A keynote address by Daniel Mminele,
Deputy Governor of the South African Reserve Bank,
at the S&P Dow Jones Indices South African Seminar
Johannesburg
12 February 2019
Understanding the core drivers of inflation in South Africa
Introduction
Ladies and gentlemen, good morning, and thank you to S&P Dow Jones Indices for
inviting me to deliver the keynote address at this conference, which brings together a
broad spectrum of investment management and other financial market professionals
to discuss, among others, key drivers of South Africa's reinvention of itself to stimulate
economic growth.
The topic chosen for this address, 'Understanding the core drivers of inflation in South
Africa', is of high relevance today - not just because of the key influence that price
developments have on the economy in general, and on corporate investment
decisions in particular, but also because of the growing debate, both at home and
globally, about the mandate of central banks and what exactly they should be
responsible for.
Within the context of today's theme, I thought it might be useful to first provide some
insight into how inflation has ended up relatively high in South Africa, the challenges
in bringing it lower, and how the South African Reserve Bank (SARB) sees the recent
encouraging developments, and its outlook for consumer prices over the near to
medium term. I will conclude my address by highlighting the SARB's policy response
to this inflation outlook and the risks thereto.
A brief history of inflation challenges in South Africa
In recent years, South African consumer price inflation has regularly exceeded the
median levels for both the world and large emerging markets. But this was not always
the case. In the three decades or so that followed the Second World War, South
African inflation was largely in line with that of its main trading partners. The decoupling
occurred mostly from the 1980s onwards, when central banks - in the advanced world
at first, though later also in emerging markets - took effective steps to root out high
inflation. By contrast, the 1980s saw South Africa experience high and volatile inflation
in an environment of growing supply constraints, disinvestment and sanctions, and a
loosening of the fiscal stance by a government facing increasing pressure for political
reform.
The advent of democracy in 1994 saw increased focus on price stability as a
necessary condition for growth and development, which is why the drafters of the
Constitution enshrined, in the country's fundamental law, the SARB's mandate of
achieving and maintaining price stability in the interest of balanced and sustainable
economic growth, and its independence. For the remainder of the 1990s, in contrast
to the previous two decades, the SARB's policy of positive real interest rates brought
inflation sustainably within single-digit territory. In 2000, the introduction of inflation
targeting helped to clarify the mandate of the SARB, providing a policy anchor and
introducing greater transparency in policy decisions.
This policy has brought clear results. Since inflation targeting began, annual consumer
price inflation has averaged 5.7% (and 5.3% so far in the present decade), compared
to 10% in the 1990s and as high as 15% in the 1980s. As the inflation-targeting regime
has gradually grown in credibility, South African inflation has also become less volatile.
The standard deviation of monthly year-on-year inflation readings has fallen to 0.9
percentage points so far in this decade, from 3.1 percentage points in the 2000s. Yet,
as I mentioned earlier, South African inflation is still relatively high by global standards:
its 2018 average of 4.6% placed it around the 80th percentile of a sample of 58 large
advanced and emerging economies.
This brief recap of the recent history of inflation in South Africa reminds us of how the
level and volatility of inflation can have a crucial impact on the decisions of both real
economy and financial investors. The high and volatile inflation in the 1980s and early
1990s, resulting in high-amplitude interest rate cycles, coincided with a large decline
in fixed investment as a share of gross domestic product (GDP), especially in the
private sector. That decline only started reversing in the 2000s, after inflation targeting
was adopted. Still, investment levels remain insufficient to trigger the kind of sustained
acceleration in economic growth that is necessary to meaningfully reduce
unemployment and poverty. It is true that low and stable interest rates provide a
conducive opportunity for investment, but the issue lies in where these funds are
channelled.
While other factors contributed to the low investment rates of earlier decades, it is not
difficult to understand why high and volatile inflation can cripple capital formation.
Uncertainty about future nominal returns makes a business more reluctant to commit
capital, except for the more profitable projects. At the same time, high inflation
discourages domestic savings, thus increasing reliance on foreign investors who are
more likely to prove risk-sensitive and demand a premium because of inflation
volatility. High uncertainty premiums can, in turn, result in misallocation of capital, with
small and medium enterprises (SMEs) in particular struggling to access funding.
Why has South Africa's inflation struggled to decline?
What are the drivers of this still relatively high rate of inflation? And why has it not
declined more after so many years of sub-par growth?
There are several factors, but the role of inflation expectations cannot be neglected.
As often happens in countries with a long history of relatively high inflation, these
expectations are in part adaptive - that is, private economic agents are often sceptical
about the authorities' ability (and, possibly, willingness) to keep inflation low, because
their experience indicates otherwise. The rand's long-term depreciating trend, caused
by positive inflation differentials with trading partners as well as a structural current
account imbalance, has fuelled such expectations: it has directly impacted on the
prices of consumer goods, as a large fraction of them is either imported or subject to
import parity pricing.
The relatively rigid wage- and price-setting process has also resulted in upward shocks
to prices proving relatively persistent, for instance after a large-scale exchange rate
depreciation. In South Africa, the coexistence (especially during recessions) of large-
scale job losses and high real salary increases bears witness to the fairly high degree
of rigidity in wage demands. It has been argued that high wage gains are a key tool to
redress past income inequalities; and also that there is a trade-off between inflation
and employment gains. While there is no denying the large levels of inequality in South
Africa, it is doubtful that high wage gains can do much to reduce income disparities
when they get absorbed by inflation or come at the expense of large job losses.
Equally, experience suggests that tolerance of higher inflation only has a short-term
boost to employment at best, with negative consequences in the long run.
Other supply-side rigidities have probably also contributed to the persistence of
relatively high inflation in South Africa. High mark-ups in several segments of the
South African economy, barriers to entry for small businesses, and the relatively slow
response of domestic producers to depreciation in the exchange rate, all suggest limits
to competition in the private sector. In turn, this prompts rigidity in upward price
adjustments. At the same time, tariff hikes by municipalities and state-owned
enterprises (for example, electricity tariffs, which are receiving particular attention at
the moment) have often exceeded the headline rate of inflation and have added to the
upside cost pressures for private businesses. It also does not help that many of these
increases affect the regular, high-frequency expenses of households, and therefore
contribute to perceptions of high inflation among the general public.
The recent encouraging signs in price trends
This is not to say, however, that price-formation patterns in South Africa are completely
static. In fact, the last two years or so have seen some encouraging developments.
From 5.3% so far this decade, average headline inflation fell to 5.0% in the last two
years and further to 4.6% in 2018, showing some gradual easing towards the midpoint
of the 3-6% target range.
Core consumer price inflation has followed similar patterns. After remaining stuck
above 5% for four whole years to February 2017, it has now been in the 4.0-4.5%
range for more than a year. True, the 2016 rand recovery did favour the decline in both
headline and core inflation, yet the trend persisted even as the rand experienced
volatility in 2017-18. Indeed, of the last 24 monthly consumer price index (CPI)
releases, 14 came out below the consensus expectation of economists polled by
Bloomberg, versus only 3 that came out higher.
Why did market economists - and indeed, the SARB's own econometric models - fail
to anticipate the extent of this inflation slowdown?
Some particular factors stand out, which were highlighted in the last issue of the
SARB's Monetary Policy Review.
First, the decline in food inflation that began in early 2017, as crops recovered from a
drought-induced plunge a year earlier, lasted longer than most projections had
anticipated. Part of this positive surprise reflected a continued decline in global food
commodity prices.
Second, the impact of the 1 percentage point value-added tax (VAT) hike implemented
in April 2018 proved lower than expected. Possibly, retailers and service providers
trimmed their margins to avoid too negative an impact on sales volumes.
Third, housing costs, incorporated into the CPI through actual and owners' equivalent
rents, slowed markedly in 2018. In many regions, rents had been slowing for several
years already, amid a lacklustre property market and downbeat building activity.
However, the national average was long distorted by an acceleration in the Western
Cape, which only reversed in the past year, in line with other regional trends.
However, the jury is still out on several of the potential causes of this latest
disinflationary trends, and whether they will last.
I will first mention the pass-through of foreign exchange movements to domestic goods
prices. In several components of the CPI, it has been less pronounced of late than in
earlier cycles. Yet economists are still assessing the full range of causes of this lower
pass-through. It is conceivable that the long persistence of a negative output gap has
made price-setters more sensitive to the weakness of demand than was the case in
the past. But will this pattern persist or will it fade once demand finally picks up again
and the output gap starts to close? More observations may be needed before we
conclude that the pass-through is now structurally lower or simply 'slower' because of
unusually weak demand conditions.
Equally, the signs of a moderation in private-sector wage inflation over the past year
or so are not yet fully understood. Remuneration per worker in the private sector
slowed to an average of 5.0% year on year in 2017 and the first half of 2018, compared
with 6.7% in the previous five years. As a consequence, unit labour cost growth slowed
to as low as 3.6% year on year in the second quarter of 2018 - the lowest reading
since early 2007 and a far cry from the double-digit readings seen at the start of the
decade. Yet it is hard to establish whether this moderation is a consequence of
prolonged cyclical demand weakness, whether the labour market has become
structurally more responsive to the business cycle, or whether wage-setters' inflation
expectations have inched permanently downwards.
The inflation outlook improved since the November 2018 Monetary Policy
Committee meeting
In light of these uncertainties, how does the SARB see the outlook for inflation over
the next two to three years?
Encouragingly, at the time of our Monetary Policy Committee (MPC) meeting last
month, our econometric models indicated a significant improvement from the earlier
projection exercise in November last year. The SARB now expects inflation to average
4.8% in 2019 (down from 5.5% in the November projection) and 5.3% in 2020 (slightly
below the previous forecast of 5.4%). Arguably, the lower assumptions for the dollar
price of oil explain a large part of the lower inflation profile for 2019. The real effective
exchange rate of the rand has also recovered somewhat, while world agricultural
prices are expected to provide more of a drag on domestic food inflation.
Importantly, core inflation forecasts have been revised downwards too. Projections for
2021, published for the first time in January, show both headline and core inflation
falling back below 5% in this end-part of the forecast. Furthermore, the SARB's
Quarterly Projection Model (QPM) shows a continued convergence of inflation
expectations, which are already off their near-6% 'perch' of the earlier part of the
decade, and seem to be steadily moving towards the midpoint of the target range. In
addition, the gap between nominal unit labour cost growth and CPI inflation is
expected to gradually fade over the forecasting period, reducing one lasting source of
upside pressure on inflation.
Risks to the inflation outlook that may still be skewed to the upside
Still, when we met in January to assess the risks to this downwardly revised inflation
outlook, the MPC found that, on balance, they were still skewed to the upside. This is
not to say that further downside surprises may not occur, of course. After all, demand
remains weak and credit creation is sluggish, and in many countries these would be
sufficient conditions for inflation to fall further. Equally, many risks, both external and
internal, could result in higher inflation should they materialise.
Among the former, exchange rate volatility remains a key factor of uncertainty in light
of South Africa's reliance on portfolio flows to fund what is, by emerging market
standards, and its current level of growth, a relatively large current account deficit. The
rand has been quite stable over the past few months, thanks in part to reduced
expectations of interest rate hikes in the United States (US) and the subsequent
moderate retreat of the US dollar. But such a situation can change if market
expectations of the future US rate path need to be revised upwards again or,
conversely, if the world economy slows faster than expected, triggering a new wave
of investor aversion towards 'riskier' assets. The implications for capital flows towards
emerging markets of global central banks' balance sheets, some of which are currently
contracting after nearly a decade of expansion, are also not clear yet. Equally, the oil
price outlook remains uncertain amid persistent geopolitical tensions.
On the domestic front, the MPC is cognisant of the upside risks to administered prices,
especially electricity and water, in light of the challenges that utilities have faced for
years to contain costs, and in light of the pressing maintenance needs if supply safety
and quality are to be secured. The MPC also sees risks of a pickup in food prices in
the outer years of the forecasting period. In addition, any unresolved domestic policy
uncertainties could trigger exchange rate volatility even in the absence of external
shocks.
The South African Reserve Bank's reaction and policy mandate
Following its decision to hike the policy rate by 25 basis points at the November 2018
meeting, the MPC felt that the inflation backdrop and outlook had improved sufficiently
enough to warrant keeping the policy rate unchanged at the January meeting. While
the MPC still judged the policy stance as broadly accommodative, the endogenous
rate path generated by the QPM now only entails one hike of 25 basis points in the
policy rate, to 7.0% by the end of 2021. As previously indicated, this does not represent
policy guidance nor commitment. The MPC will remain alert to any possible second-
round price effects of potential shocks and stands ready to act accordingly should data
indicate a shift in the inflation outlook and the risks thereto in either direction.
It has at times been suggested that the SARB should place greater emphasis on
growth and employment objectives, or even that its mandate should be modified to
make such objectives clearer. These suggestions may miss the key channels through
which monetary policy best serves the goal of long-term economic development.
South Africa's monetary policy framework is not one of rigid inflation targeting, but a
flexible one, which takes full account of the outlook for real economic growth and how
it is likely to affect inflation over the forecasting period. For instance, when demand is
weak and exerts downward pressure on prices, the SARB has far more latitude to 'see
through' external price shocks than in an environment of domestic 'overheating'.
However, as I mentioned earlier, trying to 'kick-start' economic growth and
employment through a larger dose of monetary stimulus would probably have only a
short-lived impact on activity. By contrast, its implications for the current account,
policy uncertainty and inflation expectations would most likely be negative. Over time,
therefore, the consequence would probably be higher, rather than lower, interest rates.
International and local experience does suggest that it is a stability-oriented monetary
policy framework, focused on reducing price volatility and risk premiums on financial
assets, that has the best chances of delivering lower interest rates and stronger
economic growth, amid sustainable investment, over the longer term.
Conclusion
Allow me to end my address by reiterating that in line with its constitutional mandate,
the SARB will continue to seek to ensure that the purchasing power of our currency
is protected. Monetary policy cannot contribute directly to stronger economic growth
and employment creation in the long run, but by ensuring a stable financial
environment, monetary policy fulfils an important precondition for the attainment of
growth and development. Monetary policy in South Africa considers all factors driving
inflation, including output growth and the external environment. Monetary policy has
an important role to play, but it needs to be part of a carefully defined overall macro-
economic policy mix.
Thank you.