Was it really necessary to hike interest rates? Analysts weigh in

The South African Reserve Bank’s (SARB) timid rate cutting cycle, which comprised a total of just 50 basis-points across 2017 and early 2018, ended abruptly last week with a 25 basis-point rate hike, say analysts from Overberg Asset Management (OAM).

The repo rate increased from 6.50% to 6.75%.

But was it really necessary to hike interest rates, with the economy falling into recession?

According to the analysts at OAM the hike appears to be in contradiction with SARB’s downward revision of its inflation and GDP growth forecasts, and was likely made to sustain the rand.

"In an environment of benign inflation and near-recessionary economic growth, the motivation behind the SARB’s rate hike appears to be to protect the rand."

The analysts however believe that financial markets tend to not reward this sort of rate hike.

"The rate hike will not assist the rand on a sustainable basis. If anything, the opposite may be true."

"Higher interest rates will impact GDP growth, which in turn increases the risk of further credit rating downgrades and South Africa’s expulsion from global bond indices."

South Africa economic review

• The SARB hiked its benchmark repo interest rate by 25 basis points from 6.50% to 6.75%, reversing the March rate cut.

The decision was evenly poised with three Monetary Policy Committee (MPC) members voting for a hike and three voting for no change. SARB Governor Lesetja Kganyago cast the deciding vote.

The rate hiking decision came despite the SARB lowering its headline consumer price inflation forecast for 2018 and for 2019 from 4.8% to 4.7% and from 5.7% to 5.5%, and its GDP growth forecast for 2018 from 0.7% to 0.6%. While the rand has strengthened versus the US dollar by around 4% and the dollar oil price has declined by around 20% since the last policy meeting in September, the SARB appears increasingly concerned about the inflationary impact of potential rand weakness and rising fuel prices.

In its policy statement, the SARB cautioned that: "Tighter global financial conditions, financial market volatility and the change in investor sentiment towards emerging markets remain key external risks to the rand." The SARB also cautioned that: "Administered prices, including fuel, electricity and water tariffs, are expected to increase at rates above the upper end of the inflation target range."

The SARB’s Quarterly Projection Model forecasts another three 25 basis point rate hikes between 2019 and 2020, which would lift the repo rate to 7.50%. (See Bottom Line for further analysis).

• Consumer price inflation (CPI) picked-up in October from 4.9% to 5.1% year-on-year, attributed to rising fuel, water and electricity prices. Fuel prices were up in October by 22.8% on the year causing transport inflation to rise to 10.5%. Meanwhile, housing and utilities inflation increased to 5.2% pushed-up by water and other services inflation of 11.1% and electricity and other fuel inflation of 7.7%.

Core CPI which excludes energy and food prices due to their volatility, remained stable at 4.2% year-on-year unchanged for a third consecutive month and below the mid-point of the Reserve Bank’s 3-6% target range. Core CPI data indicates negligible underlying inflationary pressure. On a month-on-month basis, core CPI increased by just 0.1% in contrast to headline CPI which increased 0.5%.

• S&P Global Ratings credit rating agency affirmed South Africa’s long-term foreign and local sovereign ratings at BB and BB+ with a "stable" outlook. While indicating little risk of an imminent downgrade, the current ratings are already below "investment grade". S&P Global observed that "anaemic economic growth in 2018 and sizeable contingent liabilities continue to weigh on South Africa’s fiscal prospects and debt burden."

The rating agency also warned against a significant weakening in the rule of law and property rights. However, it acknowledged that "the new government is pursuing a series of economic reforms that should help boost the economy from 2019 onward, despite structural impediments, chronic skills shortages, and high unemployment."

S&P Global forecasts GDP growth of 0.8% in 2018, rising to above 2% from 2019-2021, offering hope that the country could be awarded a rating upgrade if economic growth strengthened in a “significant and sustained manner.”

• The SARB composite business cycle leading indicator, a measure of expected economic conditions 6-9 months ahead, slipped in September for a third straight month, falling from 104.9 to 104.7 although not far off its recent February peak of 107.4. Of the available component sub-indices, three fell and six increased.

The biggest detractors were a decrease in the number of residential building plans passed and a deceleration in the twelve-month percentage change in job advertisement space.

The biggest contributors were an increase in the South African produced export commodity price index and a widening in the interest rate spread between 10-year government bonds and the 91-day Treasury bill. A slight concern is the deterioration in the composite leading business cycle indicator for South Africa’s major trading partners, indicating a potential drop in export volumes. 

The week ahead

• RMB/BER Business Confidence Index: South African business confidence fell to the lowest level since the country lost its investment-grade credit rating, as political and policy uncertainty continue to weigh on sentiment.

An index tracking SA business confidence declined again in the fourth quarter of the year, according to the latest business confidence index by Rand Merchant Bank and Stellenbosch university's Bureau for Economic Research.

• FNB/BER Consumer Confidence Index: Due on Wednesday 28th November. The third quarter (Q3) FNB/BER Consumer Confidence Index is expected to have corrected downwards following its surge to a record high in Q1. The CCI remained at elevated levels in Q2 but since then surging fuel prices and continued growth in unemployment are likely to have dented consumer confidence.

• Producer price inflation: Due on Thursday 29th November. Producer price inflation is likely to have nudged slightly higher in October to 6.3% year-on-year from 6.2% in September, reflecting the inflationary impulse from the weakening rand and rising international oil prices. While PPI is likely to maintain its gradual upward trend over the next few months the base effect of high comparative year-ago levels should begin to show up in lower PPI readings from the second quarter 2019.

The rand has strengthened around 10% versus the US dollar over the past three months while the Brent crude oil price has weakened by 30% since its peak in early October.

• Private sector credit extension: Due on Thursday 29th November. Private sector credit extension growth (PSCE) is expected to have picked-up slightly in October from 6.3% year-on-year to 6.6% with improving business confidence lending a hand to corporate credit growth. Household credit growth is likely to remain subdued due to relatively high household indebtedness and poor employment prospects.

• Trade balance: Due on Friday 30th November. The trade balance is expected to have run a slight deficit in October following-on from the deficit of R2.3bn in September.

While weak domestic demand is constraining the appetite for imports October traditionally marks a spike in import demand as inventories are restocked ahead of the festive season. The month of October has recorded a trade deficit for six of the past seven years.

Bottom line

• The SARB's timid rate cutting cycle, which comprised a total of just 50 basis-points across 2017 and early 2018, ended abruptly last week with a 25 basis-point rate hike. The repo rate increased from 6.50% to 6.75%.

• Was it really necessary to hike interest rates, with the economy falling into recession in the first half of the year? The rate hike appears to be in contradiction with SARB’s downward revision of its inflation and GDP growth forecasts. In its accompanying policy statement, the SARB not only lowered its headline consumer price inflation (CPI) forecast for 2018 and 2019 from 4.8% to 4.7% and from 5.7% to 5.5%, it also lowered its GDP growth forecast for 2018 from 0.7% to 0.6%, citing a widening in the output gap. The output gap has remained persistently negative indicating plenty of spare capacity in the economy.

The SARB’s forecast for the output gap, which measures spare capacity in the economy, was revised from -1.3% to -1.4% for 2018 and from -0.8% to -0.9% for 2019.

• Admittedly the recently published headline CPI rate for October is above the mid-point of the SARB’s 3-6% target range at 5.1%. However, the more important core CPI rate, which excludes food and fuel prices due to their volatility, is well below the mid-point at 4.2%.

Moreover, headline CPI is likely to decelerate sharply over coming months as the data starts to reflect the recent steep decline in oil prices and the strengthening in the rand. The rand has strengthened by over 10% against the US dollar since its low point in early September while the Brent crude dollar price has dropped by over 30% since hitting a multi-month peak in the first week of October. A fuel price decrease of around R1.70 per litre is expected to be announced before the end of the year, which would be the largest price cut on record.  

• The SARB is becoming increasingly wary of risks to the global economy and their effect on the rand, citing the potential for "extended periods of currency depreciation." In an environment of benign inflation and near-recessionary economic growth, the motivation behind the SARB’s rate hike appears to be to protect the rand. However, financial markets tend not to reward this sort of rate hike. If the rand were to collapse again the SARB would have to hike rates regardless of last week’s increase only it would come from a higher base.

• The rate hike will not assist the rand on a sustainable basis. If anything, the opposite may be true. Higher interest rates will impact GDP growth, which in turn increases the risk of further credit rating downgrades and South Africa’s expulsion from global bond indices. The credit rating agencies have consistently cited weak economic growth as one of their chief concerns.

• While acknowledging that the risk to economic growth is titled to the downside the SARB’s policy statement highlighted that "current challenges facing the economy are primarily structural in nature and cannot be solved by monetary policy alone." 

For the full report, including a look at international markets, click here.

* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable, but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report. 

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