Monetary Policy
Review


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


Monetary Policy Review
Introduction
Inflation has remained within the target range for the past 25 months, more recently
against the backdrop of a strongly growing domestic economy and robust domestic
demand. Although the inflation outlook has deteriorated moderately over the past few
months, mainly as a result of developments in international crude oil prices, there is as
yet little evidence of inflationary pressures passing through to inflation. The stance of
monetary policy has consequently remained unchanged since the publication of the
previous Monetary Policy Review in May.
The developments in international oil prices and the robust domestic demand, partly reflected
in accelerating bank credit extension, are important themes in this review of monetary policy.
The impact of these developments on inflation expectations is particularly important, given
the role that expectations play in the wage and price-formation process. Although there are
signs that inflation expectations have deteriorated recently, they nevertheless remain
consistent with the inflation target. However, a continued deterioration of inflation
expectations would be a cause for concern.
This review of monetary policy begins by analysing inflation developments and the
factors that impact on inflation. This is followed by an assessment of recent monetary
policy developments and a discussion of the inflation outlook as well as the South African
Reserve Bank’s (Bank’s) inflation forecast. Three topical issues are addressed in the
boxes. The first box focuses on the official administered price index recently released by
Statistics South Africa, while the second box reports on research into the demand for
the M3 monetary aggregate in South Africa. The final box addresses the question of how
policy should respond to oil price shocks and provides an overview of recent thinking in
this regard.
South African Reserve Bank

Monetary Policy Review November 2005

Recent developments in inflation
This section analyses recent trends in the main inflation indices, and reviews developments in the primary factors impacting on inflation in South Africa.
The evolution of indicators of inflation
Figure 1 shows that the Bank’s targeted measure of inflation, the year-on-year increase
in the consumer price index excluding mortgage interest cost for metropolitan and other
urban areas (CPIX), has remained within the inflation target range of 3 to 6 per cent since
September 2003. When the previous Monetary Policy Review was published in May
2005, the latest available CPIX inflation rate, for March, was 3,6 per cent. After
increasing to 3,9 per cent in May, and declining to 3,5 per cent in June, the CPIX inflation
rate subsequently increased to 4,8 per cent in August, before receding slightly to 4,7 per
cent in September. The analysis in this section shows that these fluctuations are largely
due to movements in petrol prices.
Quarterly CPIX inflation (measured as the annualised quarter-on-quarter rate of increase
in the seasonally adjusted data) accelerated from 2,4 per cent in the first quarter of 2005
to 4,6 per cent in the second quarter and 6,3 per cent in the third quarter.
Figure 1 also plots the inflation rate measured in terms of the headline consumer price
index for metropolitan areas (CPI). After increasing from 3,0 per cent in March 2005
to 3,4 per cent in April, the CPI inflation rate declined to 2,8 per cent in June 2005.
CPI inflation then accelerated again to 3,9 per cent in August and 4,4 per cent in
September. The quarter-on-quarter CPI inflation rate (measured on a seasonally
adjusted and annualised basis) increased from 2,3 per cent in the first quarter of this
year to 2,8 per cent in the second quarter and 5,4 per cent in the third quarter.
Monetary Policy Review November 2005
South African Reserve Bank
Percentage change over twelve months

CPI

CPIX
Figure 1
Consumer price inflation: CPIX and CPI
Source: Statistics South Africa
Table 1 shows the weighted contributions of the main components of the CPIX to the
overall year-on-year inflation rate. It is clear from the table that developments in the
transport component of the index, related to fluctuations in the petrol price, have had a
significant influence on the recent movements in the CPIX inflation rate. The contribution of
this component increased from 0,7 percentage points in April 2005 to 0,8 percentage
points in May, before declining to 0,4 percentage points in June as the overall CPIX inflation
rate slowed to 3,5 per cent. Transport’s contribution then increased to 1,3 percentage
points in September, when the overall inflation rate measured 4,7 per cent.
The contribution of the transport component to CPIX inflation has, in turn, been driven
by movements in petrol prices. The inland pump price of 93 octane leaded petrol, for
example, increased by a cumulative R1,41 per litre between the beginning of April and
October this year. It increased from R5,02 per litre in April to R5,22 per litre in May,
before declining to R5,06 per litre in June 2005. The price then increased again to R5,62
per litre in August, R5,91 per litre in September and R6,03 per litre in October. In
November, however, the price of petrol will fall to R5,72 per litre. Figure 6 in a later
section shows the relationship between these changes and international crude oil prices.
The contributions to CPIX inflation of the other components in Table 1 remained
relatively stable during the period under review, with the exception of the food
component. After contributing not more than 0,5 percentage points since July 2004,
this component contributed at least 0,6 percentage points to the overall CPIX inflation
rate in the period from July to September 2005. The housing component remained
subdued, adding 0,8 percentage points to CPIX inflation from March to June 2005,
before contributing 0,7 percentage points in August and 0,6 percentage points in
September. The contribution of medical care and health expenses to CPIX inflation
also remained steady at 0,7 percentage points from March to June 2005, before
declining to 0,6 percentage points in July – September 2005.
Figure 2 highlights the important role that energy prices, in particular, have played in
determining the CPIX inflation rate. Excluding energy prices, the year-on-year rate of
increase in the CPIX was 3,3 per cent from March to June 2005, 3,6 per cent in July
and August, and 3,5 per cent in September. Food prices, by contrast, continue to have
a moderating effect on the overall CPIX inflation rate in the sense that their exclusion
yields a higher inflation rate than that measured in terms of the overall CPIX. Excluding
food, CPIX inflation measured on a year-on-year basis increased from 4,3 per cent in
March 2005 to 5,0 per cent in May, before declining to 4,3 per cent in June and then
South African Reserve Bank

Monetary Policy Review November 2005
Table 1
Contributions to CPIX inflation
Percentage change over twelve months* and percentage points

April
May
June
July
Aug
Sep

Of which:

Source: Statistics South Africa

increasing to 5,5 per cent in August. In September, this rate declined to 5,3 per cent.
Excluding both food and energy prices, CPIX inflation was around 4 per cent between
March and August 2005, and declined to 3,6 per cent in September.
Figure 3, which plots the inflation rates for the goods and services categories of the
CPIX, reveals that services inflation continued to advance at a significantly faster pace
than goods inflation. The inflation rate for goods increased from 2,3 per cent in March
Monetary Policy Review November 2005
South African Reserve Bank
Percentage change over twelve months

Goods
Services
CPIX

Figure 3
CPIX: Goods and services inflation
Source: Statistics South Africa
Percentage change over twelve months

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


Figure 2
The effect of food and energy prices on CPIX

inflation
2005 to 2,9 per cent in May, and then declined to 2,0 per cent in June. Goods
inflation then increased to 4,3 per cent in August and 4,4 per cent in September.
Services inflation, after having moved below the upper limit of the inflation target in
January 2005, increased from 5,9 per cent in March to 6,1 per cent in June before
receding to 5,8 per cent and 5,6 per cent in August and September, respectively.
Beginning in May 2005, Statistics South Africa has been publishing an official monthly
consumer price index of administered prices. Box 1 in this Monetary Policy Review
provides details regarding this official administered price index (API), and Figure 4
presents the year-on-year API inflation rate. As the graph shows, the API inflation rate
increased from 7,4 per cent in March 2005 to 9,4 per cent in May and then declined
to 6,8 per cent in June. The rate then increased to 11,2 per cent in August 2005
before declining to 10,3 per cent in September. However, as the weights in Box 1
reveal, fluctuations in petrol prices have a significant influence on the index. Figure 4
reveals that once petrol prices are excluded from the API, the inflation rate in fact
declined from June 2005. That is, after increasing from 6,8 per cent in March 2005 to
7,0 per cent in May, the API inflation declined to 6,0 per cent in August and 4,5 per
cent in September.
South African Reserve Bank

Monetary Policy Review November 2005
Percentage change over twelve months

Administered price index (API)

API excluding petrol

CPIX
Sources: Statistics South Africa and Reserve Bank calculations

Figure 4
CPIX and administered prices

Monetary Policy Review November 2005
South African Reserve Bank
Box 1 Statistics South Africa releases an official index of
administered prices
This box seeks to highlight the publication by Statistics South Africa (Stats SA) of an official index of
administered prices for South Africa. After a series of discussions involving officials from Stats SA,
the Bank and the National Treasury, which resulted initially in the publication of a discussion paper
on administered prices in August 2004, the official index of administered prices was included in the
CPI release of May 2005.1
Details of the discussion paper, which solicited feedback from the public, were summarised in Box 1
in the Monetary Policy Review of November 2004. After taking into account the comments received,
an official definition of administered prices was adopted, based on Approach 1 of the discussion
document. This definition reads as follows:
“An administered price is defined as the price of a product, which is set consciously by an individual
producer or group of producers and/or any price, which can be determined or influenced by
government, either directly, or through one or other government agencies/institutions without
reference to market forces.”
The components of the headline CPI and CPIX that appeared in the discussion paper have been
slightly revised, and the composition of the final index is presented in Table B1.1.
The availability of the official index of administered prices renders the unofficial index previously
calculated by the Bank obsolete. The official index will therefore be used from now as the measure
of overall administered price inflation. It will also provide the basis for calculations which exclude the
petrol price from the index; these calculations will be made by the Bank since Stats SA does not
publish the index excluding petrol at this stage.
Table B1.1
Administered prices in headline CPI and CPIX
Group
Weight in CPI
Weight in CPIX

Source: Statistics South Africa

Statistics South Africa.
2005. “Consumer Price
Index – Statistical Release
P0141.1”, May.
The contributions of the various components to the overall API inflation rate, presented in
Table 2, confirm the important influence of the petrol price on this rate in recent months.
The contribution of the petrol component increased from 3,3 percentage points in April
2005 to 7,0 percentage points in August and September. The contributions of the
remaining components of the API reported in Table 2 were notably more stable, with the
exception of electricity and communication in September.
Inflation measured in terms of the production price index (PPI) increased from 1,9 per cent
in March 2005 to 4,6 per cent in September (Figure 5). The imported component of the
PPI has fuelled this increase, with its inflation rate increasing from 0,7 per cent to 6,8 per
cent over the same period. After contributing a subdued 0,2 percentage points to the
overall PPI inflation rate in March 2005, the contribution of imported goods increased to
South African Reserve Bank

Monetary Policy Review November 2005
Table 2
Contributions to administered price inflation
Percentage change over twelve months* and percentage points

April
May
June
July
Aug
Sep

Of which:

Sources: Statistics South Africa and Reserve Bank calculations
Percentage points* and percentage change over twelve months

-5

Contribution of:


Imported component*


Domestically produced component*

Production price index (PPI)
Source: Statistics South Africa
Figure 5
Production price inflation

1,7 percentage points in September. The inflation rate for the domestic component, by
contrast, increased from 2,3 per cent in March 2005 to 3,8 per cent in September 2005.
Quarterly PPI inflation (measured as the annualised quarter-on-quarter rate of increase
in the seasonally adjusted data) increased from 1,3 per cent in the first quarter of 2005
to 8,6 per cent in the third quarter. The imported component of the PPI, measured on
the same basis, increased by 13,9 per cent in the third quarter of 2005 compared to a
decline of 3,2 per cent in the first quarter of the year. The domestically produced
component of PPI inflation increased by 5,9 per cent in the third quarter compared to
an increase of 1,9 per cent in the first quarter of 2005.
Factors affecting inflation
Monetary policy decisions are made on the basis of developments and expected
developments in the wider macroeconomy. Recent developments in some of the main
variables influencing inflation in South Africa are reviewed in this section, while the outlook
for these variables and their likely impact on inflation are discussed in a later section.
International economic developments
According to the most recent International Monetary Fund (IMF) data, economic and
financial conditions in the international economy have remained generally benign since
the previous Monetary Policy Review, although there were a number of challenges. Led
primarily by the United States (US) and China, the world economy continued to grow at
solid rates although growth projections for 2005 in most countries have been revised
downward – with the important exceptions of Japan, China and India. The major global
imbalances, such as the difference between the US and Asian propensities to save, show
no significant signs of reversal. However, underlying inflationary pressures in most
countries generally have remained muted, resulting in little transmission of price pressures
to the South African economy.
Global real gross domestic product (GDP) grew by 5,1 per cent in 2004 and is projected
to increase by 4,3 per cent in 2005 (Table 3). Growth in some of the advanced
economies slowed in the second quarter of 2005 while emerging-market economies
continued to record robust growth. However, to date the impact on global growth of
higher oil prices has been moderate, reflecting in part the fact that higher oil prices have
been largely the result of strong global demand. Even though core inflation rates
remained benign, overall inflation rates in most countries have increased somewhat in
response to the sharp increase in oil prices. World inflation is projected to increase to
3,9 per cent in 2005 from 3,7 per cent in 2004. Relatively well-anchored inflationary
expectations and declining oil intensity in production have also served to soften the blow
on the global economy so far.
The US economic expansion is proceeding steadily, and the country’s economy is still
growing faster than that of any of the other major industrialised countries. However, real
GDP in the US increased at a slightly lower annualised rate of 3,3 per cent in the second
quarter of 2005, after increasing by 3,8 per cent in the first quarter. Employment and
incomes continued to rise, and other US data suggest that the economy still enjoyed
solid momentum prior to the hurricanes that hit the US Gulf Coast towards the end of
August and during September, which could impact negatively on growth in the second
half of the year. Long-term interest rates in the US have also remained surprisingly low
in recent months despite an increase in short-term rates, possibly as a result of strong
foreign demand for dollar-denominated assets.
Monetary Policy Review November 2005
South African Reserve Bank
The Japanese recovery remains on track and the economy grew at an annualised rate of
3,3 per cent in the second quarter of 2005, compared with a rate of 5,8 per cent in the
first quarter. Improvements in corporate profitability in Japan are stimulating investment
spending and enhancing the medium-term outlook for domestic demand. Growth in the
world’s second-largest economy averaged 1,7 per cent in the first half of 2005.
In the euro area, while some data are still broadly consistent with a strengthening of
activity in the second half of 2005, the tentative recovery in domestic demand observed
in the second half of 2004 has slowed considerably. The GDP growth forecast by the
IMF for 2005 as a whole has been marked down, and is now 1,2 per cent. Economic
growth disappointed in the second quarter of the year as surging oil prices and fears of
a loss in momentum of global manufacturing took their toll on confidence.
The prospects for economic activity in the United Kingdom (UK) have moderated and
GDP growth in 2005 is expected to be somewhat weaker than in 2004. Growth for the
year is expected to average 1,9 per cent in 2005. The slowdown in GDP growth in the
UK is mainly being driven by lower growth in household consumption, as the cooling
housing market and the personal debt burden dampen spending. The UK housing
market showed further signs of stabilising in August, with the rate of house price
declines easing markedly and activity increasing.
In Developing Asia, GDP growth of 7,8 per cent is expected in 2005 as China continues
to expand at a brisk pace. Growth in India also remains robust with a continued
expansion in services and accelerating industrial production, while Pakistan has posted
its fastest growth rates in more than two decades. Real GDP growth in China has
continued to exceed expectations and in the 9 months to September, China’s trade
surplus swelled to US$68 billion, more than double the surplus of US$32 billion for the
whole of 2004. While the surplus has swelled partly because of China’s export
South African Reserve Bank

Monetary Policy Review November 2005
Table 3
Annual percentage change in real gross domestic product and
consumer prices
Real GDP
Consumer prices

(estimate)
(estimate)

Other emerging-market and developing countries

Commonwealth of Independent States

Source: IMF World Economic Outlook, September 2005

performance, growing by 31 per cent year on year in the January to September
period, it has also risen because import growth has been weaker, growing by 16 per
cent in the same nine-month period.
In Latin America, regional GDP is projected to increase by 4,1 per cent in 2005. After a
strong rebound in 2004, growth in Latin America slowed in the first quarter of 2005, for
example in Brazil, Argentina and Mexico, before improving once more in the second quarter.
In Africa the overall growth picture so far in 2005 is encouraging, although non-oil
producing and drought-stricken countries are likely to lag behind. GDP growth in subSaharan Africa is forecast to moderate to 4,5 per cent in 2005 (0,4 percentage points
lower than expected by the IMF last April), partly reflecting a sharp slowdown in Nigeria
as oil production nears capacity. Growth in oil-importing countries in the sub-Saharan
Africa region, while slowing, has so far held up well, with the adverse impact of higher
oil prices so far offset by stronger non-oil commodity prices, as well as the benefits of
improved macroeconomic stability and ongoing structural reforms.
Finally, rising oil production and prices have continued to support GDP growth in the Middle
East, accompanied by dramatic improvements in external current-account and fiscal
positions. However, inflation in the region is expected to increase to 10 per cent in 2005.
Oil prices
Crude oil prices more than doubled from the beginning of 2004 to record-high levels
which approached US$70 per barrel towards the end of August 2005, before declining
to below US$60 per barrel in October. As Figure 6 shows, the relative stability of the
foreign exchange rate of the rand over this period has resulted in the rand price of crude
oil tracking these changes closely and in significant pass-through to domestic petrol
prices in 2005.
International crude oil prices rose sharply in June and mid-July owing to lower-thanexpected inventories, weaker refining capacity as well as production disruptions due to
tropical storms in the Gulf of Mexico. Prices soared further in August and September,
due to various factors including hurricanes in the Gulf of Mexico, the death of King Fahd
of Saudi Arabia, announcements related to Iran’s nuclear energy programme and a
further decline in crude oil inventories. Overall, prices rose by close to 45 per cent in the
three months to September 2005, reaching record-high levels in nominal terms
approaching US$70 per barrel on 30 August, before declining somewhat. Crude oil
prices then rose again in mid-September after the US Department of Energy predicted
that energy costs in the coming winter in the US would be the highest in 10 years.
The hurricanes Katrina and Rita, which hit the Gulf of Mexico and damaged offshore oil rigs,
refineries and ports, have been a significant factor in international oil markets in the period
under review. Estimates by the US Energy Information Administration as at 11 October
2005 were that hurricane damage in the Gulf region affected 1,5 million barrels per day of
US oil production (29 per cent of the total), 8 million barrels per day of US refining capacity
(47 per cent of the total), and 10 billion cubic feet per day of US gas production (19 per
cent of the total). In response, crude oil was allocated from the US Strategic Petroleum
Reserve and the US administration indicated that up to 30 million barrels of crude oil
would be offered over a one-month period. However, it is notable that the US Energy
Department had, by the end of September, found buyers for just over a third of the
amount offered (11 million barrels), suggesting that the binding constraint may be a
shortage of refining capacity rather than of crude oil.
Monetary Policy Review November 2005
South African Reserve Bank
The International Energy Agency (IEA) also announced that it would activate its
emergency oil plan, releasing oil for only the second time in its 29-year history. The
agency announced in September that its member countries would release 60
million barrels of petroleum products to the US market to help supplement supplies
(this includes the 30 million barrels from the US mentioned above). Furthermore, in
mid-September the Organization of the Petroleum Exporting Countries (OPEC)
announced that it would allow its members to provide up to two million barrels of extra
crude oil a day if required by the market, for 3 months beginning on 11 October.
However, higher prices do appear to be having an impact on oil demand. A US Energy
Department report released in September predicted that the higher prices would lead to
an increase of 100 000 barrels per day in US petroleum demand for the remainder of
the year instead of the 160 000 barrels per day predicted a month earlier. In September
and in October the IEA also lowered its projected growth for global oil demand for the
remainder of 2005 and for 2006 on the assumption that sustained high prices would
choke demand. The latest IEA forecast is for daily world oil demand in 2005 to grow by
1,3 million barrels to 83,4 million barrels.
South African Reserve Bank

Monetary Policy Review November 2005
US$ per barrel (monthly average price)
Indices: January 2004=100
Jan
Mar
May

Jul
Sep
Nov
Nov
Mar
May
Jul
Sep
Jan

Brent crude US dollar

Brent crude rand

Petrol price (Gauteng, 93, leaded)

Figure 6
Crude oil and domestic petrol prices

Selected central bank interest rate developments
Table 4, which shows the most recent interest rate changes made by selected central banks,
suggests that monetary policy stances have become increasingly divergent in recent months.
A number of central banks have raised official interest rates, some have reduced interest rates
and others have kept interest rates on hold. Each of these groups is discussed in this section.
The US Federal Open Market Committee (FOMC) raised its target for the federal funds rate
to 3,75 per cent in September 2005, the eleventh 25-basis-point increase since mid-2004.
The FOMC indicated that longer-term inflation expectations remain well contained in the US,
but highlighted concerns about the potential impact of higher energy and other costs on
inflationary pressures. The Bank of Canada raised its target for the overnight rate in October
2005 for the second time this year by 25 basis points to 3,00 per cent. Chile’s central bank
continued to increase its benchmark interest rate during the year, reaching 4,25 per cent in
October 2005, in order to maintain expected inflation at around 3 per cent. Strong growth
momentum forced the Bank of Thailand to increase its 14-day repurchase rate by 50 basis
points to 3,75 per cent in October 2005, the eighth increase since August 2004, in order to
keep core inflation within the target range. Taiwan’s central bank raised interest rates on
three occasions this year by 12,5 basis points to reach 2,125 per cent in September 2005
due to concerns about price stability, while the Bank of Indonesia increased its official
interest rate to 11,0 per cent in October 2005 in response to an anticipated escalating trend
Monetary Policy Review November 2005
South African Reserve Bank
Table 4
Selected central bank interest rates
Per cent
Countries
1 Jan 2005
28 Oct 2005
Latest change
(percentage points)
2,25
3,75
20 Sep 2005
(+0,25)
0,00
0,00
19 Mar 2001
(-0,15)
2,00
2,00
5 Jun 2003
(-0,50)
4,75
4,50
4 Aug 2005
(-0,25)
2,50
3,00
18 Oct 2005
(+0,25)
2,00
2,00
6 Jun 2003
(-0,50)
2,00
1,50
21 Jun 2005
(-0,50)
0,25 – 1,25
0,25 – 1,25
16 Sep 2004
(+0,25)
5,25
5,50
2 Mar 2005
(+0,25)
6,50
7,00
27 Oct 2005
(+0,25)
3,70
4,00
24 Oct 2005
(+0,25)
5,58
5,58
28 Oct 2004
(+0,27)
3,75
5,25
21 Sep 2005
(+0,25)
7,43
11,00
4 Oct 2005
(+1,00)
2,70
2,70
23 Apr 2004*
3,25
3,50
11 Oct 2005
(+0,25)
1,75
2,125
15 Sep 2005 (+0,125)
2,00
3,75
19 Oct 2005
(+0,50)
4,75
5,25
25 Oct 2005
(+0,25)
17,75
19,00
19 Oct 2005
(-0,50)
2,25
4,25
11 Oct 2005
(+0,25)
8,81
9,25
23 Sep 2005
(-0,25)
2,50
2,00
27 Oct 2005
(+0,25)
9,50
6,00
20 Sep 2005
(-0,25)
6,50
4,50
31 Aug 2005
(-0,25)
13,00
13,00
15 Jun 2004
(-1,00)
*
The central bank of Malaysia introduced a new interest rate framework on 23 April 2004
Source: National central banks
in future inflation. The central banks of Israel, South Korea and the Czech Republic reversed
course in October 2005, raising interest rates as inflationary pressures increased.
After increasing the repo rate by 100 basis points in 2004, the Bank of England reduced
interest rates by 25 basis points to 4,5 per cent in August 2005. Output growth in the
UK is expected to remain slightly below trend in the near term, reflecting the continued
sluggishness of domestic demand. Sweden’s central bank, the Riksbank, lowered the repo
rate in June 2005 from 2,0 per cent to 1,5 per cent as economic growth slowed more than
expected. The Riksbank expects that the current low inflation rate will return to the central
bank’s inflation target of 2 per cent in the next few years and left the repo rate unchanged
at its latest MPC meeting in October 2005. Slowing economic growth and lower inflationary
pressures in Brazil, Hungary, Mexico and Poland have also resulted in their central banks
reducing benchmark interest rates. After increasing the Selic interest rate by a cumulative
375 basis points since September 2004 to 19,75 per cent, Brazil’s central bank cut interest
rates in September and October 2005. The Bank of Mexico (Banxico) began easing the
monetary policy stance in August 2005 after having tightened it via the el corto mechanism
on 12 occasions since February 2004. The central bank has decided on a gradual transition
towards a policy-target regime, but kept the el corto until the transition is complete. Banxico
reduced its benchmark lending rate to 9,25 per cent in September 2005 from 9,5 per cent,
following a 25-basis-point reduction in August. The central banks of Hungary and Poland
also reduced their official interest rates, to 6,0 per cent and 4,5 per cent, respectively, in
recent months. Lower core inflation rates in Hungary were partly due to one-off factors such
as intensifying import competition resulting from the country’s European Union accession
and the transformation process underway in retail trade, while in Poland the impact of higher
oil prices has been offset by a strengthening of the exchange rate.
The Governing Council of the European Central Bank has left the key interest rate
unchanged since mid-2003 as underlying medium-term domestic inflationary pressures
remained contained. Real output in the euro area continued to grow moderately, but recent
indicators suggest that economic growth could improve in the second half of the year. The
Bank of Japan (BOJ), meanwhile, has kept official interest rates unchanged since 2001, but
eased monetary policy several times in 2003 and again in January 2004 by increasing the
target range for the outstanding balance on reserve accounts at the BOJ (currently ¥30-35
trillion). The BOJ decided in May 2005 to adopt a more flexible approach to its reserve target
and will allow a temporary undershooting of the average daily reserve balance.
Exchange rate developments
Measured against a basket of thirteen currencies, the foreign exchange rate of the rand
is currently slightly below the levels that were recorded at the end of March 2005. As
Figure 7 shows, however, within this period the nominal effective exchange rate
depreciated by approximately 10 per cent between 6 May and 2 June 2005, and then
appreciated by slightly less than this to the end of September. On a bilateral basis
against the US dollar, the rand depreciated from R5,97 on 6 May to R6,92 on 8 July
2005. The exchange rate then strengthened to R6,32 on 9 September, before
depreciating once more to around R6,70 at the end of October.
The recovery of the nominal exchange rates of the rand between June and
September was related to both international and domestic developments. At times,
movements in the US dollar on world markets were an important factor. On the
domestic front, South Africa continued to receive improved ratings from rating
agencies in 2005. After the upgrade by Moody’s in January, Standard & Poor’s
South African Reserve Bank

Monetary Policy Review November 2005

upgraded South Africa’s long-term foreign currency rating from BBB to BBB+ and
the local currency rating from A to A+ in August. Later in August, Fitch rating agency
also upgraded South Africa’s foreign currency rating to BBB+ from BBB, short-term
rating from F3 to F2, and raised the country’s ceiling from BBB+ to A-. The reasons
given for these upgrades include South Africa’s improved growth performance, its
reasonable level of international liquidity, and the credibility of monetary policy. Fitch
also highlighted South Africa’s improved external balance sheet and the associated
accumulation of official reserves.
Other factors which have influenced the exchange rate include better-than-expected
GDP data for the second quarter of 2005 and the significant inflow of capital in the past
six quarters. The period between April and October 2005 saw net purchases of about
R29 billion worth of bonds and equities by foreigners. The deficit on the current account
of the balance of payments also contracted to 3,4 per cent of GDP during the second
quarter of 2005 compared to 3,8 per cent during the first quarter.
Labour markets
Inflationary pressures arising in the labour market are influenced by developments in both
wages and productivity. Higher productivity essentially moderates the inflationary impact
Monetary Policy Review November 2005
South African Reserve Bank
Index: 2000=100 (foreign currency per rand)
Rand per euro
Rand per US dollar
Figure 7
Exchange rates of the rand

Mar
Feb
May
Apr
Jul
Jun
Sep
Aug
Oct
Jan

Nominal effective exchange rate of the rand (NEER)

Rand per US dollar

Rand per euro (right-hand scale)


of any given wage increase. Growth in unit labour cost, measured as the ratio of the
growth rates of remuneration per worker to labour productivity, is therefore an important
indicator for assessing inflationary pressures arising in the labour market. Figure 8 reveals
that although year-on-year growth in remuneration per worker slowed in the second
quarter of 2005, labour productivity growth weakened more, resulting in growth in unit
labour cost increasing from 3,8 per cent in the first quarter of 2005 to 4,5 per cent in the
second quarter. On average, however, the 4,2-per-cent growth in unit labour cost in the
first half of 2005 is lower than the 7,3 per cent average recorded in 2004.
Growth in labour productivity, which had been rising since the third quarter of 2004,
slowed to 3,2 per cent in the second quarter of 2005 from 4,3 per cent in the first
quarter. The slowdown in the rate of productivity growth is due to the growth in value
added expanding at a slower rate than that of employment. The new Quarterly
Employment Statistics survey released by Statistics South Africa, which replaces the
Survey of Employment and Earnings, reports that the year-on-year rate of increase in
nominal remuneration per worker was 8,3 per cent and 7,9 per cent in the first and
second quarters, respectively, having declined from a high of 12,7 per cent in the fourth
quarter of 2004.
South African Reserve Bank

Monetary Policy Review November 2005
Percentage change over four quarters

Figure 8
Remuneration 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

Note: Data from the fourth quarter of 2004 are from the Quarterly Employment
Statistics (QES) published by Statistics South Africa, which replaced the
Survey of Employment and Earnings (SEE) in June 2005. Since these two
surveys differ both in terms of their sample sizes and content, data from the
fourth quarter 2004 onwards may not necessarily be fully comparable with
previous periods.

The slowdown in the growth of remuneration per worker in the first half of 2005 is also
reflected in wage settlements, as depicted in Figure 9. Despite the intense bargaining and
strike activity that characterised wage negotiations this year, the rate of increase in wage
settlements maintained a downward trend. For the year until September 2005, growth in
wage settlements averaged 6,2 per cent, compared to last year’s average of 6,8 per cent.
Demand and output
Growth in the South African economy regained momentum in the second quarter of 2005.
Table 5 shows that quarterly real GDP growth accelerated from an annualised rate of
3,5 per cent in the first quarter of the year to 4,8 per cent in the second quarter. The rapid
expansion in economic activity in the second quarter marked the twenty-third consecutive
quarter of uninterrupted growth since the economy began the current upswing in 1999.
The contributions to GDP growth in the second quarter were broadly based, with strong
performances recorded in agriculture as well as in the secondary and tertiary sectors of
the economy. Buoyant horticultural-sector performance boosted the gross value added
by the agricultural sector, while manufacturing and construction bolstered the output of
the secondary sector. The continued resilience of domestic demand added impetus to
manufacturing output while activity in the construction sector remained buoyant (as
discussed in a later section). Several subsectors within the tertiary sector also recorded
impressive growth rates.
Aggregate gross domestic expenditure growth increased from 1,7 per cent in the first
quarter of 2005 to 4,9 per cent in the second quarter. The high second-quarter growth
rate is attributed to the continued expansion in final consumption expenditure by
households and the rebound in final consumption expenditure by general government.
Monetary Policy Review November 2005
South African Reserve Bank
Per cent

Figure 9
Average annual inflation and wage settlements*
Growth in real final consumption expenditure by households, which accounted for
64 per cent of expenditure on GDP, remained brisk. In the second quarter of 2005 it
increased at a rate of 5,9 per cent compared to the 5,5 per cent recorded in the previous
quarter. All major spending categories recorded sustained growth. Growth in real final
consumption expenditure by general government rose sharply from 1,2 per cent in the
first quarter to 5,3 per cent in the second quarter of 2005, due mainly to higher growth
in expenditure on non-wage goods and services although real compensation of
employees also picked up slightly.
Real fixed capital formation grew by 5,7 per cent in the second quarter of 2005
compared to the 10,1-per-cent growth rate recorded in the first quarter. All institutional
sectors – private business enterprises, general government and public corporations –
recorded sustained growth in investment spending. The somewhat slower overall
growth in the second quarter was mainly attributable to less buoyant increases in public
corporations’ capital expenditure.
Developments in the external sector of the economy occurred against the backdrop of
a somewhat slower pace of global economic expansion and an acceleration in
domestic expenditure. The growth in the value of exports of goods and services
rebounded from -13,3 per cent in the first quarter of 2005 to 23,9 per cent in the
second. Similarly, import values grew by 22,8 per cent in the second quarter after
contracting by 17,2 per cent in the first quarter of the year. Crude oil imports
represented approximately 12,9 per cent of the value of merchandise imports in the
second quarter of 2005 compared to 9,5 per cent in the first quarter. The slightly more
subdued growth in real imports together with further increases in real exports
contributed to a current-account deficit narrowing from 3,8 per cent of GDP in the first
quarter of 2005 to 3,4 per cent in the second quarter.
The deficits on the current account in the first two quarters of 2005 were more than fully
covered by surpluses on the financial account, leading to continued surpluses on the
overall balance of payments. South Africa’s reserve position strengthened further over
the past months as the Bank continued to purchase foreign exchange with the objective
of building reserves in a prudent manner. At the end of September 2005 gross reserves
South African Reserve Bank

Monetary Policy Review November 2005
Table 5
Growth in real gross domestic product and expenditure
components
Per cent*

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

Final consumption expenditure

Quarterly data refer to quarter-on-quarter growth at annual rates of seasonally adjusted data
**
Constant 2000 prices

amounted to US$19,5 billion and the international liquidity position was US$16,1 billion.
This can be compared to the situation at the end of May 2005, when gross reserves
stood at US$17,2 billion while the international liquidity position was
US$13,7 billion.
Real-estate and equity prices
The growth in house prices continued to moderate in the period under review. Figure 10
shows that after rising sharply to peak at over 35 per cent in September and October 2004,
the year-on-year rate of increase in the Absa House Price Index declined continuously to
reach 17,6 per cent by September 2005. This growth rate is the lowest recorded by the
index since December 2002. The average year-on-year increase in the first nine months of
2005 was 24,3 per cent. Real house prices measured relative to the CPI experienced a
similar slowdown, growing by 12,8 per cent in the twelve months to September 2005
compared to the 33,7 per cent growth rate recorded in September 2004.
Building statistics published by Statistics South Africa suggest that economic activity in
the real-estate market remains buoyant (Table 6). In the first eight months of 2005 the
real value of buildings completed and building plans passed grew by 30,1 and 41,1 per
cent, respectively, compared to the same period in 2004. The growth in the value of
residential building plans passed appears to have slowed relative to 2004, recording
30,4 per cent growth in the eight-month period, while that of the non-residential and
additions and alterations categories accelerated to 70,2 and 50,2 per cent, respectively.
Equity prices on the JSE Limited (JSE), which had weakened from mid-March to the end
of April 2005 in step with world markets, recovered strongly to repeatedly set new all-time
highs. As Figure 11 shows, the closing level of the daily all-share price index rose by over
Monetary Policy Review November 2005
South African Reserve Bank
Percentage change over twelve months

Absa House Price Index (nominal)

Absa House Price Index (deflated by CPI)
Source: Absa
Figure 10
House prices
Note: The Absa House Price Index records the total purchase price of houses in the
80 – 400 m2 size category, valued at R2,2 million or less in 2004 and for
which loan applications were approved by Absa.
35 per cent from a low of 12 467 in April to reach 16 876 on 30 September, before
declining somewhat. The resources index performed particularly strongly over this period,
with firm commodity prices contributing to growth of over 50 per cent. Financial share
prices were supported by the lower interest rate environment and the acquisition of a
controlling interest in Absa Bank by Barclays plc.
Fiscal policy
Key indicators of the fiscal policy stance are presented in Table 7, which reports the
revised estimates for the fiscal year 2005/06 and medium-term projections for the fiscal
years to 2008/09 provided by the Medium Term Budget Policy Statement (MTBPS)
released on 25 October 2005. Revenue for 2005/06 is now expected to increase to
R400,1 billion, R30,2 billion more than the estimate provided in the February 2005 Budget,
South African Reserve Bank

Monetary Policy Review November 2005
Table 6
Real value of building plans passed and buildings completed
Annual percentage change

2005*
Building plans passed

Buildings completed

Figures in this column are the percentage changes for the first eight months of 2005 compared to the first eight
months of 2004
Source: Statistics South Africa
Indices


FTSE/JSE all-share index
FTSE/JSE resources index
FTSE/JSE financials index
FTSE/JSE industrials index
Figure 11
Share price indices

as a result of the strong growth performance of the economy, robust consumer expenditure,
higher company profits and growth in imports. This represents 25,9 per cent of GDP, a ratio
which is expected to remain stable in the medium term. The revised estimate for
expenditure in 2005/06 is R415,8 billion, or 27,0 per cent of GDP, slightly below the R417,8
billion projected in the 2005 Budget in February. The resulting revised budget deficit for
2005/06 is R15,7 billion (1,0 per cent of GDP, compared to the 3,1 per cent of GDP
projected in February). The deficit is projected to average around 2,1 per cent of GDP over
the next three years. The revised public-sector borrowing requirement is 1,2 per cent of
GDP in 2005/06, increasing to around 3,4 per cent in the medium term.
Monetary conditions
Growth in the monetary aggregates has trended upward in 2005, partly reflecting the
robust acceleration in aggregate real gross domestic expenditure. For the first nine
months of 2005, the average monthly year-on-year growth rate for the broad monetary
aggregate (M3) was 15,8 per cent compared to 13,3 per cent in the corresponding
period in 2004 (Figure 12). The rate of growth in M3 accelerated from 15,0 per cent in
April 2005 to 19,9 per cent in July, before declining to 16,7 per cent in September. The
quarter-on-quarter annualised growth rate for seasonally adjusted M3 increased from
6,3 per cent in the first quarter of 2005 to 29,3 per cent in the third quarter.
The growth rate of M2 exhibited the same robust upward trend evident in M3. For the
first nine months of 2005, the average monthly year-on-year growth rate in M2 was
15,5 per cent compared to the corresponding 12,3 per cent in 2004. The monthly yearon-year growth in M2 increased from 11,8 per cent in March 2005 to 20,0 per cent in
July, before slowing to 17,1 per cent in September. The quarter-on-quarter annualised
rate of growth in seasonally adjusted M2 increased from 5,2 per cent in the first quarter
of 2005 to 29,7 per cent in the third quarter of the year.
The narrower monetary aggregates also grew strongly in 2005. M1A and M1 showed
average monthly year-on-year increases of 15,7 per cent and 13,3 per cent, respectively, for
the first nine months of 2005. Quarter on quarter, the annualised rate of growth in seasonally
adjusted M1A and M1 increased from 18,0 per cent and 0,5 per cent, respectively, in the first
quarter of 2005, to 26,8 per cent and 36,9 per cent in the third quarter.
Monetary Policy Review November 2005
South African Reserve Bank
Table 7
Public finance: Ratios to gross domestic product
Per cent

Actual
Budget
Revised
Medium-term
estimates
estimates
National government

Total loan debt (gross) ....

Includes provision for RSC levies of R7 billion in 2006/07, R8 billion in 2007/08 and R9 billion in 2008/09
**
PSBR: Public-sector borrowing requirement
Source: National Treasury, 2005. Medium Term Budget Policy Statement
For the period under review, the value of total bank loans and advances to the private
sector continued to accelerate, mainly driven by a robust increase in asset-backed credit
(mortgage advances, leasing finance, and instalment sales credit). On average, the yearon-year growth rate in total loans and advances was 20,8 per cent in the first nine months
of 2005, compared to the corresponding average rate of 12,3 per cent during 2004. The
monthly year-on-year growth rate of total loans and advances increased from 18,6 per cent
in March 2005 to 23,5 per cent in July, before declining to 21,5 per cent in September.
Quarter-on-quarter seasonally adjusted total loans and advances recorded an annualised
growth rate of 18,2 per cent in the third quarter of 2005 compared with 21,2 per cent in
the first quarter of the year.
South African Reserve Bank

Monetary Policy Review November 2005
Per cent

Total loans and advances

M3
Figure 12
Growth in monetary aggregates
Box 2 The demand for M3 in South Africa
The money demand function typically shows the relationship between monetary aggregates,
income and interest rates. The stability of this function, along with the purported high correlation
between money growth and inflation in historical data2, was central to the monetarist view that
monetary targeting should be the cornerstone of a non-inflationary policy stance3. The experience
with monetary targeting has not been a success4, however, and a number of central banks have
recently shifted toward inflation targeting as a monetary policy framework.
Within an inflation-targeting framework, monetary aggregates are considered together with other
variables that act as leading indicators of prices and output, and their usefulness depends partly on
the existence of a stable money demand function. This box reports on research into the long-run
demand for M3 in South Africa, its stability and the long-run link between M3 and inflation5.
The long-run demand function is estimated using the following log linear specification:
mt – pt = ß0 + ß1yt + ß2Rst – ß3Rlt – ß4Δpt + nt
(1)
where mt and pt are logs of nominal money balances (M3) and consumer prices (CPI), respectively; yt is
the log of a real scale variable (GDP); Rst is the the central bank’s accommodation rate and serves as a
proxy for the own-rate of return on M3; Rlt is the long-term bond yield and measures the return on
financial asset alternatives to money, and t is a time subscript. Inflation (Δpt), measured as the log first
difference, represents the additional opportunity cost of holding money and could be thought of as the

For example, see
McCandless and Weber
(1995).

South Africa pursued a
monetary policy strategy
that included setting some
pre-announced M3 targets
from 1986 to 1989 and M3
guidelines from 1990 until
formal inflation targeting
was introduced in 2000.

In this regard, a former
governor of the Bank of
Canada, Gerald Bouey,
famously noted: “We didn’t
abandon the monetary
aggregates, they
abandoned us.”

There is debate about
which monetary aggregate,
i.e. M1, M2 or M3, best
captures the concept of
money that is likely to be
most closely associated
with inflation.

Monetary Policy Review November 2005
South African Reserve Bank
return on goods. ß0 is a constant, ß1,...ß4 are coefficients with their expected signs and nt is the
Gaussian error term.
Seasonally unadjusted quarterly data for South Africa for the period 1980 to 2003 are used, with
seasonality accounted for by appropriate seasonal dummies. With the exception of interest rates,
all variables are in natural logarithms. Dummy variables were inserted for the second and third
quarters of 1998 (a period corresponding to very high interest rates due to the emerging-markets
crisis), and for the third quarter of 1984 (period corresponding to the elimination of banking
competition restrictions which allowed new entry into the banking industry, and also a period of
high interest rates).
Equation (1) is estimated using the cointegrated vector autoregressive framework of Johansen
(1991, 1995). The identified long-run money demand6 function is:
mt – pt = 3,200yt – 6,297(Rlt – Rst) – 0,006t
(2)
Recursive tests for stability proposed by Hansen and Johansen (1999) suggest that this M3
demand relationship is stable over the sample period, when short-run fluctuations are corrected for.
The income elasticity indicates that an increase of one per cent in income generates an increase
of 3,2 per cent in real money balances in the long run. This elasticity is high by international
standards. This could be a reflection of the importance of the portfolio (store of value) motive for
holding money but might also be a reflection of a wealth variable omission bias. It may also be due
to changes in income distribution in South Africa such that increases in income are concentrated
in the poor sectors and their money use rises much faster than overall income.
The coefficient on the interest rate spread (Rlt – Rst) in Equation (2) is a semi-elasticity since the
interest rates are not in log form. The negative sign indicates that an increase in the opportunity
cost of holding money results in a decline in real balances in the long run, as agents switch from
money to other high-yielding assets.
The adjustment dynamics suggest that only income and real money are error correcting to the
money demand relation, i.e. they adjust to disequilibrium in the money demand as reflected by
significant adjustment coefficients in the vector error-correction model (not shown in this box).
Both interest rates are not error correcting in this sense. More importantly, there is a positive
adjustment coefficient in the inflation equation as theory would suggest, such that excess money
exerts upward pressure on inflation and as inflation rises, real money decreases to restore
equilibrium. However, the corresponding adjustment coefficient is statistically insignificant, which
is interpreted here to mean that the link between M3 and inflation is rather weak.
The weak link between M3 and inflation could be attributable to a variety of factors. Firstly, it could
be due to measurement errors in variables. In particular, the simple sum accounting approach that
is used to measure monetary aggregates assumes that all components are perfect substitutes
and this may not be the case7. Secondly, this study uses the CPI as a measure of prices. Other
measures of prices such as the CPIX, core inflation, the GDP deflator or any other measure of
prices, may yield a different conclusion.
References
Fisher, P, Hudson, S and Pradhan, M. 1993. Divisia Indices for Money: An Appraisal of Theory and
Practice. Bank of England Working Paper, No 9.
Hansen, H and Johansen, S. 1999. Some Tests for Parameter Constancy in Cointegrated VARmodels. Econometrics Journal, No 2, pp. 306-333.
Johansen, S. 1991. Estimation and hypothesis testing of cointegration vectors in Gaussian vector
autoregressive models. Econometrica, No 59, pp. 1551-1580.
Johansen, S. 1995. Likelihood-based inference in cointegrated vector auto-regressive models.
Oxford: Oxford University Press.
McCandless, G T and Weber, W E. 1995. Some Monetary Facts. Federal Reserve Bank of
Minneapolis Quarterly Review, Vol 19, No 3, pp. 2-11.
Todani, K R. 2005. A cointegrated VAR model of M3 demand in South Africa. South African
Reserve Bank Discussion Paper, DP/05/04.

Equation (1) was estimated
using the cointegrated
vector autoregressive
framework of Johansen
(1991, 1995). On the basis
of a well-specified VAR
with two lags and
Johansen (1995) Bartlettcorrected trace statistics,
three cointegrating vectors
between the variables in
Equation (1) were selected.
Equation (2) was obtained
by normalising the first
cointegrating vector on
money, imposing a zero
restriction on inflation and
equal coefficients on
interest rates. Appropriate
restrictions were also
imposed on the other
cointegrating vectors and
are discussed in Todani
(2005). All coefficients are
statistically significant at
the 5-per-cent level.

This problem may be
mitigated by computing the
Divisia indices for monetary
aggregates. See Fisher, et
al. (1993) for a discussion
of the theory and practice
of these indices.
Monetary policy
Against the backdrop of a strongly growing domestic economy and robust domestic demand,
there has been no change in the monetary policy stance since the previous Monetary Policy
Review. Consequently, the repurchase rate has remained unchanged at 7 per cent per annum
(Figure 13). The inflation outlook deteriorated moderately over the past six months, and by the
October meeting of the Monetary Policy Committee (MPC) the first-round effects of the fuel
price increases were apparent. The MPC’s view has consistently been that there is little that
monetary policy can do to avoid these initial effects. The view of the committee is that the
appropriate action would be to accept such first-round price increases and to focus on
preventing these price increases from being passed on – the so-called second-round effects.
If these second-round effects are minimal, the initial impact on inflation will be short-lived. Box
3 discusses the problems policy-makers face in dealing with shocks such as significant oil
price increases (p. 27).
As usual, the central forecast of the Bank’s model is a useful tool, although it does not
play a determining role in the MPC’s monetary policy decisions. In the earlier part of the
year, despite the threats posed by international oil prices, the outlook became
increasingly benign and culminated in the reduction in the repo rate in April. At the
subsequent three meetings, however, there was a progressive deterioration in the
forecast. At the June meeting it was noted that the central forecast for CPIX inflation
was expected to peak in the first quarter of 2006 at a level slightly higher than the
previous forecast of around 5,0 per cent, and then to decline to a level of around
4,8 per cent at the end of the year. The moderately higher forecast was seen to be a
consequence of revised expectations relating to petrol prices, the exchange rate and
the easing of monetary conditions.
In August, a similar trajectory for the central CPIX inflation forecast was reported,
although the peak was expected to be higher, at a level slightly below 5,5 per cent. This
marginally higher forecast reflected changes in the oil price and exchange rate
South African Reserve Bank

Monetary Policy Review November 2005
Per cent

Figure 13
The repo and short-term interest rates

Prime overdraft rate

Repo rate

3-month NCD rate

assumptions. In October, the outlook deteriorated further, mainly as a result of
significantly higher oil price assumptions, as international oil prices continued to surprise
on the upside. Nevertheless, CPIX inflation was still expected to remain within the target
range for the forecast period. The forecast presented to the MPC in October is
reproduced later in this review. The MPC’s views on the outlook for some of the
determinants of inflation are highlighted below.
The main themes running through the MPC deliberations over the past six months were
the petrol price developments and the robust domestic demand which was also
reflected in accelerating credit extension. International oil prices had already had a
significant impact on monetary policy discussions for a number of months. Not only
were these prices trending upward, there was also a high degree of volatility as a range
of factors such as geopolitical tensions, supply disruptions and weather conditions
confounded most forecasts. By the August meeting Brent crude prices had reached
new record levels, having breached US$64 per barrel, despite further increases in official
production quotas by OPEC. Worse was still to come, and in the wake of hurricanes
Katrina and Rita, oil prices reached levels of around US$70 per barrel. By the October
meeting, the price of Brent crude had fallen below US$60 per barrel, having averaged
US$64,50 and US$63 in August and September, respectively. Although there appeared
to be some respite in the oil markets, the MPC felt that the volatility of international oil
prices meant that significant upside risk would remain.
As noted earlier, the implication of these international oil price fluctuations was a
cumulative increase in the petrol price of R1,41 per litre in the period between April and
October 2005. This had a marked impact on the CPIX inflation data presented to the
October meeting (the latest available inflation rate, for August, was 4,8 per cent).
However as was noted by the MPC, these increases were in line with expectations, and
given that CPIX inflation excluding petrol and diesel had remained relatively stable at a
level of around 3,5 per cent, there were no signs of second-round effects at that stage.
Nevertheless it did raise the issue of how pre-emptive monetary policy should be.
Because monetary policy acts with a lag, it has to be forward-looking. It is estimated that
an interest rate change takes between 18 and 24 months to fully work through to prices.
This does not mean that monetary policy has no effect at all in the short term, however.
It is estimated that in South Africa, half of the effect of monetary policy actions is felt after
about 9 months. Whatever the nature of the lag, it means that monetary policy has to
be forward-looking, as there is little that can be done about current inflation. The
problem for policy-makers is that the future is inherently uncertain, and any pre-emptive
action requires taking a view on events that are difficult to predict. A different policy
reaction would be appropriate if international oil prices were expected to stabilise at
current levels compared to a scenario where they continue on their erratic upward trend.
A reversal towards lower levels could also require a different stance. The difficulty is
compounded by the fact that the ultimate impact on domestic fuel prices and domestic
inflation is also affected to a significant degree by the exchange rate of the rand, which
itself is difficult to predict. Monetary policy therefore has the difficult task of weighing up
the risk of taking potentially unnecessary or incorrect action by being too pre-emptive,
against the cost of delaying too long before taking excessive action. As is noted in
Box 3, the greater the credibility of monetary policy, the less pre-emptive monetary
policy may need to be. This may explain in part why the impact of the higher oil prices
on domestic and world inflation has been more moderate than initially feared.
Despite the higher oil prices, world inflation is still expected to be well contained. The
MPC noted in October that although the IMF’s World Economic Outlook had raised its
Monetary Policy Review November 2005
South African Reserve Bank
forecast for world inflation in 2006 from 3,1 per cent to 3,7 per cent, this was
nevertheless lower than the revised 3,9 per cent average expected for 2005. This
indicates that world inflation is expected to remain under control. The continued
subdued world inflation has been one of the considerations in the setting of domestic
monetary policy. The higher oil prices had previously resulted in a 0,5-per-cent
downward revision of world economic growth, and the current forecast expects world
growth to be sustained at a robust rate of 4,3 per cent.
Wage developments are an important element in the pass-through process, although
this may take some time to manifest itself, given the lag in wage negotiations. At the April
meeting the MPC had commented on the divergence between wage settlement trends
and unit labour cost trends. By August there was greater consistency between the two,
and unit labour costs appeared to be in line with the inflation target. These trends were
confirmed at the October meeting.
A crucial element in the wage and price formation process is inflation expectations. The
second-quarter inflation expectations survey conducted by the Bureau for Economic
Research showed that lower inflation expectations had remained entrenched, with little
change from the first quarter’s optimistic outlook. However, in the third-quarter survey, it
became evident that the higher oil prices were beginning to have a negative impact on
inflation expectations. This trend was confirmed in the breakeven inflation rates,
measured by the spreads between the yields on South African CPI inflation-linked bonds
and conventional nominal bonds of the same maturity. The committee noted that if the
deterioration in expectations was to continue, it would be a cause for concern.
Domestic demand growth remained an important focus of MPC deliberations. As seen
earlier, domestic expenditure remained robust and was sustained by higher consumer
confidence, the moderately stronger rand, lower interest rates, higher real incomes and
high asset prices. Although asset prices were boosted by the strong increases in share
prices on the JSE, there was continuing evidence that the rate of increase in house
prices is declining. During this period, motor vehicle sales also reached new record
levels, although by September there was a decline in the rate of growth of new vehicle
sales. Nevertheless, although the strong consumer demand continued over the period,
there was little evidence of inflationary pressure emanating from this.
Both money supply and credit extension accelerated significantly over this period, reflecting the
robust domestic demand. In the earlier part of the year, M3 money supply growth had
remained fairly stable at around 12 per cent on a year-on-year basis. However, by July and
August M3 was growing by almost 20 per cent year on year, and credit extension was growing
even faster. As before, much of this was related to mortgage loans, reflecting the buoyant
conditions in the property market, and the purchase of motor vehicles. The MPC noted the
progressive rise in consumer indebtedness, as household debt as a percentage of disposable
income rose from 60 per cent in the first quarter to 62 per cent in the second quarter of 2005.
However, it was also noted that the debt servicing ratio remained low and unchanged at
around 6,5 per cent of disposable income.
On the output side, the outlook changed significantly over the past period. Earlier in the
year the committee had commented on the downturn in the manufacturing sector in
particular. By June it was clear that the contraction in this sector had reduced GDP
growth in the first quarter of 2005. This trend was also reflected in the continued
downward movement in the leading business cycle indicator and the decline in
manufacturing capacity utilisation. However, by the August meeting the outlook had
changed significantly and indications were that the output gap had narrowed.
South African Reserve Bank

Monetary Policy Review November 2005

Manufacturing production had recovered, the leading indicators were positive and the
various business confidence and trade activity indices showed that expectations were
strongly positive. By October these trends had been confirmed with second-quarter
GDP growing by 4,8 per cent, a further increase in capacity utilisation and a favourable
outlook indicated by the leading business cycle indicator.
The MPC also took cognisance of the current-account deficit which had increased to
4 per cent of GDP in the final quarter of 2004. By the June meeting it was clear that
there would be a moderate narrowing of the deficit as a result of an improvement in the
trade balance. The deficit measured 3,8 per cent of GDP in the first quarter and
subsequently improved further to 3,4 per cent in the second quarter. However, the MPC
noted that the trade deficit is likely to widen in the third quarter. Nevertheless, over the
period the deficit was financed by capital inflows which also allowed for an increase in
foreign exchange reserves.
A deterioration in the current account is not in itself a threat to the inflation outlook. The
potential threat to inflation comes through its possible impact on the exchange rate. The
strong capital inflows meant that this threat was not significant. During the period under
review the exchange rate of the rand remained relatively stable. At the June meeting the
rand had depreciated on a trade-weighted basis by 5,7 per cent since the previous
meeting. At these levels it was within the range in which it had traded for much of the
previous year. The MPC expressed the view that this retracement was unlikely to have
a significant impact on the inflation outlook. By August there had been a moderate
appreciation of the rand, and by the October meeting the rand had experienced a
marginal depreciation on a trade-weighted basis. The rand’s movements were also
determined by US dollar movements, rather than by domestic factors alone. As noted
in the June MPC statement, although the US is likely to outperform growth in the euro
area, Japan and the UK, significant macroeconomic imbalances remain, contributing to
the uncertain outlook for the US dollar.
Other issues raised by the MPC included fiscal policy, which remained supportive of
monetary policy; the moderate downward trend in the inflation rates of services prices
and non-petrol administered prices; and the level of food price inflation which remained
low despite the recent increases in maize prices.
Overall, this past period has shown some deterioration in the inflation outlook and inflation
expectations. It appears that these developments are driven primarily by international oil
price developments. Although this has not resulted in a change in the stance of monetary
policy, the MPC expressed concern about these developments. The committee reiterated
its position that it would not react to first-round effects of higher oil prices but stressed
that it has to remain vigilant in anticipating second-round effects. Although at the time of
the October meeting there was no conclusive evidence of these effects, the MPC warned
that the increased risk of this happening would inform future policy-making.
Monetary Policy Review November 2005
South African Reserve Bank
Box 3 Policy responses to oil price shocks
Oil price shocks pose a number of problems for monetary policy-makers. Although these are perhaps
fewer than in the past, as Bernanke (2004) notes, the economic consequences are still unpleasant.
Sharp increases in oil prices tend to result in higher inflation, slower growth in output, or a combination
of these effects. Whether the oil price increase is a spike or more permanent is also important in this
regard. In response, policy-makers have only one policy instrument at their disposal, generally the
interest rate, which influences both output and inflation in the same direction.
The effects of oil price shocks are well known. Higher oil prices result in slower growth in output in the
short term by reducing aggregate demand. In the case of an oil-importing country, higher oil prices
curtail domestic spending on other goods unless accommodated by monetary policy. At the same
time, higher oil prices increase inflationary pressures in the economy. The increase in international
crude oil prices is passed through to domestic energy prices with a short lag, and appears in producer
and consumer price indices soon thereafter. This direct impact is generally termed the “first-round
effect” of the oil price shock, and is partly determined by the weight of energy prices in the relevant
index. Furthermore, price and wage-setting behaviour in the economy may also be influenced by these
first-round effects, as firms and labour pass through the increase in energy prices, so magnifying the
impact on overall inflation. These indirect effects are sometimes termed “second-round effects”. The
overall impact of the oil price shock on inflation therefore conceptually contains both first and secondround effects. In the 1970s and early 1980s, for example, both the first and second-round effects of
oil price shocks were generally large. Focusing on a measure of “core” inflation, which excludes energy
prices from the overall inflation rate, may help to distinguish the second from the first-round effects of
the shock.
How then should monetary policy-makers respond to such oil price shocks? Traditionally, two
extreme responses have been compared. The first would be to focus exclusively on cushioning the
impact of the oil price shock on output, by easing the monetary policy stance to accommodate the
shock. The downside of this approach is that the full inflationary effect of the shock would impact
on the economy. Perhaps most importantly, the public’s expectations regarding future inflation may
rise as a result. These inflation expectations affect wage and price setting in the economy which, in
turn, has an effect on the actual rate of inflation. Well-anchored inflation expectations help to
minimise the second-round effects of shocks, and to ensure that they have only a moderate and
temporary effect on core inflation.
South African Reserve Bank

Monetary Policy Review November 2005
Per cent
US$ per barrel (current prices)

Figure B3.1
OECD inflation and oil prices

OECD inflation rate

Brent crude oil price (right-hand scale)

Sources: Bloomberg and IMF International Financial Statistics

The outlook for inflation
Although adverse developments in international oil markets have caused the Bank’s
inflation forecast to deteriorate recently, CPIX inflation is nevertheless expected to remain
within the target range of 3 to 6 per cent over the forecast period. The outlook and
uncertainties relating to some of the factors that are incorporated in this projection, as
well as the fan chart representation of the Bank’s forecast (Figure 15), are discussed
below.
International outlook
The global economy has proved remarkably resilient to shocks in recent years and the
short-term outlook remains generally positive. However, there are a number of
Monetary Policy Review November 2005
South African Reserve Bank
At the opposite extreme of the policy spectrum, policy-makers could opt to focus their efforts
entirely on offsetting the impact of the oil price shock on inflation. This approach would entail
tightening the monetary policy stance to ensure that the second-round effects of the shock do not
arise, even though aggregate output has already been adversely affected. If inflation responds
sluggishly to the monetary tightening, this approach is therefore likely to result in large output losses.
Where policy-makers pitch policy relative to these two extreme cases depends on a number of
factors. For example, whether the shock is perceived to be permanent or transitory is an important
consideration. If the shock is in reality permanent, i.e. oil prices have moved to a new higher level,
then there is no reason to accommodate this by easing monetary policy; potential GDP in an oilimporting economy will fall permanently in this case, and actual GDP should therefore also shrink to
keep the output gap from widening. However, if the oil price shock is transitory, such as the spike
experienced at the time of the Gulf War in 1990-91, and if the output costs of tightening monetary
policy are substantial, then using policy to moderate the temporary contraction in output seems
sensible, even if this is at the cost of temporarily higher inflation.
A second set of factors that may influence policy-makers relates to the likely size and persistence of
the output effects of the oil price shock. The speed with which the oil-exporting countries recycle their
increased revenues will affect the size of the overall output effect, as will the oil intensity of production
and the flexibility of economies. Although the oil intensity of production has generally declined since
the 1970s, suggesting that the impact of oil shocks will have diminished, it tends to be higher in
developing countries which are therefore more vulnerable to shocks. It may also matter for policymakers whether the oil price shock arises on the supply side of the international oil market, for
example, as a result of production disruptions or producers withholding supply, or if it results from
demand growth in the global economy as has recently been the situation. In the latter case, it is
possible that high oil prices will themselves tend to reduce demand and therefore help to stabilise the
system, resulting in demand shocks having a less permanent effect on the global economy than true
supply shocks (Gramlich, 2004).
The final consideration discussed here relates to the importance of keeping inflation expectations
well anchored, and ensuring that the economy has a nominal anchor to secure the inflation rate.
When the public’s expectation is that inflation will remain low, despite the oil price shock, the
second-round effects of the shock are minimised and this helps to contain the overall effect on
inflation. In addition, well-anchored expectations help stabilise output and employment. This simply
emphasises the lesson for monetary policy-makers that credibility matters. As Gramlich (2004)
concludes his discussion of how to respond to oil price spikes, the worst outcome is not the
temporary increases in inflation and unemployment that may result, but rather “for monetary policymakers to let inflation come loose from its moorings”.
References
Bernanke, B S. 2004. Oil and the Economy. Remarks at the Distinguished Lecture Series, Darton
College, Albany, Georgia, 21 October.
Gramlich, E M. 2004. Oil Shocks and Monetary Policy. Remarks at the Annual Economic Luncheon,
Federal Reserve Bank of Kansas City, Kansas City, Missouri, 16 September.
continuing developments that could constrain growth or lead to strains in financial
markets. Factors that suggest that the longer-run foundations of the global expansion
may become shakier include the rising protectionist sentiments evident in the US and
the euro area, rising household-sector indebtedness, growing external and fiscal
imbalances, and the dependence of the global economic recovery on continued
favourable growth outcomes in the US and China. Unsustainable medium-term fiscal
positions also continue to be a risk. In the near term, the potential impact of high and
volatile oil and petroleum prices on the prospects for growth and inflation remains the
most significant global risk.
The IMF’s World Economic Outlook sees global manufacturing and trade still
strengthening, but warns that the continuing rise in crude oil and refined product
prices – recently exacerbated by the impact of the hurricanes in the Gulf of Mexico – is
an increasingly important counterbalance to this. Although the IMF projects global GDP
growth to average 4,3 per cent in both 2005 and 2006 (Table 8), growth is expected to
slow slightly in early 2006, picking up modestly thereafter with the adverse impact of
higher oil prices offset by still-accommodative macroeconomic policies, benign financial
market conditions (especially low long-term interest rates), and increasingly solid
corporate balance sheets. However, the IMF has raised its inflation forecasts for most
countries for 2005 and 2006.
The US economy is expected to continue growing at a solid rate during the remainder
of 2005 and in 2006. Although GDP growth in the US is expected to ease moderately
to 3,3 per cent in 2006 from 3,5 per cent in 2005, it is projected to remain among the
highest in the G-7. The hurricanes which hit the Gulf region in the latter part of the third
quarter are expected to have a temporary impact on economic growth. A Reuters survey
of 23 economists established that estimates of GDP growth in the fourth quarter have
been cut to 3,1 per cent compared with 3,4 per cent before the hurricanes hit, but also
South African Reserve Bank

Monetary Policy Review November 2005
Table 8
IMF projections of world growth and inflation for 2005
and 2006*
Per cent
Real GDP
Inflation rates

World ...................................................................... (4,3) 4,3
(4,4) 4,3
(3,6) 3,9
(3,1) 3,7
Advanced economies ............................................ (2,6) 2,5
(3,0) 2,7
(2,0) 2,2
(1,9) 2,0
United States...................................................... (3,7) 3,5
(3,6) 3,3
(2,7) 3,1
(2,4) 2,8
Japan ................................................................ (0,8) 2,0
(1,9) 2,0
(-0,2) -0,4
(0,0) -0,1
Euro area............................................................ (1,6) 1,2
(2,3) 1,8
(1,9) 2,1
(1,7) 1,8
United Kingdom ................................................ (2,6) 1,9
(2,6) 2,2
(1,7) 2,0
(2,0) 1,9
Other advanced economies................................ (3,1) 3,2
(3,4) 3,9
(2,0) 2,0
(2,1) 2,3
Other emerging-market and developing countries

Africa.................................................................. (5,0) 4,5
(5,4) 5,9
(7,7) 8,2
(5,9) 7,0
Central and eastern Europe................................ (4,5) 4,3
(4,5) 4,6
(5,2) 4,8
(4,0) 4,3
Commonwealth of Independent States .............. (6,5) 6,0
(6,0) 5,7
(11,4) 12,6
(8,8) 10,5
Developing Asia.................................................. (7,4) 7,8
(7,1) 7,2
(3,9) 4,2
(3,4) 4,7
China .............................................................. (8,5) 9,0
(8,0) 8,2
(3,0) 3,0
(2,5) 3,8
India................................................................ (6,7) 7,1
(6,4) 6,3
(4,0) 3,9
(3,6) 5,1
Middle East ...................................................... (5,0) 5,4
(4,9) 5,0
(8,6) 10,0
(8,3) 9,7
Western hemisphere .......................................... (4,1) 4,1

IMF projections for 2005 and 2006 as at April 2005 in parentheses
Source: IMF World Economic Outlook, April and September 2005

that economists’ forecasts for next year have been revised upward. The Federal Reserve
is expected to continue moving away from the accommodative stance that it had
maintained from 2001 until the middle of 2004 by further raising the target for the federal
funds rate until it reaches a neutral level that will support sustainable growth while at the
same time maintaining low inflation.
In the latest World Economic Outlook, the IMF highlights the vulnerability of European
economies to oil price shocks and cuts the growth forecasts for the four large European
economies: Germany, France, the UK and Italy. The growth forecast for the euro area as
a whole has been revised downward to 1,2 per cent for 2005 and 1,8 per cent for 2006,
while the growth forecast for the UK has been revised to 1,9 per cent for 2005 and 2,2
per cent for 2006. In contrast to its view on Europe, the IMF raised its forecast for growth
in Japan in 2005-2006 and if the forecasts of 2,0 per cent in both 2005 and 2006 are
borne out, the period from 2004 to 2006 will prove to have been Japan’s best period of
growth since the economy entered its long stagnation in 1990.
The overall outlook for developing Asia is more uncertain than earlier in the year, with
some risks now being accentuated. However, developing Asia’s healthy expansion is
expected to continue, with a growth projection of 7,8 per cent and 7,2 per cent in 2005
and 2006, respectively. Sustained high GDP growth is forecast for China and India in
2005 and 2006, and although there is general concern for Asian countries regarding
higher oil prices, strengthening fundamentals and the impact of large infrastructure
investments are expected to outweigh the negative effect of high oil prices.
Growth prospects for emerging-market and developing countries in aggregate remain
broadly unchanged. The IMF projects GDP growth in sub-Saharan Africa to rebound to
5,9 per cent in 2006, led by strong growth in oil producers as new capacity is realised.
However, in general growth will depend on the strength of policies, improved political
stability, and favourable weather conditions.
Outlook for domestic demand and supply
The current business cycle expansion is the longest on record, and although the
somewhat softer global growth performance and higher oil prices can be expected to
have a growth dampening impact, the outlook for the domestic economy remains
broadly favourable. The capital formation outlook, in particular, is positive, given the
investment plans of government and the public corporations. The latest Reuters
consensus forecast, based on surveys undertaken between September and October
2005, is for real GDP growth of 4,3 per cent in 2005 and 3,9 per cent in 2006. The
forecasts are the means of 13 individual forecasts ranging between 4 per cent and
4,5 per cent for 2005, and between 3,5 per cent and 4,6 per cent for 2006. The National
Treasury in its MTBPS expects real economic growth of 4,4 per cent in 2005/06 and
4,0 per cent in 2006/07.
Indicators suggest an ongoing improvement in business confidence. The FNB/BER
business confidence index posted a near-record high in September 2005 (reaching a
level only slightly below the 23-year high recorded at the end of last year). The Standard
Bank/Sacob Trade Conditions Survey, which appraises overall trading conditions in
South Africa on a monthly basis, indicated that trade conditions, although still robust,
had trended slightly weaker in July and August before improving again significantly in
September. The medium-term outlook (six months ahead) also continues to be
optimistic. Growth rates in both sales volumes and new orders are expected to increase
over the medium term.
Monetary Policy Review November 2005
South African Reserve Bank
Consumer confidence is also relatively high, as is borne out by the most recent FNB/BER
consumer confidence index for the third quarter of 2005. The improvement in the index
was broad based, with confidence remaining robust across all population and income
groups. The factors that pushed consumer confidence higher earlier this year remained
effective. These include the lowest nominal interest rates in more than two decades, low
inflation and continued, albeit more moderate, growth in house and share prices.
All in all, the short to medium-term outlook for domestic demand and supply remains
generally favourable, with the main risks arising from a possible deterioration of the
external environment. The strong performance of the South African economy thus far in
2005 is expected to continue on the back of robust domestic expenditure growth and
an improved contribution from net trade. However, a sustained further increase in oil
prices and overly strong domestic demand would raise the risks to external balances
and strengthen inflationary pressures.
Indicators of inflation expectations
Although expectations about the future path of inflation are unobservable and therefore
difficult to measure, various indicators do provide some insight in this regard. The results
of the survey of inflation expectations undertaken by the Bureau for Economic Research
(BER) in the third quarter of 2005, which are reported in Table 9, show that the average
CPIX inflation expectations of the various groups of survey respondents all increased
moderately relative to the results reported in the previous quarter.
The expectation for average CPIX inflation in 2005 is 4,7 per cent, rising to 5,2 and
5,4 per cent in 2006 and 2007, respectively. These results represent a slight
deterioration relative to the results of the survey undertaken in the second quarter of
2005 (expectations are now 0,2 percentage points higher for 2005, 0,3 percentage
points higher for 2006, and 0,4 percentage points higher for 2007), possibly reflecting
the impact of higher petrol prices on CPIX inflation expectations. The expectations of
labour union officials were adjusted by the highest margin compared to the secondquarter survey. Their expectation is now for inflation to rise to 5,1 per cent, 5,2 per cent
and 5,5 per cent in 2005, 2006 and 2007, respectively. Expectations of analysts and
business have also been revised upward, although by smaller magnitudes. Despite
these increases, the CPIX inflation expectations reported by the BER are consistent with
the inflation target range of 3 to 6 per cent.
Breakeven inflation rates, measured as the difference between the yields on South
African CPI inflation-linked bonds and conventional nominal bonds of similar maturity,
are also used to infer information about market participants’ expectations of future
South African Reserve Bank

Monetary Policy Review November 2005
Table 9
BER survey of CPIX inflation expectations: 3rd quarter 2005*
Per cent


Second-quarter 2005 results in parentheses
Source: Bureau for Economic Research, University of Stellenbosch

inflation. These rates reflect not only inflation expectations, but also changes in
perceived uncertainty about future inflation and in the perception of liquidity risk.
Depicted in Figure 14, they suggest a similar increase in inflation expectations as the
BER survey results. Breakeven inflation rates obtained from the R197 (maturing
2023), R189 (maturing 2013) and R198 (maturing 2008) inflation-linked bonds have
risen from around 4 per cent in early August 2005 to just below 5 per cent at the end
of September.
Inflation expectations indicators obtained from the Reuters monthly survey of long-term
forecasts for the South African economy, published on 6 October, paint a slightly different
picture. This survey reports that CPIX inflation is expected to average 4,2 per cent in
2005, rising to 5,0 per cent in 2006, before slowing to 4,7 per cent in 2007. These results,
reported in Table 10, reflect a downward movement from the previous month’s survey.
The median forecasts have not changed significantly from the previous survey, however,
at 4,2 per cent, 5,0 per cent and 4,7 per cent, respectively, for 2005 to 2007.
Monetary Policy Review November 2005
South African Reserve Bank
Percentage points

Figure 14
Breakeven inflation rates

Spread between R189 and R153 bonds

Spread between R197 and R186 bonds

Spread between R198 and R194 bonds
Table 10
Reuters survey of CPIX forecasts: September 2005*
Per cent


August 2005 survey results in parentheses
Source: Reuters
The Bank’s inflation forecast
Figure 15 presents the Bank’s latest quarterly forecast for CPIX inflation. The fan chart
has a forecast horizon running to the fourth quarter of 2007, and was presented to the
MPC meeting on 12 and 13 October 2005.
The Bank’s forecast is for the CPIX inflation rate to remain within the inflation target range
of 3 to 6 per cent over the forecast period. Figure 15 shows that the central projection
for the CPIX inflation rate will rise to about 5,8 per cent in the second quarter of 2006
before easing slightly to 5,3 per cent in the final quarter of 2007. The probability that the
CPIX inflation rate will remain within the inflation target range in the final quarter of 2007
is approximately 70 per cent.
However, the actual rate of inflation might differ from the central projection on both sides
of the distribution due to a number of risk factors. Although they have declined recently,
the volatility of international crude oil prices means that they continue to represent a
significant upside risk to the forecast. Rising inflation expectations are also a cause for
concern, given their role in the price and wage formation process, as are increases in
administered prices that exceed the upper limit of the inflation target range. In addition,
the increase in maize prices from about R500 a ton earlier in the year to above R800 a
ton may have important implications for consumer and production prices, and present
some upside risk to the forecast. By contrast, comparatively subdued rates of domestic
producer price inflation and subdued foreign inflationary pressures may contribute to a
downside risk to the inflation forecast.
South African Reserve Bank

Monetary Policy Review November 2005
Per cent

Figure 15
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).

Assessment and conclusion
Over the past few months, the inflation outlook has deteriorated moderately, mainly as
a result of the risk posed by international oil price developments. Domestic demand and
output are also buoyant and point to some additional upward pressure on inflation. To
date there has been little evidence of demand pressures or second-round effects of oil
price increases impacting on inflation.
Although there is little that monetary policy can do to prevent exogenous oil price
increases from impacting on the domestic inflation rate, it has to remain vigilant with
respect to the possible pass-through to the prices of other goods and services. The
speed and extent to which these petrol price increases are passed through to
generalised inflation will depend to a significant degree on inflation expectations, which
in turn are partly determined by the credibility of monetary policy. If monetary policy has
a high degree of credibility, then the MPC will be expected to react appropriately to
prevent the emergence of an inflation spiral.
Despite the fact that there has been some deterioration in inflation expectations, these
changes are consistent with the Bank’s inflation forecast and the increased risks to the
inflation outlook. Although CPIX inflation over the next two years is expected to be higher
than in previous surveys, expectations are still in line with the inflation target, and there
does not appear to be a widely-held belief that inflation is likely to get out of control.
However, a continued deterioration of inflation expectations would be a cause for
concern to the MPC, given the critical role of expectations in the price formation
process. Expectations will be determined in part by the outlook for the factors that affect
inflation and in part by the expected reaction by the MPC to such developments. It is
essential therefore for monetary policy to continue to monitor events closely and to take
appropriate action when necessary to ensure that the inflation target mandate continues
to be achieved.
Monetary Policy Review November 2005
South African Reserve Bank