Economic Research survey
that is reported on later in this Review.
The MPC highlighted a number of uncertainties that could impact on the inflation outlook.
The higher domestic demand has had an impact on imports and therefore on the currentaccount deficit. Despite South Africa’s terms of trade having improved as a result of the
increase in commodity prices, export volumes had disappointed. Although the financial
account had been comfortably financed, a widening deficit was seen as a threat to the
inflation outlook through its possible impact on the exchange rate of the rand.
Also emphasised were developments in nominal unit labour cost. Although the rate of
increase of these costs had declined from 6 per cent in 2002 to 5 per cent in 2003, the
salaries and wages per worker still increased at a rate of 8,6 per cent. Other threats to
the inflation outlook were the stronger trend in monetary growth and the threat of
increased international instability which could pose a threat to low inflation and growth
in emerging-market economies. The decision not to change the repo rate at this stage
was in line with market expectations.
South African Reserve Bank
Box 3
The transmission mechanism of monetary policy
The transmission mechanism describes how changes in monetary policy affect output and inflation.
Although there are a number of explanations of this mechanism, the precise channels which operate
and how they coexist and evolve over time are not known with certainty. Figure B3.1 presents a
stylised depiction of the key linkages in the transmission mechanism.
Economic theory suggests that in the long run, when prices are flexible, money should be
approximately neutral, with changes in nominal money being reflected in nominal prices rather than
in real output. It is in the short and medium term, when rigidities may prevent the full adjustment of
wages and/or prices, that money will have real effects. It is within this context that the transmission
mechanism is discussed.
The stylised depiction of the mechanism in Figure B3.1 serves as a useful expositional device. For
the sake of simplicity, it concentrates on the major links, and omits certain interactions between the
variables and does not provide quantitative information about the size and timing of effects.1
Consider, for example, a tightening of the monetary policy stance, say in response to new forecasts
of inflation above the upper limit of the target range. The instrument of monetary policy in South
Africa, the repurchase (repo) rate at which the central bank refinances the liquidity requirement of the
banking sector through repurchase agreements, is therefore raised. Assuming that this increase was
unanticipated and that it is not expected to be reversed soon, the repercussions of this monetary
policy action may be traced out in Figure B3.1.
The first stage of the mechanism involves the impact of this change in the repo rate on other interest
rates and asset prices. The interest rates faced by firms and households that borrow and lend are
not the repo rate itself, but the rates of the commercial banks. However, the strong link between the
repo rate and commercial bank rates ensures that domestic banks adjust their rates by an amount
similar to the policy change. Mahadeva and Sinclair (2001) explore econometrically the long-run
relationship between official interest rates and interest rates on loans and deposits in a number of
countries, and obtain coefficients of 0,935 for deposit rates and 1,006 for loan rates in the case of
South Africa 2. So, given time, retail rates respond about one to one to the repo rate.
South African Reserve Bank

Monetary Policy Review May 2004
The change in the repo rate also impacts on the prices of assets such as bonds, equities and real
estate. Bond prices are inversely related to long-run interest rates, which the expectations theory of
the term structure suggests depend on the average of current and future expected short-term rates.
The prices of equities may slip in response to the increase in interest rates as expected future returns
are discounted by a larger factor. Real-estate prices will also be negatively affected by the higher
mortgage interest rates, as well as being affected by yields on other asset classes.
A further effect of the change in the repo rate will be on nominal exchange rates. The increase in the
repo rate, which widens the gap between domestic and foreign interest rates, would tend to make
rand-denominated assets relatively more attractive. The exchange rate of the rand will therefore tend
to appreciate to equilibrate expected returns on domestic and foreign assets.
The role played by the expectations of economic agents in determining the impact of monetary policy
changes is difficult to restrict to a particular channel in Figure B3.1. Repo rate changes impact on
expectations regarding future developments in economic variables, which in turn influence many of
the channels identified in the figure. Besides the downstream effects examined below, the roles of
expectations of future interest rates and exchange rates in this first stage of the mechanism have
already been noted.
The second stage of the transmission mechanism depicted in Figure B3.1 focuses on the
repercussions of these changes to interest rates and asset prices on aggregate expenditure and the
external trade account. A direct effect from the interest rate increase to consumption expenditure
(especially on durables) is identified here, as well as net wealth effects resulting from the changes to
asset prices. As discussed earlier, the increase in the repo rate lowers equity and real-estate prices,
and the resulting reduction in wealth will tend to decrease spending. Similarly, firms which rely on
loans whose rates respond to the repo rate will be affected by the increase in this rate, and would
be expected to delay their investment plans. Investment spending will also drop when equity capital
becomes more expensive.
Asymmetric information in financial markets provides a basis for further effects on expenditure which
operate through bank lending and the balance sheets of firms and households. The first of these
implies that a tightening in monetary policy reduces bank reserves and bank deposits, thus reducing
the amount of loans granted, and investment and consumer spending financed by them. The
second, the balance sheet effect, is based on the view that the lower the net worth of firms and
Repurchase rate
Figure B3.1
The monetary policy transmission mechanism
Nominal
exchange rate
Commercial bank
rates
Bond, equity & real-estate
prices
Expectations
Import
spending
Export
receipts
Bank lending
effect
Balance sheet
effect
Net wealth
effects
Volume of
business
Future price
& wage
changes
Expenditure & investment
Inflation rate
Total demand
Import/export
prices
Trade balance
Monetary Policy Review May 2004

The outlook for inflation
The view of the MPC is that CPIX inflation will move towards the upper limit of the
inflation target range before moderating and remaining within the target range. The
outlook and uncertainties relating to some of the factors that are incorporated in this
projection are discussed below.
International outlook
The world’s economic recovery now appears to be broadly based, although the nature
of the upturn differs between regions. With global GDP growth having averaged nearly
6 per cent on an annualised basis in the latter half of 2003 – the highest rate achieved
since late 1999 – and the balance of risks improving, the challenge for industrial
countries will be in sustaining growth and then limiting expansionary policies once
recovery is well established.
The improving global outlook has resulted in the IMF revising upward its projections for
world output growth (Table 6). Global GDP growth is now projected to reach 4,6 per
cent in 2004 and 4,4 per cent in 2005, in both cases an increase of 0,6 percentage
points on the September 2003 forecast.
South African Reserve Bank
households, the more severe the adverse selection and moral hazard problems are of lending to
them and also on the fact that the fall in the value of collateral squeezes loan supply as well. The
contraction in monetary policy discussed here lowers asset prices and collateral available for loans,
exacerbating these problems for banks and reducing their willingness to lend.
An external effect of the exchange rate on the trade balance is also identified in Figure B3.1. If the
nominal exchange rate appreciates because of the increase in the repo rate, this will impact on import
spending and export receipts and hence on total demand. Imports will be relatively cheaper in domestic
currency terms, stimulating import spending, while the higher foreign currency price of exports should
reduce export receipts. The trade balance may therefore deteriorate, contracting total demand further.
In time, however, the contraction in domestic expenditure will also impact on import spending, working
in the opposite direction to this effect.
The final stage in Figure B3.1 concentrates on the impact of the various channels on inflation. All else
being equal, the contraction in total demand will reduce output relative to its potential level, and this
will, in turn, slow the rate of increase in the price level relative to its trend. It will also reduce the rate
of wage increases in the labour market. These effects are supplemented in the figure by a direct
effect for price and wage expectations to influence the inflation process, and also a direct channel
for the appreciation-induced reduction in traded goods prices to pass through to lower domestic
inflation. Together, these channels transmit the effect of an increase in the repo rate to ultimately
lower output and inflation.
A cut in the repo rate, by contrast, say in response to new forecasts of inflation below the target
range, works through the transmission mechanism to raise the inflation rate. The commercial banks’
rates fall in response to the cut in the repo rate, stimulating consumption and investment spending,
and bond, real-estate and equity markets strengthen, with similar consequences. The exchange rate
of the rand may ease, strengthening net exports. Aggregate demand therefore expands relative to
productive potential, which tends to raise pay increases and price inflation. The exchange rate passthrough effect and the impact on expectations of future wage and price increases will reinforce these
effects, together raising output and ensuring inflation returns to the target range in due course.

The October 2001 Monetary Policy Review presents a discussion of the results from a simulation model illustrating the
magnitude and time path of the effects of a change in the repo rate, based on Smal, M M and de Jager, S. 2001. “The
monetary transmission mechanism in South Africa”, South African Reserve Bank Occasional Paper No 16, September.
The results suggest that a change in the repo rate will take around 5 quarters to have its maximum impact on output and
between 6 to 8 quarters to have its maximum impact on inflation in South Africa.

Mahadeva, L and Sinclair, P. 2001.“The Transmission Mechanism of Monetary Policy”. Centre for Central Banking
Studies, Bank of England, June.
South African Reserve Bank

Monetary Policy Review May 2004
The US economy is accelerating sharply and the IMF projections are for growth of
4,6 per cent in 2004 and 3,9 per cent in 2005. This is roughly in line with the
US Congressional Budget Office’s forecast that real GDP will grow by 4,8 per cent in
2004 and by 4,2 per cent in 2005, and that the unemployment rate will fall to 5,8 per
cent in 2004 and 5,3 per cent in 2005. While sceptics point to ongoing imbalances in
the US economy such as the large Federal budget deficit, the large current-account
deficit, and very low personal saving, in the short run they are likely to be overwhelmed
by the cyclical momentum.
Japan’s recent growth performance has been stronger than expected, although there
are concerns regarding the sustainability of growth. GDP growth is projected at 3,4 per
cent in 2004 before slowing to 1,9 per cent in 2005. In Europe, there are some
encouraging signs of an upturn, although the pace of recovery is likely to be moderate
when it eventually gathers momentum. Growth is forecast at 1,7 per cent in 2004 and
2,3 per cent in 2005. Stronger external demand will help accelerate growth, but further
appreciation of the euro could hinder an upturn.
The prospects for emerging-market economies are generally improving, though there
are also considerable regional differences. Emerging Asia remains the world’s fastestgrowing region. China, in particular, grew at 9,1 per cent in 2003, and is anticipated to
grow at 8,5 per cent and 8,0 per cent in 2004 and 2005, respectively. The regional and
global effects of this growth are significant. For example, 50 per cent of South Korea’s
exports go to China, and for Japan that figure is 11 per cent. There are indications,
however, that China could begin to rein in growth.
Developing countries in the Caribbean and Latin America are also expected to see an
acceleration in growth. In the Middle East, relatively robust growth is anticipated, but
the recent resurgence in geopolitical tensions could serve to derail the more favourable
outlook. Economic growth in Africa is expected to be 4,2 per cent in 2004, rising to
5,4 per cent in 2005, although the risks to forecasts of growth tend to be significant.
The projections in Table 6 suggest that the outlook for inflation remains benign. Of the
regions in the table, double-digit inflation is forecast only for the Commonwealth of
Table 6
IMF projections of world growth and inflation for 2004
and 2005
Per cent
Real GDP
Inflation


Other emerging-market and developing countries ..

Source: IMF World Economic Outlook, April 2004
Monetary Policy Review May 2004

Independent States, and in this case only for 2004. The US, despite recent rapid GDP
growth and the depreciation of the US dollar, still has relatively low inflation, labour
markets remain relatively sluggish and productivity growth remains high. In the euro
area, inflation has been relatively sticky but inflation pressures are likely to be restrained
by weak domestic demand, continued wage moderation and a stronger currency.
Global inflation, with very few exceptions, remains subdued.
The more rapid global recovery combined with developments in the foreign exchange
markets have, however, impacted on commodity prices. As Figure 13 and the earlier
discussion in this Review reveal, oil prices have risen in recent months contrary to the
decline implied by futures prices in November 2003 at the time of the previous publication
of the Monetary Policy Review. The outlook for international oil prices provided by the
futures price for Brent crude oil is for slightly lower prices in the coming months, although
the level of the implied prices is above those provided in November and in February.
Although the higher-than-expected oil prices in recent months are likely to contribute to
inflationary pressures in the months ahead, OPEC has indicated that it may raise its
production quota if demand for oil does not decline as expected. A prime concern of
OPEC ministers is that a glut of oil could put pressure on prices in coming months. An
important factor contributing to a supply increase, however, is the fact that prices have
stayed high long enough to encourage more production. At the same time that supply
is growing, the increase in demand has also been significant. Oil consumption has been
increasing 6 per cent per year in China and the improved growth performance of the
world’s biggest consumer of oil, the US, has increased demand significantly. However,
in many other countries consumption has been flat or falling.
With rising global trade, buoyant financial markets and the rebounding world economy,
the balance of risks to global growth has improved significantly since the release of the
November 2003 Monetary Policy Review. Although global growth may be even higher
South African Reserve Bank
Figure 13
Brent crude oil spot and futures prices
US dollars per barrel

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

Brent crude spot price

Futures prices (on 4 May 2004)

Futures prices (on 27 February 2004)

Futures prices (on 4 November 2003)
Source: Bloomberg
South African Reserve Bank

Monetary Policy Review May 2004
than projected in the short to medium term, geopolitical risks and oil prices have
become increasing concerns. Furthermore, among the industrial countries, domestic
demand is generally strongest in those countries with the largest current-account
deficits, so that the recovery may exacerbate underlying imbalances. The most
important challenges will be the orderly resolution of global imbalances and managing
the eventual transition to higher interest rates.
Outlook for domestic demand and supply
The latest Reuters consensus forecast, based on surveys undertaken in late March 2004,
is for real GDP growth of 2,5 per cent in 2004 rising to 3,2 per cent in 2005. The forecast
for 2004 is the mean of 13 individual forecasts ranging between 2 and 3 per cent, and that
for 2005 is the mean of 13 individual forecasts with a low of 2,7 per cent and a high of
3,9 per cent.
Improving global growth, buoyant commodity prices and the lagged impact of interest rate
cuts in the second half of 2003 are expected to lift domestic economic growth in 2004
whereas the lagging European recovery and unfavourable conditions in the local agricultural
sector remain potentially serious obstacles to growth. Real final consumption expenditure
by households and by government, as well as continued high levels of gross fixed capital
formation, are likely to sustain relatively robust growth in gross domestic expenditure.
However, declining profitability could result in a moderation in fixed investment. There is little
likelihood of inflationary pressure emerging from supply constraints, as there is still
considerable idle production capacity in the economy.
There have been concerns that food prices would once more provide upward pressure
on inflation, although these have eased recently. While the review of the main inflation
indicators showed that food price inflation has been moderate, the low rainfall experienced in many parts of the country in 2003 and forecasts for international prices raised
fears that food prices would rise strongly. The South African Futures Exchange (SAFEX)
futures price for white maize for delivery in July 2004, shown in Figure 14, increased
sharply from around R1 000 per ton in October – November 2003 to R1 578 per ton early
Figure 14
Closing prices for white and yellow maize on

SAFEX: July 2004 futures contract
Rand per ton

White maize

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

Source: SAFEX
Monetary Policy Review May 2004

in February 2004. However, prices have subsided to around R1 100 per ton since March
as rainfall figures improved late in the season and higher crop estimates were published.
The government’s Crop Estimates Committee estimated in April that commercial farmers
would harvest 7,814 million tons of maize in 2003/04, compared with earlier forecasts of
7,023 million tons released in February and 7,672 million tons released in March 2004.
Indicators of inflation expectations
The Bureau for Economic Research (BER) at the University of Stellenbosch conducts a
survey of inflation expectations on behalf of the South African Reserve Bank. The results
of the survey of financial analysts, business executives and representatives of the trade
union movement conducted between 25 February and 24 March 2004, are presented
in Table 7. On average, these indicate a continuation of the downward trend in CPIX
inflation expectations that began five quarters ago.
The average CPIX inflation expectation for 2004 is 6,0 per cent, rising to 6,3 per cent in
2005 and 6,4 per cent in 2006. The expectations of the various groups of respondents
differ, as has been the case in earlier surveys. Financial analysts once again have the
lowest inflation expectations, and anticipate average annual CPIX inflation remaining
within the 3 – 6 per cent inflation target range over the next three years (the expectation
is for inflation rates of 5,3 per cent, 5,6 per cent and 5,5 per cent, respectively). The
expectations of business and trade unions are higher, by contrast, and their averages
remain outside the inflation target range.
As Figure 15 shows, however, the expectations of business executives and trade union
officials for CPIX inflation in 2004 have fallen sharply over the previous five quarterly
surveys as measured inflation has declined, and have contributed most to the recent
decline in overall inflation expectations. Trade union expectations for 2004, in particular,
moderated from 10,4 per cent in the first-quarter survey in 2003 to just 6,1 per cent in
the most recent survey, while those of business declined from 9,0 per cent to 6,6 per
cent. The expectations of financial analysts, which peaked at 6,4 per cent in the fourthquarter survey in 2002, actually rose slightly to 5,3 per cent in the most recent survey,
although they remain well within the inflation target range.
The expectations of the financial sector for CPIX inflation may also be obtained from the
Reuters monthly survey of long-term forecasts for the South African economy. This
survey of economists based in South Africa, the US and the UK, solicits forecasts of key
South African economic indicators for the current and subsequent seven quarters, and
for the current and next two calendar years. The recent survey published on 5 April
reports that the mean of 13 forecasts for CPIX inflation in the second quarter of 2004 is
5,2 per cent, rising to 5,9 per cent in the fourth quarter before declining once more to
5,5 per cent in the fourth quarter of 2005. The median forecasts for these periods are
5,3 per cent, 5,9 per cent and 5,5 per cent, respectively, while the mean annual forecast
is 5,6 per cent for both 2005 and 2006.
South African Reserve Bank
Table 7
BER survey of CPIX inflation expectations: 1st quarter 2004
Per cent


Source: Bureau for Economic Research, University of Stellenbosch
South African Reserve Bank

Monetary Policy Review May 2004
Figure 16 shows the spreads between the yields on South African CPI inflation-linked
bonds and conventional nominal bonds of similar maturity, or breakeven inflation
rates. These spreads provide an indication of expected inflation over the period until

Figure 16
Breakeven inflation rates
Percentage points
Spread between R189 and R153 bonds
Spread between R197 and R186 bonds
Spread between R198 and R194 bonds
Figure 15
CPIX inflation expectations for 2004
Per cent
Q1
Q4
Q3
Q2
Q1
Q4
Q3
Q2
Q1

Analysts

Business

Labour

Average
Source: Bureau for Economic Research, University of Stellenbosch
Survey conducted during:

Monetary Policy Review May 2004

the bond matures. The inflation expectations obtained in this way from the R189
(maturing 2013) and R198 (maturing 2008) inflation-linked bonds moved from around
8 per cent in October 2002 to roughly 4.1⁄2 per cent in December 2003, before
increasing to about 5,9 per cent at the beginning of May 2004. The spread on the
longer-dated R197 (maturing 2023) has remained lower than the others throughout,
and is currently just above 5 per cent.
The Reserve Bank inflation forecast
The Bank’s latest quarterly forecast for CPIX inflation is presented in Figure 17. This is
the forecast that was presented to the MPC at the 21 – 22 April 2004 meeting, and
incorporates recent trends in actual and preliminary data that were available at this time.
The latest observed value for CPIX was for the fourth quarter of 2003, for example,
although January and February data were incorporated in the forecast of CPIX for the
first quarter of 2004. As usual, the forecast is based on the assumption of an unchanged
repo rate of 8 per cent over the forecast period. The fan chart technique is again
employed to indicate the uncertainties surrounding the central projection.
The central projection of the forecast is for the CPIX inflation rate to increase from around
4.1⁄2 per cent in the first quarter of 2004 to just below the upper level of the target in the
final quarter, before gradually declining from the second quarter of 2005 to around
5.1⁄2 per cent by the end of the year. The probability distribution for this forecast reveals
that there is approximately a 60-per-cent probability that the CPIX inflation rate will be
between 3 and 6 per cent in the final quarter of 2005.
South African Reserve Bank
Figure 17
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).
South African Reserve Bank

Monetary Policy Review May 2004
With regard to the risks to this forecast, there are a number of factors that increase the
possibility of outcomes that deviate from the central projection. Geopolitical
uncertainties currently represent a significant risk to stability in economic markets,
especially the international crude oil market. The risk of volatility in this market remains
a concern, despite the anticipated downward trend in world oil prices. Volatility in the
foreign exchange rate of the rand would also increase the risks associated with the
forecast. Furthermore, the potential impact of the drought remains a risk, although the
magnitude of this risk has declined recently. Domestically, the possibility of higher-thananticipated wage and salary settlements is a factor that increases the risk of an outcome
above the central projection. Overall, however, the balance of risks associated with this
forecast is deemed to be neutral.
Assessment and conclusion
The strong world economic recovery is expected to be sustained and this could begin
to put upward pressure on world inflation. However, most major central banks appear
confident that the low inflation environment will continue. Nevertheless, the strength of
the economic recovery in the US in particular has prompted a general expectation that
an upturn in the world interest rate cycle is likely to commence sooner than was
previously anticipated. Adding to the uncertainty of the world inflation outlook is the
stronger trend in international oil prices, which is influenced not only by market
conditions but by geopolitical factors as well.
The domestic inflation outlook will continue to be influenced by these international as
well as domestic developments. Although the impact of oil price developments appears
to be more of a risk than was the case 6 months ago, the risk to the inflation target that
was posed by drought-induced food price increases has dissipated somewhat. The
exchange rate of the rand continues to be characterised by a relatively high degree of
stability, and with the improved foreign exchange reserve position, this stability should
be sustained. Developments in the US dollar exchange rate could however impact on
this stability. A further uncertainty relates to the trend in wage settlements, where no
clear pattern has as yet emerged.
Although the inflation outlook is not as benign as was the case when the previous
Monetary Policy Review was published, the inflation rate has remained within the
inflation target band of 3 – 6 per cent and is expected to remain within this target band.
Although late last year there were expectations in the market of further interest rate
reductions, monetary policy has remained forward-looking and focused on the expected
trend of inflation. The actions of the MPC will continue to be guided by its mandate to
maintain CPIX inflation within the target range.