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Statement of the Monetary Policy Committee, 3 August 2006 Domestic
inflation is on an upward trend, with food price inflation adding to the pressures
emanating from persistent petrol price increases. Household consumption spending
has continued to grow at a strong pace and consumer confidence remains high. This
has been reflected in strong credit extension and preliminary indications are
that the deficit on the current account of the balance of payments might have
remained high in the second quarter. These factors, combined with a general depreciation
of the rand, have resulted in a further deterioration in the inflation outlook.
In the recent past there has been considerable volatility in international
financial markets in general, and in emerging markets in particular. These developments
have cantered around the uncertainty about the future path of interest rates globally.
However, the latest developments appear to suggest that some calm may be returning
to the financial markets, as evidenced by the narrowing spreads on emerging market
debt. Recent inflation developments Inflation as measured
by the consumer price index for metropolitan and other urban areas excluding the
interest cost on mortgage bonds (CPIX) increased at a year-on-year rate of 4,8
percent in June, compared to 3,7 percent in April and 4,2 percent in May. This
upward trend is not only attributable to petrol price increases. If petrol prices
were excluded, CPIX would have measured 3,5 percent and 3,8 percent in May and
June respectively. This latter figure is the highest rate of increase of this
measure since June 2004. Food price inflation has also made a significant contribution
to this upward trend. Prices of petrol and diesel increased at year-on-year
rates of 13,2 percent and 22,7 percent in May and June respectively. Food price
inflation has been increasing steadily since late 2005. In November last year,
year-on-year food price increases measured 2,0 percent. In each subsequent month
food price inflation increased, and measured 7,2 percent in June. Significant
increases in the prices of meat, fish and vegetables have been the major contributors
to this trend. Grain product prices have not fully responded to the sizable increase
in maize prices since the latter part of last year although some upward pressure
is evident. In June, the grain products inflation component of CPIX measured 3,8
percent compared to 0,2 percent in January 2006. Most of the other CPIX
categories continue to exhibit low rates of price increases, while the categories
of clothing and footwear and furniture and equipment have shown persistent price
declines. Services price inflation has declined continuously in the past few months
and measured 3,3 percent year-on-year in June 2006. Administered prices excluding
petrol are predominantly services and therefore have exhibited a similar trend
but at marginally lower rates of increase. Indications of possible consumer
price pressures come from production price inflation which increased at a year-on-year
rate of 7,6 percent in June, compared to 5,5 percent and 6,3 percent in April
and May respectively. Although food and energy were important drivers of these
increases, the pressure was more broad-based. If food and energy were excluded,
production price inflation would have measured 4,5 percent in June, compared to
2,9 percent in April, and 3,6 percent in May of this year. Some of the upward
pressure in June can be attributed to the change to winter electricity tariffs.
The outlook for inflation Since the previous meeting of the
Monetary Policy Committee (MPC), the inflation forecast of the bank has deteriorated
moderately. The most recent central forecast of the bank projects inflation to
peak above the six percent level and to remain outside the target range for the
first two quarters of 2007. Thereafter, based on the current assumptions, CPIX
inflation is projected to decline slowly to reach a level marginally above five
percent by the end of 2008. It seems to us that the use of the forecast
in monetary policy decisions needs to be further explained. The MPC does not use
the forecast in a mechanical way as the basis for policymaking. The forecast provides
a broad guide to possible inflation outcomes, but the Committee relies on its
judgement about possible future developments. No model can adequately capture
all the relevant dynamic processes in any economy. It is worth emphasising that
the model outcomes are also dependent on the assumptions that are fed into it.
Furthermore, the MPC takes a view of the risks to the forecast. The exchange
rate has exhibited considerable volatility, and fluctuated between levels of around
R6,70 and R7,50 to the United State (US) dollar since the June MPC meeting. The
behaviour of the rand was initially related to increased global risk aversion,
combined with concerns relating to domestic balance of payments imbalances. More
recently, expectations that the monetary policy tightening cycle globally may
be at or near its peak have prompted an appreciation of the rand to current levels
of around R6,90. On a trade-weighted basis, the rand has depreciated by about
14 percent since the beginning of the year, and by 2,5 percent since the previous
MPC meeting. Some pass-through from the exchange rate to prices can be expected,
particularly to domestic petrol prices, which have increased by a cumulative R0,56
in July and August. Exchange rate movements accounted for about R0,44 of this
adjustment. The prospects for the rand going forward, and the associated risks
to inflation, depend to some extent on the global interest rate trend. In
previous statements the MPC expressed concerns about the expanding deficit on
the current account of the balance of payments. Current account deficits are a
reflection of higher domestic expenditure and are not in themselves inflationary.
There is however a possible risk to the exchange rate if the deficits are perceived
to be unsustainable, particularly if the deficits are reflecting higher consumption
expenditure. The recent exchange rate reaction to the higher deficit is
indicative of this, but it is also part of the macroeconomic adjustment process.
In order for the exchange rate to play its part in this process, it is important
that the exchange rate changes are not simply offset by higher inflation. The
current account deficit is expected to be adequately financed through capital
inflows, although the focus of non-residents has shifted from the equity market
towards the domestic bond market. In July, non-residents became net sellers of
shares to the value of R2 billion, whilst non-resident net bond purchases totalled
R11,8 billion in the same month, compared to net sales of R1,3 billion in June.
Household consumption expenditure, which grew at an annualised rate of
7 percent in the first quarter of this year, shows few signs of abating. The First
National Bank (FNB)/ Bureau for Economic Research (BER) Consumer Confidence Index
declined marginally in the second quarter of 2006, but nevertheless remain close
to historically high levels. Motor vehicle sales continue to exhibit strong growth.
New vehicle sales grew by 20,8 percent in the year to July. This higher
consumer demand has been underpinned by low nominal interest rates, rising real
incomes, and wealth effects arising from strong asset price growth. The residential
property market remains buoyant, although the rate of increase in house prices
has declined somewhat during 2006. According to the ABSA house price index, house
prices recorded year-on-year increases of 13,6 percent in June. Prices on the
Johannesburg Stork Exchange Securities Exchange have been somewhat volatile with
the ALSI fluctuating between 18380 and a high of 21592. Growth in credit
extension to the private sector reflects the growth in consumer expenditure and
higher property prices. Growth over twelve months in total loans and advances
accelerated from 22,5 percent in May 2006 to 23,2 percent in June. Asset backed
credit growth, which accounts for a significant part of the increase in total
loans and advances, has remained around 27 percent since February 2006. Until
recently wage developments presented a benign picture. During 2005, unit labour
cost in the formal non-agricultural sector increased by 3,4 percent, providing
further evidence that wage pressures were well contained. However in the first
quarter of 2006, nominal unit labour cost increased by 7,6 percent compared to
the same quarter of the previous year, and up from an increase of 2,6 percent
in the fourth quarter of 2005. This development is attributed in part to a decline
in labour productivity in the first quarter of 2006 compared to the first quarter
last year, as employment outpaced output growth. It is too early to tell
if this represents a reversal of the previous trend, but as a significant number
of wage negotiations are concluded in the third quarter, these developments will
be closely monitored. Wage settlements surveys conducted by Andrew Levy Employment
Publications show that settlements have averaged 6,2 percent in the first half
of 2006, compared to 6,3 percent in 2005 as a whole. Preliminary indications
are that economic growth, although still robust, continues to show some moderation
compared to the 4,9 percent achieved in 2005, and consequently poses little threat
to the inflation outlook. The Rand Merchant Bank (RMB)/BER Business Confidence
Index declined in the second quarter, although it remains at a high level. Manufacturing
output growth has shown some signs of sustaining the first quarter recovery after
the subdued levels in the second half of 2005. The physical volume of manufacturing
production increased by 4,4 percent on a year-on-year basis in May, while the
Investec/BER Purchasing Managers Index has increased for six consecutive months,
with the measure for July indicating a strongly positive outlook for the sector.
Mining production, however, remains under pressure. Total mining production decreased
by 6,8 percent year-on-year in May although in the past three months mining production
increased by 5,4 percent compared to the previous three months, mainly as a result
of increased platinum group metals production. International factors also
pose a risk to the inflation and interest rate outlook. International oil price
developments remain a significant source of concern. In mid-June the price of
Brent crude oil had declined to levels of around US$66 per barrel as a result
of higher reported inventories. However by the end of June, oil prices had risen
to levels of around US$75 per barrel as a result of strong demand pressures, supply
constraints and rising geopolitical tensions. In July the price of Brent crude
oil averaged almost US$74 per barrel, compared to US$68 per barrel in June. Despite
the relatively subdued global inflation environment, inflationary pressures have
begun to emerge in a number of countries. This has prompted further tightening
of monetary policy by several central banks in the past few months. Monetary
policy stance The MPC remains concerned about the longer term threats
to the inflation outlook and has therefore decided that a further adjustment to
the repo rate would be prudent. Accordingly, the repo rate is increased by 50
basis points to 8,0 percent per annum with immediate effect. The Monetary Policy
Committee will, as is always the case, remain vigilant in order to ensure that
CPIX inflation stays within the inflation target range. Enquires: Cathy
Powers
Tel: (012) 313 4420
E-mail: Cathy.Powers@resbank.co.za
Issued by: South African Reserve Bank
3 August 2006 Source:
South African Reserve Bank (http://www.reservebank.co.za)
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