MONETARY POLICY
REVIEW
April 2003
South African Reserve Bank
SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
Contents
Monetary Policy Review


MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
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ISSN: 1609-3194
Monetary Policy Review
Introduction
Over the past few months, the world economic slowdown has continued unabated, and global geopolitical uncertainties have contributed to the turbulence in
international financial markets. Although the conflict in Iraq is seen as a major
cause of the continued slowdown, it is unlikely that a resolution of this conflict will
solve the underlying growth problems in industrialised countries. A number of
industrial country central banks, including those in the United States of America,
the United Kingdom and the euro area, have responded by easing monetary
policy further, and fears of deflation rather than inflation tend to predominate.
Despite this low inflation international environment, uncertainties regarding the
impact of the war in Iraq on the global outlook and the international oil price
remain a cause for concern.
Against this turbulent international background, the South African economy has
proved to be remarkably resilient. The 3 per cent growth rate achieved in 2002 was
high by international comparison, and should be seen in the context of the weak
international economy and the monetary policy measures taken to deal with inflationary pressures caused mainly by the weakness of the rand in late 2001. During
2002 the interest rate was increased on four occasions by 100 basis points each
time. However, at the time of the Monetary Policy Committee (MPC) meeting in
November, there were indications that the inflation rate had peaked and it was
decided to keep the repo rate unchanged. Although the outlook for inflation
improved further during the first quarter of 2003, at the March meeting of the MPC
the interest rate was put on hold pending confirmation of a sustained downward
trend in inflation. The MPC was particularly concerned about wage developments
which could have a negative impact on inflation.
Monetary policy was also affected by the decision of the Minister of Finance to modify
the inflation targets for 2004 and 2005. In 2001 the targets for these years were set at
3 – 5 per cent. However, the sharp increase in the inflation rate in 2002 meant that
achieving this lower target range within the original timeframe would put excessive pressure on the economy. In October 2002 the Minister announced that the inflation target
would remain at 3 – 6 per cent for 2004. Subsequently it was announced in the February
2003 Budget that the target would remain at 3 – 6 per cent for 2005 and that the target
for 2006 would be announced in October 2003.
This Monetary Policy Review provides an analysis of recent price developments, the
factors that affect inflation as well as the outlook for inflation. In addition, four focus
topics are provided in boxes. The first inflation target was set for 2002, and the inflation outcome for that year was above the target range. Box 1 restates the MPC view
of the reasons for the target being missed. Food prices were a significant source of
inflation during 2002 and developments in this area provide a good indication of the
future direction of inflation in general. Box 2 analyses recent trends in spot and futures
prices of grain and their implications for food prices. The recently announced
exchange control amnesty has focused attention on the possible impact of the
amnesty on the exchange rate and tax revenues. Box 3 provides a brief review of
international experience with such amnesties. Box 4 considers the implications of the
revision of the targets for the credibility of the inflation targeting framework.
SA RESERVE BANK
MONETARY POLICY REVIEW April 2003

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Box 1
Statement on the inflation outcome for 2002
Extract from the Statement of the Monetary Policy Committee, issued by Mr T T Mboweni, Governor
of the Reserve Bank, 20 March 2003
In February 2000 an announcement was made by government that an inflation targeting framework
had been adopted for monetary policy purposes. This change was made to improve the co-ordination between monetary policy and other macroeconomic policies, as well as to make monetary policy more transparent and accountable. Under this framework the Reserve Bank and more specifically
the Monetary Policy Committee was given the task to achieve an average rate of increase in the overall consumer price index for metropolitan and other urban areas excluding mortgage interest costs
(the CPIX) of between 3 and 6 per cent for the year 2002. The CPIX measure of inflation was chosen to ensure a wide coverage of consumer items, but without the mortgage interest cost component that would perversely fall as monetary policy was relaxed, and vice versa.
In 2002 the rate of increase in the CPIX averaged 10 per cent, or 4 percentage points above the upper
limit of the target range. In the light of this outcome the Reserve Bank wishes to inform the public in
general why the actual inflation rate deviated from the target. The Bank would also like to spell out
what measures have been taken to bring the inflation rate within the target band in due course.
The inflation outcome for 2002
The Monetary Policy Committee is of the opinion that four factors were mainly responsible for the
acceleration in the rate of increase in the general price level in 2002. First and foremost the rapid rise
in the prices of consumer goods and services was related to the sharp depreciation in the external
value of the rand in the second half of 2001. The nominal value of the rand on a trade-weighted basis
declined by 34,3 per cent from the end of June 2001 to the end of that year. Initially the weakness
of the rand was mainly linked to the contagion effects of the political situation in Zimbabwe and financial stability problems experienced in emerging-market economies such as Argentina and Turkey.
Later developments in the exchange rate of the rand were characterised by typical financial market
behaviour under the circumstances which prevailed at the time where further declines in the
exchange rate of the rand became a self-fulfilling prophecy based on market expectations.
The increased risk aversion of international investors caused asset fund managers to withdraw portfolio investments from South Africa. These sales of South African securities increased the demand
for dollars in the domestic currency market, which put downward pressure on the exchange rate of
the rand. At the same time, importers made advance payments to avoid paying more in rand for
foreign-currency denominated purchases of goods abroad at a later stage, while exporters delayed
the repatriation of foreign-currency earnings to obtain expected higher rand proceeds from a depreciating currency. The effects of the leads and lags in foreign payments and receipts on the exchange
rate of the rand were aggravated by the appearance of a deficit on the current account of the balance of payments during the second half of 2001.
A second factor leading to the acceleration in inflation during 2002 was the rise in domestic food
prices which had already started from the middle of the preceding year. The prices of food increased
by no less than 16,7 per cent in 2002. If the increases in food prices are excluded from the overall
CPIX, the rate of increase in the prices of other goods and services averaged 7,8 per cent in 2002.
Food prices are generally a highly volatile component in consumer expenditure and can have a significant impact on other price developments in South Africa. The substantial rise in food prices during 2002
can to a large extent be attributed to the depreciated value of the rand. After the liberalisation of agricultural pricing, export and import parity prices have generally set the lower and upper bounds to the
prices of domestically produced agricultural goods. The rise in international prices of grain products
together with the depreciation of the rand caused the prices of food in South Africa to rise considerably. Moreover, the regional demand and supply of crops in Southern Africa shifted the prices of agricultural goods higher resulting in a movement away from export parity pricing to import parity pricing.
Thirdly, the acceleration in the prices of consumer goods and services was the result of increases in
international oil prices during 2002. After the Brent price of oil had stabilised around US$20 per barrel in January and February 2002, it started to move higher and reached an average of approximately
US$28 per barrel in December 2002. This increase was mainly related to concerns about a possible
US-led attack on Iraq and disruptions in the supply of oil due to general strikes in Venezuela.

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
Fourthly, the inflation outcome in 2002 was affected by large increases in some administered prices.
In particular, the prices of medical and education services and water rates continued to increase at
very high rates of approximately 10 per cent or more in 2002, following on even higher increases in
2001. Assessment rates and fees for sanitary services and refuse removal also rose at a high rate
in 2002. As a result, the increase in the prices of all administered goods and services averaged
8,4 per cent in 2002, or was about equal to the increase in the preceding year. High increases in
administered prices, which have a weight of almost 25 per cent in the CPIX, continue to make it
extremely difficult to bring inflation down to the targets set by government.
This brief exposition of the major reasons why the inflation target was not met in 2002 indicates that it
was largely due to extraordinary events that could not be foreseen and which were beyond the control
or influence of monetary policy. At the beginning of 2002, when it had already become apparent that
the inflation target would not be met, the Reserve Bank considered whether to make use of the escape
clause, which recognises circumstances which could temporarily lead to deviations from the target. In
the end the Bank decided that it would be unwise to make use of this clause. Continued monetary discipline was regarded as essential for price stability and sustainable high economic growth. It was also
argued at the time that the negative effect of higher interest rates on short-term economic growth would
be neutralised to a large extent by the very competitive external value of the rand.
Rather than opting for a temporary increase in the inflation target, the Monetary Policy Committee
decided that corrective measures should be applied. The committee affirmed that it was highly unlikely that any measures would bring the inflation rate to within the target range for 2002 because of the
long lags between interest rate increases and a slowdown in inflation. The objective of the committee
accordingly became focused on bringing the rate of increase in CPIX within the target range as soon
as possible with the least short-term cost to economic growth and employment creation.
The first corrective step was taken at a special meeting of the Monetary Policy Committee early in
January 2002. At this meeting the committee decided to increase the repurchase rate of the Bank
by 100 basis points to counter rising inflation expectations. Monetary policy was tightened further at
the subsequent three scheduled meetings of the Monetary Policy Committee. At all three meetings
the repurchase rate was increased by 100 basis points to bring the level to 13,5 per cent in
September 2002. On the basis of expected inflation, this led to a significant increase in real shortterm interest rates in South Africa and therefore a tightening in monetary policy.
At the November meeting of the Monetary Policy Committee it was decided that the right dose of
monetary discipline had been applied and that there were some signs that inflation pressures were
abating. The committee therefore kept the repurchase rate unchanged because this level of the rate
was regarded as appropriate to bring the inflation rate within the target range in due course.
Recent developments in inflation
This section analyses recent trends in the main inflation indices, and reviews the developments in the primary factors impacting on inflation in the South African economy.
The evolution of indicators of inflation
The main inflation indices trended upward for most of 2002, driven mainly by the interaction of rising food prices and the effects of the large depreciation of the exchange
rate in 2001. Late in the year, as the stimulus to inflation provided by these factors
weakened and the effects of tighter monetary policy became apparent, the various
measures of inflation reached their peaks and began moving downward into 2003.
Figure 1 depicts the twelve-month percentage change in the consumer price index
for metropolitan areas (CPI) and consumer price index excluding mortgage interest
cost for metropolitan and urban areas (CPIX). As the figure shows, CPIX inflation rose
steadily from 7,1 per cent in January 2002 to 12,7 per cent in November, before
declining to 11,3 per cent in February 2003. The annual average was 10,0 per cent,
4,0 percentage points above the upper band of the inflation target range for 2002.

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Headline CPI inflation increased at a faster pace than CPIX in 2002, reflecting the
impact of the four 100-basis-point repo rate increases in the course of the year. CPI
inflation rose from 5,0 per cent in January 2002 to peak at 14,5 per cent in October
and November. Inflation measured by this index then slowed to 13,7 per cent in
January 2003 and to 12,5 per cent in February.
Food prices were the dominant factor determining the observed trend in CPIX inflation in 2002. Figure 2 shows that, after contributing 1,0 percentage point when the
total CPIX inflation rate was at its recent low of 5,8 per cent in September 2001, its
contribution then rose sharply to 5,3 percentage points in October 2002 when total
CPIX inflation was 12,5 per cent. As noted earlier, food price inflation then moderated, and the contribution of this component to CPIX inflation declined to 4,5 percentage points in January 2003 and further to 4,0 percentage points in February. In
these months total CPIX inflation was 11,8 and 11,3 per cent, respectively. The outlook for food prices is discussed further in Box 2.
Of the other components of the CPIX, the contribution of housing to inflation
increased from 1,3 percentage points in January and February 2002 (when total CPIX
inflation was 7,1 and 7,5 per cent, respectively) to 3,1 percentage points in February
2003. The contribution of transport costs fluctuated in line with movements in oil
prices and the exchange rate, declining to 0,8 percentage points in July 2002 before
increasing to 1,4 percentage points in October – December, and then declining again
to 0,9 percentage points in February 2003. The contribution of this component will be
watched closely in the coming months, with the war in Iraq, coupled with the very low
levels of international oil reserves, impacting on oil prices. Already the impact has
been felt domestically with the 30 cents per litre increase in the petrol price in March.
Figure 1
Consumer price inflation: CPIX and CPI
Percentage change over twelve months

CPIX
CPI
Source: Statistics South Africa

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
Box 2
Food price inflation: a view from the grain markets
Food price inflation has eased recently. After rising from 3,2 per cent in June 2001 to peak at
20,9 per cent in October 2002, the inflation rate for food prices in the CPIX has since declined to
15,3 per cent in February 2003. This box considers developments in the grain market and the outlook for grain prices, which play a significant role in determining food prices, both directly, and indirectly as an input cost to livestock and dairy operators. An earlier discussion, which dealt with the
determination of prices in the grain market and the reasons for the sharp increases experienced in
2002, was presented as Box 2 in the April 2002 Monetary Policy Review.
Grains (white and yellow maize, sunflower seeds and wheat) are tradeable commodities and their
prices are derived from dollar-based export and import parity prices. In 2001 and 2002, a combination of demand-pull and cost-push factors adversely affected domestic grain prices (evident in
Figure B2.1). Over this period, poor weather conditions, regional shortages and the effects of the
fall in the value of the rand in 2001 resulted in prices in the various grain markets moving up to, and
sometimes briefly beyond, the import parity price level. During the planting season in 2002, for
example, when rainfall and stock levels were low and fears of El Nino were widespread, prices were
substantially above import parity pricing even though the rand was strengthening.
Since late in 2002, grain prices have been falling. Maize prices, in particular, have declined sharply.
The price of white maize fell to a three-year low of R790 per ton at the end of March 2003, close
to the export parity price of R770 per ton which is the breakeven price for the export of surplus
maize. Yellow maize, the main feed for livestock in South Africa, is currently also trading below
R900 per ton.
Figure 2
Contributions to CPIX inflation
Percentage points

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

~

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Futures prices, which play an important role in the price discovery process, have also adjusted downward as new information has become available to market participants. Figure B2.2 shows that the
price of white maize for delivery in July 2003 on South African Futures Exchange (SAFEX), for example, more than halved from R1 989 per ton at the beginning of December 2002 to R821 per ton at
the end of March 2003. The figure shows that the SAFEX prices of futures contracts for yellow maize,
wheat and sunflower seeds for delivery in May, July and September 2003 have all adjusted to developments in the grain markets in a similar way in recent months.
A number of factors have played a role in easing the inflationary pressures in the grain markets. The impact
of the stronger rand on the import and export parity prices in the markets, the generally favourable
prospects for the domestic 2002/03 crops, relatively stable international grain markets, and the improvement of the food supply situation in the Southern African region are all important in this regard.
The domestic maize crop has benefited from good rains in early December 2002, which provided relief
after a dry November, and again in late February. The National Department of Agriculture estimates that
the total domestic maize crop for the 2002/03 season will be 9,1 million tons (the second production
forecast as at 19 March 2003), slightly down from the 10,0 million tons produced in 2001/02. In the
case of wheat, which is a winter grain (and a lower volume, higher value product), some uncertainty
has arisen over domestic output levels, related to the land area planted. This helps explain the spike
observed in recent spot prices (Figure B2.1). Although wheat producers and millers experienced some
difficulties during the 2002/03 season, the domestic wheat crop is projected at 2,1 million tons and
imports at between 250 000 and 300 000 tons. Last year, 2,4 million tons of wheat were produced
domestically and 600 000 tons were imported.

White maize
Figure B2.1
Selected grain prices
Rand per ton

J
A
O
D
A
O
F
J
A
D
F
A

J
A
O
D
A
O
F
J
A
D
F
A

J
A
O
D
A
O
F
J
A
D
F
A

Yellow maize
Rand per ton
Rand per US dollar
Rand per US dollar

Sunflower seeds
Rand per ton

Rand per US dollar
SAFEX spot price
Import parity prices
Export parity prices

Wheat
Rand per ton
Rand per US dollar
Rand per US dollar

Source: Grain South Africa
J
A
O
D
A
O
F
J
A
D
F
A

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
The role that food and energy prices have played in determining the trend of CPIX
inflation is revealed by Figure 3, which shows the effect of excluding these prices
from the main index. It is clear from the graph that food has been the main determinant
of both the timing and magnitude of CPIX increases. The exclusion of food price inflation, which peaked at 20,9 per cent in October 2002 before declining to 15,3 per cent
in February 2003, delays the turning points and lowers the recent path of CPIX inflation
White maize
Figure B2.2
Prices of SAFEX futures for 2003 delivery
Rand per ton

Yellow maize
Rand per ton

Sunflower seeds
Rand per ton

May 2003
July 2003
September 2003
Wheat
Rand per ton

J
F
M
A
J
J
M
A
S
O
N
D

Source: SAFEX
J
F
M
A
J
J
M
A
S
O
N
D

J
F
M
A
J
J
M
A
S
O
N
D

J
F
M
A
J
J
M
A
S
O
N
D

On the international front, grain prices have receded in recent months as global supplies appear sufficient to meet demand. The US Department of Agriculture’s March forecast was that world trade in maize
in 2002/03 would be unchanged from 2001/02 at nearly 102 million tons, although stock levels are
expected to decline to relatively low levels. World wheat trade in 2002/03 is forecast at 104,8 million
tons, down 5,3 million tons from 2001/02, with lower production and higher consumption expected.
The recent decline in grain prices has contributed to a decrease in the inflation rate of agricultural products measured at the production level. Agricultural prices in the production price index (PPI) actually fell
by 1,1 per cent in the twelve months to February 2003, after increasing by as much as 30,1 per cent
when measured on the same basis in September 2002. As the benefits of lower production prices only
impact on consumer prices with a lag, reflecting the relative stages of the production process and the
time taken to deplete existing stocks, this sharp decline is not yet fully evident in the CPIX. So far, as
noted earlier in the box, the inflation rate for food prices in the CPIX has fallen from 20,9 per cent in
October 2002 to 15,3 per cent in February 2003. On the basis of production price data, food prices
at the consumer price level should continue to fall in the coming months, and assist in bringing the
overall rate of inflation down in 2003.

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
significantly. CPIX inflation excluding food prices increased from 5,7 per cent in January
2002 to 10,9 per cent in December before falling to 10,2 per cent in February 2003. The
exclusion of energy prices, by contrast, has little impact on the path of CPIX inflation.
Figure 4 presents a breakdown of CPIX inflation into the broad ‘goods’ and ‘services’
categories. The goods category, containing relatively more items that are tradeable
on international markets than the services category, is more susceptible to changes
in the global environment and the exchange rate. This is evident in Figure 4, where
the path of goods price inflation reflects the effects of the depreciation of the rand in
late 2001 and the impact of the regional demand for grains. Goods inflation rose from
4,7 per cent in September 2001 to 10,3 per cent in June and July 2002, and gained
further momentum to peak at 13,4 per cent in October 2002. The stronger rand and
slower rate of food price inflation then aided a fairly sharp decline to 11,4 per cent in
January and 10,7 per cent in February 2003.
The services category, by contrast, has been less variable, and has followed goods
price inflation with a lag. Services inflation trended upwards from just over 7 per cent
in January – March 2002 to 12,4 per cent in February 2003. The inflation rate for this
category, which is primarily affected by internal factors such as wage-cost relationships and administered prices, is currently above that of the goods category and is
slowing the decline in CPIX inflation. However the rate of increase appears to be
slowing down and the index is expected to moderate over the coming months.
Administered prices have a significant weight in the CPIX basket, and therefore play
an important role in determining the overall inflation outcome. As Figure 5 shows, the
inflation rate for the South African Reserve Bank’s (the Bank’s) administered price
index (API) displayed no clear trend in 2002, tracking the fluctuations in the domestic petrol price to average 8,3 per cent for the year. However, stripping out petrol and
diesel prices, over which the least control is arguably exercised, the inflation rate for
Figure 3
The effect of food and energy prices on CPIX inflation
Percentage change over twelve months

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

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
the index declined from an average of 8,9 per cent in 2001 to 8,5 per cent in 2002.
The inflation rate for both the all-inclusive API and the index excluding petrol and
diesel prices declined further to below 7 per cent in the first two months of 2003.
Figure 4
CPIX: goods and services inflation
Percentage change over twelve months

Services
Goods
Source: Statistics South Africa

Figure 5
CPIX and administered prices
Percentage change over twelve months

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

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Although administered price inflation is currently below the overall CPIX inflation,
the concern of the Bank is that these prices tend to be relatively inflexible and
therefore may not follow the downward trend of the overall inflation rate. Secondly,
there have been a number of highly publicised administered price increases or
proposed price increases (for example those announced by Telkom and Eskom)
that are above the current inflation rate. The danger is that these increases could
have a disproportionate impact on inflation expectations, and make the task of
monetary policy more difficult.
Developments in production prices often precede those in the downstream consumer price indices. Figure 6, which plots the year-on-year change in the production price index (PPI), and that of its imported and domestic components,
shows that these measures are presently signalling lower consumer price inflation
in 2003. The overall PPI inflation rate, which rose from a low of 8,3 per cent in
December 2001 to reach 15,4 per cent in August and September 2002, fell gradually to 12,4 per cent in December before rapidly halving to 6,2 per cent by
February 2003. The inflation rate for the imported PPI component, which has a
weight of 27 per cent in the total PPI, has fallen particularly quickly recently. As the
effects of the stronger exchange rate of the rand and the sharp increase in the
index in the December 2001 to April 2002 period have been incorporated into the
calculation of the inflation rate for this component, it declined from 15,2 per cent in
November 2002 to only 2,6 per cent in February 2003. The domestically produced
component of the PPI has followed a similar path, albeit at a slower rate, falling from
15,4 per cent in August 2002 to 7,6 per cent in February 2003.
Figure 6
Production price inflation
Percentage change over twelve months

PPI
Imported component of PPI
Domestically produced component of PPI
Source: Statistics South Africa

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
Factors affecting inflation
This section reviews recent developments in some of the main drivers of inflation in
South Africa. These include the external environment and the exchange rate, as well
as domestic demand and output, fiscal policy and monetary conditions. A discussion
of the outlook for these variables and their likely impact on inflation is presented later.
International economic developments
The global economy showed signs of recovery in early 2002 after the worldwide slowdown in 2001. It is estimated that world growth registered a modest improvement in
2002, rising to 3,0 per cent from 2,3 per cent in 2001 (Table 1). The economic recovery
was, however, uneven in both timing and geographical distribution.
The pattern of US growth during 2002 was uneven as concerns about economic,
political and corporate governance issues weighed heavily on an economy already
adjusting to a succession of shocks from previous years. Real gross domestic product (GDP) growth was 2,4 per cent for the year as a whole compared with 0,3 per
cent in 2001. Measured at seasonally adjusted and annualised rates, growth fluctuated quite considerably, registering 5,0 per cent, 1,3 per cent, 4,0 per cent and 1,4
per cent, respectively, during the successive quarters of 2002. Consumer confidence
has deteriorated in recent months as a result of worsening labour market conditions,
concerns surrounding the war with Iraq, warnings of possible terrorist attacks and
high oil prices. While the increase in oil prices has already translated into higher consumer price inflation, core inflation remains low.
The export-led recovery in Japan during the first half of 2002 turned out to be shortlived. Real GDP increased by 0,3 per cent in 2002 as a whole, compared with an
increase of 0,4 per cent in 2001. Deflation persisted mainly due to sluggish domestic
demand, declining consumer confidence and record unemployment levels. Economic
performance in the euro area, which is an important destination for South African
exports, deteriorated during 2002 as the economy expanded by 0,8 per cent compared to 1,4 per cent in 2001. The German economy contracted by 0,1 per cent in the
fourth quarter of 2002.
Table 1
Annual percentage change in real gross domestic product and
inflation rates
Real GDP
Inflation rates

(estimate)
(estimate)

Source: IMF World Economic Outlook, April 2003

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Emerging Asia grew more than twice as fast as the global average in 2002, but
there were significant differences between the countries in the region. The Chinese
economy once again outperformed the rest of the region with 8,0 per cent GDP
growth in 2002, underpinned by growth in government spending, foreign investment and exports. The Asian recovery, however, contrasts with a disappointing
performance in Latin America. The crises in Argentina and Venezuela and mounting concerns about prospects for Brazil contributed to the decline in regional output during 2002.
The low growth environment contributed to the continued moderation of world inflation which declined from 4,4 per cent in 2001 to 3,6 per cent in 2002 (Table 1).
Inflationary pressures have, however, increased in several Latin American countries,
especially Argentina.
Oil prices
The strengthening of the rand during 2002 meant that rand oil price movements
were more muted than dollar price developments (Figure 7). The spot price of Brent
crude oil increased significantly from $19 per barrel in January 2002 to almost $35
in the beginning of March 2003. Oil prices initially rose after global economic activity began to improve in May 2002. Upward pressure on crude oil prices also came
from increased political tensions in the Middle East and Venezuela. The pressure
intensified late last year as a strike in Venezuela almost shut down that country’s oil
industry. The increasing prospects of a war with Iraq, along with a very low level of
crude oil inventories, especially in the United States, also kept oil prices high in the
first months of 2003.

Figure 7 Brent crude oil price and rand/US dollar exchange rate

South African rand/US$
Brent US dollar price
Brent rand price
Source: Bloomberg
Index: 2 January 2002 =100
Crude oil prices began to fall after the US-led war on Iraq became a certainty.
Brent crude prices fell to almost $25 per barrel after the attacks began, mainly as
a result of speculation that the war would be short, with limited disruption of
Middle East oil supplies.
World interest rates
Poor growth prospects have dominated monetary policy decisions in many developed countries (Table 2). Interest rates were reduced in a number of European
economies in March to address concerns regarding the slowdown in economic
growth. The Bank of Canada, however, increased interest rates prompted by higher
core and total CPI inflation over the past few months due to an increase in domestic
demand and crude oil prices.
A number of Latin American central banks tightened monetary policy as a result of
the inflationary impact of weakening currencies. In Brazil, for example, the central
bank increased the Selic overnight rate for the fifth time since October 2002 to
26,5 per cent on 19 February 2003. This decision was aimed at slowing inflation that
has accelerated after the Brazilian currency, the real, lost a third of its value in the past
12 months. By contrast, Chile, whose growth rate outpaced that of the rest of the
region in 2002, unexpectedly cut its benchmark lending rate in January by 25 basis
points to 2,75 per cent. This action was taken in the light of weak domestic demand
and slowing inflation.
Table 2
Key central bank interest rates
Per cent
Countries
1 Jan 2002
11 April 2003
Latest change
(percentage points)
1,75
1,25
6 Nov 2002
(-0,50)
0,00
0,00
19 Mar 2001
(-0,15)
3,25
2,50
6 Mar 2003
(-0,25)
4,00
3,75
6 Feb 2003
(-0,25)
2,25
3,00
4 Mar 2003
(+0,25)
3,25
2,50
7 Mar 2003
(-0,25)
3,75
3,50
18 Mar 2003
(-0,25)
1,25 – 2,25
0 – 0,75
6 Mar 2003
(-0,50)
4,25
4,75
5 Jun 2002
(+0,25)
4,75
5,75
3 Jul 2002
(+0,25)
3,80
8,70
1 Apr 2003
(-0,20)
3,25
2,75
7 Nov 2002
(-0,50)
17,62
11,31
9 Apr 2003
(-0,09)
5,00
5,00
20 Sep 2001
(-0,50)
4,00
4,25
7 May 2002
(+0,25)
2,13
1,63
12 Nov 2002
(-0,25)
2,25
1,75
19 Nov 2002
(-0,25)
6,50
6,25
29 Oct 2002
(-0,25)
19,00
26,50
19 Feb 2003
(+1,00)
6,50
2,75
9 Jan 2003
(-0,25)
4,75
2,50
31 Jan 2003
(-0,25)
9,75
6,50
17 Jan 2003
(-1,00)
11,50
6,00
26 Mar 2003
(-0,25)
25,00
18,00
17 Feb 2003
(-3,00)
Source: National central banks

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Certain European emerging economies’ monetary authorities (including those of the
Czech Republic, Hungary and Poland) also cut interest rates as there was little evidence of excessive demand inflation pressures, and some concern about excessive
currency appreciation.
Exchange rate developments
While the previous year’s large depreciation of the rand adversely affected inflation in
2002, the exchange rate recovered and generally performed strongly through 2002
and into 2003 (Figure 8). Despite coming under pressure between June and late
August 2002 when it depreciated from R9,74 to R10,90 against the US dollar, and
again briefly in January 2003, the exchange rate nevertheless appreciated to levels
below R8,00 to the US dollar in March and April 2003.
The strong appreciation of the rand since September 2002 has been influenced by
a number of factors. The uncertain state of the US economy and the associated
weakness of the US dollar against a range of currencies is certainly important in this
regard. However, it is also clear from the figure that the rand has strengthened more
against the US dollar than have the euro and Australian and New Zealand currencies.
Between the end of August 2002 and the end of March 2003 the trade weighted
index of the rand appreciated by 28 per cent. Additional factors that help to explain
this relative strengthening include the steady growth performance of the economy in
2002, the wider nominal interest rate differentials that resulted from the four interest
rate increases in 2002, an improvement in the country’s terms of trade and currentaccount position, and a generally more positive perception, including from the rating
agencies, of the outlook for the South African economy.
Figure 8
US dollar per rand, euro, and Australian and New Zealand dollar
Index: 2 January 2002=100

Jan
Feb
Mar
Apr
May
Jun
Jul
Aug Sep
Oct
Nov
Dec
Jan
Feb Mar Apr
US dollar per euro
US dollar per Australian dollar
US dollar per New Zealand dollar
US dollar per rand

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
Labour markets
Labour cost developments play an important role in the inflation process in South
Africa and are watched closely for monetary policy purposes. The rate of increase
in unit labour cost (i.e. the increase in wages adjusted for changes in productivity),
has been trending upward since 2001, and at times in 2002 has been growing
faster than the upper limit of the inflation target. Between the second half of 2001
and the corresponding period in 2002, growth in nominal unit labour cost increased
by 8,4 per cent.
As Figure 9 shows, the higher growth rate in unit labour cost in the formal non-agricultural sectors of the economy was driven by rates of increase in nominal remuneration per worker that were not matched by growth in labour productivity. Growth
in remuneration per worker increased from just over 9 per cent in the first and second quarters of 2002 to 14,5 per cent in the third quarter before moderating to just
over 7 per cent in the final quarter. Survey results from Andrew Levy Employment
Publications, which found that the increase in average wage settlements rose from
7,4 per cent for the year to December 2001 to 8 per cent for the same period in
2002, provide supporting evidence for this increase in remuneration per worker in
2002. Growth in labour productivity, by contrast, continued to trend downward
throughout the year.
Figure 9
Remuneration per worker, labour productivity and unit labour
cost in the formal non-agricultural sectors
Percentage change over four quarters

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

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Demand and output
The South African economy weathered the difficult international environment relatively well in 2002. Until the end of the year, domestic economic growth remained robust
despite losing some momentum during the second half of the year. Table 3 indicates
that annual real growth in GDP for 2002 was 3 per cent, marginally above the rate that
was achieved in 2001.
On a quarterly basis, real GDP growth declined from 3,8 per cent in the second
quarter to 2,9 per cent in the third quarter and 2,4 per cent in the last quarter of
2002. This slowdown in growth was due to slower growth in the real value added
by the secondary sectors of the economy, and virtually no growth in the primary
sectors of the economy. Activity in the tertiary sectors remained lively in 2002. There
is still considerable surplus production capacity in the economy, which lessens the
likelihood of inflationary pressure emerging from supply constraints.
Aggregate real gross domestic expenditure demonstrated strong growth in 2002,
increasing by 4,2 per cent during the year after recording 2,3 per cent growth in
2001. Contributing to this growth in 2002 was a strong increase in gross fixed capital formation, at a year-on-year rate of 11,5 per cent in the fourth quarter and 6,5
per cent for 2002 as a whole. This was due to increases in capital expenditure by
the private and public sectors. In the public sector, Transnet took delivery of the first
two of South African Airways’ new Airbus aircraft, while further progress was made
with the Coega project.
Final consumption expenditure by government grew at 3,7 per cent in 2002, an increase from the 3,3 per cent growth recorded in 2001. On a quarterly basis, the rate of
increase rose over the course of the year from 3,5 per cent in the first and second quarters to 4,2 per cent in the final quarter of 2002. Growth in consumption expenditure by
households remained constant at 3,1 per cent in 2002, although on a quarterly basis it
declined from 3,5 per cent in the second quarter to reach 2,3 per cent by the fourth
quarter of the year. Consumer demand for durable goods slowed down, reflecting the
negative effect of the four increases in lending rates during 2002.
In the external sector of the economy, exports of goods and services declined by
1,4 per cent in 2002 while imports grew by 3,1 per cent, reflecting the slowdown in
world economic activity, the effect of the appreciation of the exchange rate and the
growth performance of the South African economy.
Table 3
Growth in real gross domestic product and expenditure components
Per cent*

1st qr
2nd qr
3rd qr
4th qr
Final consumption expenditure by households....

Final consumption expenditure by government...

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

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
Fiscal policy
Although fiscal policy continues to provide a mildly expansionary stimulus to the economy, this is not a cause for concern for monetary policy. The 2003 Budget, presented
to parliament by the Minister of Finance on 26 February 2003, projects a deficit of
2,4 per cent of GDP for the 2003/04 fiscal year (Table 4). This is slightly above the
February 2002 Budget estimate of 2,1 per cent for 2002/03, but more significantly
above the latest estimated outcome of 1,4 per cent of GDP. This lower anticipated
deficit to GDP ratio is the result of larger-than-expected revenue collections over the
period. The medium-term estimates presented in the 2003 Budget suggest that this
measure of fiscal pressure will remain stable for the next two years, with deficits of 2,4
and 2,3 per cent of GDP being forecast for 2004/05 and 2005/06, respectively.
The public-sector borrowing requirement (PSBR), which takes into account borrowing
by central government, provinces and municipalities as well as by non-financial public
enterprises such as Eskom, Telkom and the Post Office, is expected to increase from
1,4 per cent of GDP in 2002/03 to 3,1 per cent in 2003/04. This is the result of expected increases in capital expenditure both within the main Budget and by the non-financial public enterprises, and also provision for extraordinary payments and receipts. In
the medium term, the National Treasury projects that the PSBR will decline to 2,9 per
cent in 2004/05 and to 2,7 per cent in 2005/06. Fiscal pressure from the government
gross debt position also remains under control, with the ratio of total national government loan debt to GDP estimated in the Budget Review at 39,4 per cent at the end
the 2002/03 fiscal year. This is projected to fall to 37,3 per cent at the end of 2005/06.
In his Budget Speech, the Minister also announced further steps regarding the liberalisation of exchange controls. Besides allowing institutional investors and South
African companies increased offshore investment opportunities, these included the
freeing of emigrants’ blocked funds and the introduction of an exchange control
amnesty with accompanying special tax provisions.
The amnesty is aimed at encouraging the repatriation of assets held abroad in contravention of the foreign exchange and tax regulations, and the broadening of the tax
base. At this stage it is difficult to assess the extent to which the tax base will be affected, or the possible impact on the exchange rate. The value of assets abroad is
unknown, as is the amount that will be repatriated. The Reserve Bank does, however,
have some discretion in regulating the rate of outflow of blocked rand balances.
Box 3 provides a discussion of the international experience with amnesties.
Table 4
Public finance: ratios to gross domestic product
Per cent

Budget
Revised
Budget
Medium-term
estimate
estimate
estimate
estimates
National government:

PSBR: Public-sector borrowing requirement
Source: National Treasury, Budget Review 2003

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
Box 3
Foreign exchange and tax amnesty: an international perspective
Countries that have experienced capital flight often consider using exchange control or tax
amnesties. Two broad motivations which emerge from the international experience with amnesties
are briefly discussed here. The first case is where the intention is to use an amnesty to repatriate flight
capital for the purpose of fostering national development, and the second is where the intention is to
‘regularise’ assets held abroad and include them in the tax base.
Underlying the first motivation is the perception that flight capital is an unutilised reserve of funds that
can be retrieved to promote national development. Capital flight results in the exportation of domestic savings and foreign exchange from countries where they are generally in short supply, with negative consequences for investment and growth (and for debt levels if financed externally). Proponents
of amnesties see the repatriation of flight capital as necessary to reverse this process. Proposals for
amnesties to repatriate capital in certain Latin American countries and more recently in Russia have
emphasised this view.
The foundations of this argument require closer scrutiny, however. If the concern is the enhancement
of investment and growth then, as Buiter and Szegvari (2002: 7) argue in the Russian context, it does
not matter in principle whether the necessary capital inflows are repatriated flight capital rather than
foreign direct or portfolio investment by non-residents. Unless economic arguments for specifically
targeting past flight capital can be made, the appropriate response is to attempt to attract flows from
all potential investors by improving the investment climate. Evidence suggests that improved macroeconomic stability and governance encourage the return of flight capital (for example Ajayi, 1997
cited in World Bank, 2002: 71).
The second and perhaps less controversial motivation for an amnesty is what might be termed the
regularisation of undisclosed offshore investments. In this case, even if the funds for these investments were acquired legitimately, the manner in which they were transferred abroad criminalised
them. This provides a barrier to repatriation, even when the circumstances that encouraged capital
flight have changed. Furthermore, since the investments are not reported, they remain outside the
tax net in residence-based tax systems. The intention of the amnesty in this context is to regularise
these investments by decriminalising them and bringing them into the tax net. Repatriation may or
may not be required in order to qualify for the amnesty.
The recent Italian ‘tax shield’ is an example of this type of mechanism. In late 2001, the Italian government approved legislation to encourage the repatriation of capital and the regularisation of assets
held abroad. The measures allowed natural persons who were in violation of tax and foreign
exchange regulations a ‘one-off’ opportunity to regularise (with or without repatriation) their offshore
assets by paying a ‘substitute tax’ equal to 2,5 per cent of the amount declared, or by investing a
sum equal to 12 per cent of the amount in special government securities.
To qualify for the amnesty, a disclosure of assets needed to be lodged with an intermediary. Only in the case where assets were not repatriated was it required that the taxpayer be named
to the tax authorities. By making the declaration, the taxpayer was permitted to create a protective
shield against future tax audits relating to the period prior to their making the declaration.
At the same time as the amnesty was introduced, the level of penalties for not declaring offshore assets
was increased, and the Ministry of Economics and Finances announced that the fight against the illegal holding of offshore assets would become a priority in the 2002 programme of tax assessments.
The magnitude of the amounts involved when amnesties are discussed is notoriously difficult to
determine. In the Italian case, the Banca d’Italia estimated that around ¤500 billion was illegally held
offshore. Government budget revenue estimates of ¤50 million for 2001 and ¤1 billion for 2002
implied an expected repatriation or regularisation of more than ¤40 billion (Banca d’Italia Annual
Report for 2001). More recent reports estimate that the Italian amnesty in the period to 2002 resulted in repatriation of roughly 10 per cent of the capital held abroad.1
Indications are that the German government is also considering a tax amnesty and a reduced savings tax on interest income to lure tax evaders back to the country. The proposed amnesty calls for
self-incrimination before the end of 2003 (with a penalty rate of 25 per cent) or before July 2004
(penalty rate 35 per cent), following which immunity from prosecution will not be granted. Savings
income will then be taxed at a flat rate of 25 per cent in future, decoupling this from the income tax

Although an initial deadline of 15 May 2002 was set,
with a special extension to
1 July 2002, the Italian tax
shield scheme was renewed in
2003, with the rate payable
being increased to 4 per cent
and the alternative of subscription to government bonds
no longer permitted. Budget
estimates are that revenue of
¤2 billion will be raised from
the measure in 2003.

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
Monetary conditions
The growth in the broad money supply (M3) slowed down to relatively low rates in
the second half of 2002 while narrow money holdings (M1A) – usually accumulated
to finance spending – actually declined in the fourth quarter of 2002 after rising
rapidly in the first three quarters of the year. The demand for M1A money during the
first three quarters of 2002 was probably influenced by rapidly rising nominal income
and expenditure. From early 2002 the demand for M3 money balances was also
strengthened by heightened stock market uncertainty and concerns that global economic weakness might spill over to South Africa. Exporters repatriated export earnings more rapidly than before, further adding to the demand for money balances.
After bank lending rates were increased in January 2002, monetary growth
accelerated initially but was thereafter reined in significantly by the Reserve
Bank’s progressive tightening of its monetary policy stance during the year. The
growth rate of M3 – measured over twelve months as well as from one quarter
to the next – had decelerated significantly by the end of 2002 and the early
months of 2003. Although broad money supply growth averaged 15,4 per cent
for 2002, the annualised quarterly growth rate had slowed to 7,1 per cent by the
fourth quarter.
regime which has a top marginal rate of 48,5 per cent. Estimates from the finance ministry are that
the amnesty would result in repatriation of ¤100 billion (1⁄3 of estimated capital flight of ¤300 billion)
and therefore for additional tax revenues of ¤25 billion.
References
Banca d’Italia Economic Bulletin, various.
Buiter, W.H. and Szegvari, I. 2002. Capital flight and capital outflows from Russia: symptom, cause
and cure. European Bank for Reconstruction and Development. Working Paper No 73, June.
Paternollo, R. and Salvadori di Wisenhoff, V. 2002. Italy’s tax shield: shedding light on offshore
investments? Tax Notes International, 11 March.
World Bank. 2002. Global Development Finance: Financing the Poorest Countries. Washington, DC.
Table 5
Percentage change in monetary aggregates
Per cent
Period
M1A
M1
M2
M3
Private-sector
credit extension
Quarterly change*

Twelve-month change

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

MONETARY POLICY REVIEW April 2003
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The rising cost of credit during 2002 helped to put a brake on the growth of aggregate
nominal spending and contributed to an appreciable slowdown in aggregate credit
growth. Aggregate credit growth fell to very low levels in the middle quarters of 2002
but strengthened in the fourth quarter due to technical reasons. Banks commenced
fully reporting on their balance sheets all assets and liabilities arising from their involvement in repurchase and other similar transactions. Since a sizeable portion of repurchase transactions involves government securities, the wider implementation of these
accounting procedures led to a sharp increase in banks’ claims on the government
sector. Underlying credit demand by private-sector businesses and households continued to grow at a modest rate in the fourth quarter of 2002.
In the early months of 2003, the twelve-month growth rate in domestic private-sector
credit extension showed a strong increase, moving from 4,4 per cent in December
2002 to 12,4 and 13,8 per cent in January and February 2003. This can be ascribed to
technical factors related to the reporting of mark-to-market positions in derivatives on a
gross rather than a net basis, in line with developments in accounting practice and bank
regulation. Adjusting for these factors, the twelve-month growth in credit extension in
January and February would have been 8,8 and 9,1 per cent, respectively.
Monetary policy
After the September 2002 MPC meeting the outlook for inflation was still uncertain.
Although inflation was expected to peak by the end of the year, factors such as higher wage settlements, high money supply growth figures, stubbornly high producer
prices and questions over the sustainability of the exchange rate recovery cast doubt
on the strength of the expected downturn in the inflation rate. The outlook for a relaxation of the monetary policy stance was also influenced by the fact that the targets
for 2004 and 2005 were to decline to 3 – 5 per cent, which added to the pressures
on monetary policy.
In October 2002 the Minister of Finance announced a revision of the targets for 2004
and 2005. In his Medium Term Budget Policy Statement (MTBPS) he announced that
he and the Governor of the Reserve Bank had decided to modify the targets by maintaining the target at 3 – 6 per cent for 2004, and that the target of 3 – 5 per cent would
be suspended until further notice. Subsequently, in the February Budget Speech, it
was announced that the target for 2005 would also be maintained at 3 – 6 per cent,
and that the target for 2006 would be announced concurrent with the October 2003
MTBPS. Box 4 assesses the changing of the target in more detail.
The November MPC meeting was the first meeting in 2002 where interest rates were
not increased. This decision was taken despite the fact that CPIX inflation was still
rising, having reached a year-on-year rate of 12,5 per cent in October, and an even
higher quarter-on-quarter annualised rate of 12,7 per cent in the third quarter. However, the prices of non-food goods appeared to be levelling off, although services
prices, which are traditionally more sticky, were still accelerating.
Monetary policy is set on a forward-looking basis, so despite the fact that the inflation
figures still disappointed on the upside, there was sufficient evidence to suggest that the
turning point in inflation had either been reached or was imminent. There were a number of fundamental factors that convinced the MPC not to raise rates further at that
stage. These factors, discussed earlier in this review, included the significant slowdown
in production price inflation; the strengthening of the external value of the rand; the
decline in international oil prices; slower growth in bank credit extension; and a decel-

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
eration in the pace of growth in the more broadly defined money supply aggregates.
These factors had been a major cause for concern earlier in the year. In addition, there
were other factors which continued to be conducive to a lower inflation environment,
including continued excess production capacity in the economy, the lack of signs of
excess spending, and continued fiscal discipline on the part of government.
Box 4
The changing of the targets: what does it mean for the inflation
targeting framework?
In October 2002 the Minister of Finance announced that the target of 3 – 5 per cent for 2004 and
2005 had been suspended until further notice, and that the target for 2004 would remain at 3 – 6 per
cent. Subsequently the target for 2005 was also set at 3 – 6 per cent. Although the change has generally been received favourably, it has been criticised by some as representing a lack of commitment
to the inflation target. It should, however, be emphasised that whereas the goal of inflation targeting is
to achieve the target, the objective is not to hit it as quickly as possible or at all costs.
Most central banks would regard themselves as flexible inflation targeters. This does not necessarily
mean that they have dual or multiple objectives, but rather that they are mindful of the costs of attaining the target or getting back to the target when they are knocked off course. It is generally the case
that central banks, when they find themselves outside the target, do not try to get back to the target
as quickly as possible. Most central banks choose a policy horizon within which to influence inflation
outcomes. The horizon is determined by various factors including the time lags between a change in
monetary policy and its impact on inflation, the behaviour of inflation expectations and the importance
a central bank may attach to other policy objectives.
In Canada, for example, a policy horizon of six to eight quarters is specified for getting back to the
target. Other countries have greater flexibility. The Swedish framework specifies a horizon of one to
two years, although departures from this general rule may be warranted. According to Sweden’s
central bank, the Riksbank, a mechanical approach that invariably attempts to bring inflation back
to the targeted level within the next one to two years could, in certain cases, lead to unduly large
and undesirable fluctuations in economic activity. Such extensions to the horizon should not represent a change in the fundamental commitment to long-term price stability.
In the UK, the Monetary Policy Committee of the Bank of England is given the flexibility to propose
the horizon over which a deviation from the target will be rectified. This will depend on the nature
and severity of the initial shock which caused inflation to deviate from the target.
The Australian approach recognises the fact that responses to monetary policy actions may differ
depending on the phase of the business cycle. The target is therefore specified as keeping underlying inflation between 2 and 3 per cent on average over the cycle, which allows for short-run variations
and deviations from target. Recently the New Zealand system has adopted a similar approach whereby the inflation target is specified over the medium term to give the Reserve Bank greater flexibility in
deciding how to respond to shocks to the economy and inflation variations around the target.
In South Africa, the issue is complicated by the fact that inflation has not yet come down to its target level. When inflation gets thrown off course, the question is not only how quickly to get it back
to where it was before the shock, but also whether the original disinflation path and timeframe
should be maintained. The original targets were set on the basis of what was believed to be an
attainable and sustainable disinflation path. This path and speed of disinflation were chosen as it
was felt to be the optimal rate of disinflation that would not unduly affect the real economy.
Subsequent to the setting of the targets, the unexpected increase in inflation made the target for
2002 unattainable unless draconian monetary policy measures were adopted. A policy of strict inflation targeting would have required getting back to the target as quickly as possible, irrespective of
the cost. However, the higher level of inflation that had ensued meant that to try and achieve the
original targets within the same time period would clearly not be optimal.
Under such circumstances, maintaining the target at 3 – 6 per cent for 2004 does not mean that
the authorities have reduced their commitment to lower inflation. Rather, it is a recognition that there
are long lags in monetary policy; trying to achieve a target too quickly may not be technically feasible; and achieving a target too quickly may come at an unacceptably high price, particularly if the
reason for the deviation from the disinflation path is not the result of Reserve Bank policy in the first
place. Missing or changing a target does not necessarily undermine the inflation targeting framework as a whole, as long as there is a sustained commitment to low inflation.

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
There were, however, a number of upside risks highlighted by the MPC. The committee was particularly concerned about high inflationary expectations, the high
increases in some administered prices as well as the faster growth in nominal unit
labour cost. This latter factor was of particular concern given the strong relationship
between unit labour cost increases and inflation, and the possibility of a wage/price
spiral, combined with higher inflation expectations.
The relatively long gap between the November 2002 meeting and the meeting in
March 2003 gave the committee a better chance to assess the sustainability of the
improved inflation climate. By the time of the meeting there were more positive signs
that the downward trend in inflation was sustainable. As seen above, apart from the
fact that the CPIX inflation rate itself had appeared to be on a downward trajectory,
production price inflation, as a leading indicator of future trends in consumer prices,
had declined significantly. Most of the factors that had shown some improvement at
the time of the November MPC meeting continued to give cause for optimism. The
rand’s recovery proved to be sustained, and money supply and underlying bank
credit extension growth continued to moderate. Apart from a decrease in capacity
utilisation, the committee noted that although fiscal policy was expected to be more
expansionary in the coming year, the projected levels for the budget deficit over the
next three years would not present any difficulties for monetary policy. Two other factors that had improved the inflation outlook since the previous meeting were the fact
that the current account recorded a surplus in the fourth quarter and the fact that
food price increases, a major driver of inflation in the recent past, had shown signs of
moderating. Although food price inflation was still at a higher level than the average
inflation rate, indications were that the downward trend would continue.
Despite this positive outlook, the MPC felt that it would be premature to be too complacent about inflation and left the repo rate unchanged. The committee was reluctant to reverse the policy stance because certain risks were identified that could
prevent or slow down the expected decline in the inflation rate. The major risk identified was that of the rate of increase in unit labour cost which, as seen above, had
risen considerably in the third quarter of 2003. Furthermore, it was felt that the publicity surrounding a number of recently announced increases in administered prices
could have a negative impact on inflation expectations in general. Finally, the uncertainty surrounding the outcome and impact of the war in Iraq made it difficult to predict the short to medium-term outlook for the recovery in the world economy and
the behaviour of oil prices.
Although the projections of the Bank’s forecasting models are not followed in a
mechanistic manner, a further restraining element was that although the central forecast of the model is for inflation to drop within the target range of 3 – 6 per cent by
the fourth quarter of 2003, the central forecast for 2004 (which is the relevant
period for current policy) shows that the inflation rate is expected to settle slightly
below the top end of the target range. This also assumes an unchanged policy
stance. Given the uncertainties inherent in the forecast, at this stage there is still an
uncomfortably high probability that the outcome for 2004 will be above the target
range. The forecast is presented in more detail below.
The outlook for inflation
The view of the MPC is that year-on-year CPIX inflation will move to within the target range towards the end of 2003. The outlook and uncertainties relating to some
of the factors that are incorporated in this projection are discussed below.

SA RESERVE BANK
MONETARY POLICY REVIEW April 2003
International outlook
Although the international outlook is overshadowed by the developments in Iraq, the
resolution of this crisis is not expected to result in an early, high-growth global scenario
because of underlying problems in the industrialised economies. The dependence of
the global recovery on the US has become increasingly apparent and, as the prospects
for US growth have deteriorated, an increasing number of analysts have downgraded
their forecasts for global growth. In the latest World Economic Outlook, for example,
the IMF has downgraded its forecast for world growth from 3,7 per cent to 3,2 per
cent, and for the advanced economies from 2,5 per cent to 1,9 per cent. World growth
is expected to recover to 4,1 per cent in 2004 (Table 6).
Although consumption in the US is still holding up relatively well, consumer sentiment
has seen marked declines. It is possible that a continued worsening in labour market
conditions and weaker equity prices may further affect consumption, especially given
the relatively high indebtedness of the household sector. Meanwhile, capacity utilisation rates in manufacturing remain low, acting as a drag on new investment. The risk
of weaker consumption, combined with question marks about whether business fixed
investment will pick up significantly in 2003 given the outbreak of the Iraq war, has
increased uncertainty about US growth prospects. Supportive monetary policy and the
recent fiscal stimulus are, however, expected to limit the extent of the downturn.
According to the latest preliminary indicators, the euro area has continued to expand
in the first quarter of 2003 but at a slower rate than last year and at only about half
the euro area’s estimated long-run trend growth rate of between 2 and 21⁄2 per cent
a year. A recently published National Bank of Belgium business confidence index for
the euro area fell to its weakest level in 18 months. The latest IMF projection for
growth in 2003 has been revised down significantly to 1,1 per cent from the 2,3 per
cent forecast in September 2002, similar to the European Commission’s revised
forecast of 1 per cent. The outlook in Germany in particular remains weak, with
growth of 0,5 per cent projected by the IMF for 2003.
In Japan, deflation continues apace indicating the stubbornness of the problem, and
suggesting the need for still more policy action. The faltering recovery in the US and
Europe has continued to constrain Japanese growth prospects.
Table 6
IMF projections of world growth and inflation
Per cent
Real GDP
Inflation
2003*

2003*


IMF projections for 2003 as at September 2002 in parentheses
Source: IMF World Economic Outlook, April 2003

MONETARY POLICY REVIEW April 2003
SA RESERVE BANK
The prospects for the major emerging-market countries have become increasingly
diverse. Vulnerabilities are seen in a number of countries in Latin America, and the
IMF forecast for 2003 growth has been halved to 1,5 per cent. In emerging Asia, by
contrast, the recovery has so far proved stronger than expected, and there are signs
of domestic demand growth becoming established more broadly, not only in China
and South Korea. However, the relatively positive outlook may be tempered by the
recent outbreak of Severe Acute Respiratory Syndrome (SARS).
Growth in Africa, which has been better sustained than in many other regions during the downturn, is expected to be resilient this year, with the outlook for much of
the region continuing to depend heavily on favourable commodity market developments and political stability.
The low world growth prospects mean that world inflation is expected to remain low,
including in the high growth areas of Asia (Table 6). The lower inflation environment
suggests that as long as the rand remains stable or strengthens, non-oil imported inflation will not be a cause for concern. Higher oil prices in recent months have contributed to the resurgence in energy price pressures in oil importing countries although
these are expected to abate. Although the oil price will probably remain volatile until
the cessation of hostilities in Iraq, the concern of oil-producing export countries (OPEC)
is now to prevent prices from falling too low as a result of increased crude oil output.
Interest rates in most industrialised countries have declined with the deteriorating economic conditions, amidst little evidence of non-oil price pressures. Macroeconomic
policies in the industrialised countries are expected to remain supportive of a global
recovery.
Outlook for domestic demand and supply
As noted earlier, by the fourth quarter of 2002 there were already some signs of a slowdown in domestic growth. Activity in the primary and secondary sectors may also have
stagnated somewhat in the first quarter of 2003 as a result of weaker foreign demand
and the strengthening of the value of the rand. The latest Reuters consensus forecast
for real GDP growth, surveyed in March 2003, is for growth of 2,8 per cent in 2003 rising to 3,4 per cent in 2004. The forecast for 2003 is the mean of 14 individual forecasts
ranging between 2,2 and 3,5 per cent, and that for 2004 is the mean of 14 individual
forecasts with a low of 3,0 per cent and a high of 3,8 per cent.
Although substantial unemployment characterises the labour market, certain skills
remain in short supply and higher wage demands resulted in nominal unit labour
cost increasing significantly in the second half of last year. Rising wage demands
may continue putting upward pressure on unit labour cost, and thus affect inflation.
The rate of growth in real government expenditure is expected to remain robust given
the average annual increase published in the National Treasury's Budget Policy
Statement for February 2003. These increased levels of real government expenditure
make provision for increased expenditure on non-interest items such as health, education, social grants, municipal infrastructure and housing, improved police and justice
services and the speeding up of electrification services to rural areas.
Consumer demand appears to have slowed down somewhat in early 2003 through
the cumulative effect of higher interest rates and higher inflation levels, but the recently announced personal income tax relief should mitigate against this.

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Importantly, the growth in real outlays on gross fixed capital formation by the private
sector and public corporations accelerated significantly over the past two years and
further relatively robust growth in capital formation by these sectors is projected for
2003. The recent real exchange rate appreciation coupled with less robust foreign
demand will probably serve to dampen export volume growth during the first half of
2003, but foreign demand and dollar-denominated commodity prices are expected
to improve during the latter half of 2003.
Indicators of inflation expectations
The Bureau for Economic Research (BER) at the University of Stellenbosch conducts quarterly surveys of inflation expectations in the South African economy.
The survey of CPIX inflation expectations undertaken in the first quarter of 2003
found that this inflation rate is expected to average 9,2 per cent in 2003, before
declining to 8,5 per cent in 2004 and 8,4 per cent in 2005. Comparing these
results with those from the survey undertaken in the fourth quarter of 2002,
presented in parentheses in Table 7, and with earlier surveys, it is evident that
inflation expectations have tended to follow the upward movement in actual inflation through 2002.
The expectations of the financial analysts reported in Table 7 are lower than those
of business and trade union officials for each year in the 2003-05 period. Financial
analysts expect CPIX inflation to move to the upper end of the target range in 2004
and to remain at that level in 2005 (averaging 5,9 per cent and 6,0 per cent, respectively). Business expectations are for inflation to fall only gradually over the period,
from 9,7 per cent in 2003 to 8,7 per cent in 2005, while trade union officials expect
inflation to increase from 9,5 per cent in 2003 to around 101⁄2 per cent thereafter.
The BER-surveyed expectations of the financial sector analysts are above those
obtained from the Reuters monthly survey of long-term forecasts for the South
African economy, although a similar medium-term downward trend is evident. The
Reuters March survey of economists based in South Africa, the UK and the US
reports that CPIX inflation is expected to average 8,3 per cent in 2003. This is the
mean of 14 individual forecasts ranging between 7,5 per cent and 8,7 per cent. The
expectation is that CPIX inflation will then decline to average 5,3 per cent in 2004
(14 forecasts ranging from 4,5 – 6,0 per cent) before rising to 5,4 per cent in 2005
(8 forecasts ranging between 4,9 and 6,0 per cent).
Lower inflation expectations are also evident in the longer term. As Figure 10 shows,
the spreads between the yields on South African CPI inflation-linked bonds and conventional nominal bonds of similar maturity, or breakeven inflation rates, have declined
Table 7
BER survey of CPIX inflation expectations: 1st quarter 2003*
Per cent


Fourth-quarter 2002 survey results in parentheses
Source: Bureau for Economic Research, University of Stellenbosch

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steadily since October 2002. These spreads provide an indication of expected inflation over the period until the bond matures, assuming no changes to the risk premium associated with future inflation and differences in the liquidity of the bonds and
their payment patterns. The inflation expectations obtained in this way from the R189
(maturing 2013) and R198 (maturing 2008) inflation-linked bonds moved from around
8 per cent in October 2002 to just above 6 per cent in April 2003, while the spread on
the longer-dated R197 (maturing 2023) is currently slightly above 5 per cent.
The Reserve Bank inflation forecast
The Bank’s latest forecast for CPIX inflation is presented in Figure 11. This is the forecast
that was presented to the MPC at the March meeting, and being produced from a quarterly model it means that the latest observed value for CPIX was for the fourth quarter of
2002, and the CPIX for the first quarter of 2003 is the first value that is forecasted. As
usual, the forecast is based on the assumption of an unchanged repo rate over the
forecast period. The fan chart technique is again employed to indicate the uncertainties
surrounding the central projection (the March 2001 Monetary Policy Review provides
more details regarding this technique).
The central forecast projects a similar time path to that presented in the October
2002 edition of this review. The central projection of the forecast is for the CPIX inflation rate to dip below the upper level of the target to 5,7 per cent in the final quarter
of 2003, and then to remain at around this level in 2004. The probability distribution
for this forecast implies that there is approximately a 60 per cent probability that the
CPIX inflation rate will be below 6 per cent in the final quarter of 2003.
With regard to the risks underlying these confidence intervals, a number of factors
might slow the expected decline in inflation and result in actual inflation above the
Figure 10
Breakeven inflation rates

Spread between R189 and R153 bonds
Spread between R197 and R186 bonds
Spread between R198 and R194 bonds
Percentage points

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central projection. These include the possibility that the war in Iraq will have a worse
than anticipated impact on oil prices, and the risk that the stubbornly high level of
inflation expectations by business and trade unions will result in salary and wage
increases being negotiated above the rate that can be justified on the basis of productivity changes and the inflation target. In addition to these risks, there is also the
possibility that administered prices will be allowed to rise at rates which are not
consistent with the inflation targets.
A slightly lesser risk exists that the actual CPIX inflation outcome will be below the
central projection. A stronger than anticipated performance of the exchange rate
would add to the likelihood of this occurring, as would the contractionary impact of
a weaker-than-expected world economy in 2003.
Assessment and conclusion
The outlook for inflation has improved considerably over the past few months, and there
are indications that the downward trend in inflation may be sustained, particularly
against the backdrop of a weak international economy. Since the MPC meeting in
March, further confirmation of this trend has been provided by lower than expected PPI
and CPIX figures as well as subdued money supply data. In addition the rand has maintained its stronger levels. Although the international oil price is expected to remain
volatile, threats to inflation from this source are receding. Critical to the inflation outlook
will be the extent to which inflation expectations adjust to the lower trend in inflation as
well as the future course of wage settlements in the economy.
Figure 11
CPIX forecast
Per cent

Note:
The fan chart uses confidence bands to depict varying degrees of certainty. The darkest band
of the fan chart covers the most likely 10 per cent of probable outcomes foreseen for CPIX
inflation, including the central projection. Each successive band, shaded slightly lighter and
added on either side of the central band, adds a further 10 per cent to the probability until
the whole shaded area depicts a 90 per cent confidence interval (see Box 4 “Understanding
the fan chart” on p 27 of the March 2001 Monetary Policy Review).
There is no doubt that the tightening of monetary conditions has contributed to the
improved outlook for inflation. The MPC came under considerable criticism in the
course of 2002 for the measures taken to combat the surge in inflation. It would appear,
however, that the monetary policy actions taken in 2002 have prevented an uncontrolled inflation spiral. In achieving this, the MPC acted cautiously in order to avoid a
destabilising impact on the real economy. The result was that despite the increase in
the repo rate over the year, economic growth and domestic expenditure remained
relatively resilient. Similarly, a premature or excessively fast move on the downside
could also be destabilising. Monetary policy will continue to be focused on bringing
the inflation rate to within the target range of 3 – 6 per cent as soon as possible, while
being mindful of the possible short-term consequences for economic growth.

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