If you think this year radical, with inflation and interest rates moving painfully higher and growth falling away, next year could be just as radical, but potentially in the opposite direction.

Certainly our capital market has been saying so for over a month, with long-term yields steadily dropping. It was joined two weeks ago by the equity market turning up.

A SARB speech last week reiterated a long understanding, namely that “the standard response to exogenous shocks is for the monetary authorities to allow for the first-round effects, but to react to any second-round or generalized effects that may come through.”

Core-CPIX (ex oil and food) can be taken as “loose evidence of second-round effects.”

There is the further consideration that “compounding evidence of second-round effects were the concerns regarding the size of the current-account deficit, rising administered prices, Eskom tariff increases, and so on.”

This makes for an interesting smorgasbord of effects.

By September this year, the CPIX will have risen by over seven percent above its target range of three to six percent will have risen nearly fourfold its 2005 low point and threefold from a smoothed trend through mid-2006.

In contrast, core-CPIX will only be slightly out of the three to six percent target range, having risen by four percent since mid-2006, and today being only two percent higher than the 4.5 percent mid-point of the inflation target range.

Meanwhile the current-account deficit has risen to a very large nine percent of GDP.

So which of these complex effects warrant a five percent interest rate increase since mid-2006? Bear in mind “it is the view of the SARB that the current monetary policy stance is appropriate to deal with the inflationary pressures that we are facing.”

CPIX will shortly be 7.5 percent over target and nine percent above the midpoint of the target range. Tightening interest rates by five percent has therefore clearly not kept pace with the rising headline CPIX, as one would expect with most of the inflation rise being due to exogenous first-round effects (oil and food mainly, to which can be added future special Eskom tariff increases).

But that what the SARB claims to be primarily responding to, namely second-round effects, have only risen two percent from the target midpoint. Even if these effects were to rise another 0.5 percent before peaking, it sounds rather stiff medicine to raise rates by five percent in response.

Unless, that is, one can split the difference.

Half the rate increases was to match rising core-CPIX, namely second-round effects. And the remaining half of the policy response was aimed at other concerns, primarily the rising current-account deficit.

Even if confirmation of such policy weighting were not to be forthcoming, it leaves us with something to consider when contemplating 2009-2010.

It isn’t a given that the global oil market dynamics have already adjusted adequately to warrant belief in lower oil prices ahead. There has been rich-world demand destruction, but much less so in emerging markets. The global reserve buffer between oil demand and supply remains an unacceptably tight 2mbd.

Low oil price scenario

Yet this past month the oil price has fallen, as oil market participants take cognizance of slower global growth and the ongoing demand destruction in especially richer OECD countries. If we may assume that this is adequate for market psychology, and there are no new surprise developments shocking oil market sensibilities anew, we could next year see a low oil price scenario ($80-$120) rather than a high one ($150-$300).

One should please carefully note the hedged qualifications in such assumptions.

But having dreamed nightmares for a couple of months, with oil potentially still doubling up, and thereby giving the CPIX scenario a ‘blue sky’ quality well beyond 13 percent in 2009, let’s for once dream pleasant dreams.

Oil unchanged at $125 would already be enormously good stuff, never mind it receding to $80. But given tight global reserve buffer, uncertain geopolitical conditions, and only a modest global growth slowing, we should for ‘sweet dreams’ purposes stick with $125 oil for now.

If similar assumptions can be made about food prices, with the rand getting stuck somewhere in 7-8:$ territory, we are getting a CPIX scenario that peaks at 13.5 percent shortly, but then from early next year races lower, ending 2009 barely above the SARB’s three to six percent target zone.

In other words CPIX took 18 months outside the target zone to get to 13.5 percent, and may take only two-thirds of this time to retrace the distance to get back to within shouting distance of the target zone.

That’s radical stuff.

Two more questions must be asked and answered, before contemplating the SARB’s likely reaction function.

For if the conditions of the past 18 months constituted a challenge, one has to consider the next 18 months an even bigger challenge for the SARB. For what is one supposed to do next?

The two questions: what will core-CPIX (second-round effects) do? And what about the current-account deficit?

The SARB has a way of referring to core-CPIX as being prices other than oil and food. But the ultimate economy-wide proxy is wage costs. Or rather unit labour costs, being labour costs less productivity.

For the economy overall, productivity may be as much as 2.5 percent annually, with nothing in some sectors and four to five percent in others, and a lot more in the one to three percent range.

If last year wage costs were 7.5 percent, employment gains three percent, with capital and property earning the remaining one percent to 1.5 percent, one gets to nominal income growth of 11 to 12 percent.

This year, wage costs look closer to nine to 10 percent, with no employment gain. Still allowing for the productivity gain (which isn’t constant and can vary), we may face unit labour costs of seven percent, only a little higher than the present core CPIX which is still rising gradually.

But next year that picture could change once again, radically even.

Take the public service as biggest employer as benchmark. This year its mid-2008 wage increase guided by CPIX was 10.5 percent plus one percent. By mid-2009 in “sweet dreams” it would be 6.5 percent plus one percent.

The second-round effects could unwind a lot faster than ever imagined, mostly driven by the unwinding commodity price shocks, the headline CPIX reversal and the contractual agreement to be CPIX bound. Thus 2009 would literally be 2008 in reverse.

The implication for economy-wide wage costs next year could be closer to six to seven percent instead of nine to ten percent.

In other words, the SARB should have fewer concerns that the second-round effects will become embedded.

A ‘blue sky’ scenario certainly would imply inflation and wage trouble, but a ‘sweet dreams’ scenario should not. The build-down in 2009 would be as dramatic as the step-up was in 2008.

The implication for unit labour costs in 2009 would be closer to four to five percent, back at midpoint of the SARB target range.

As for the current-account deficit, it should ease next year because of GDP growth much closer to two percent rather than the five percent of 2007 and the two to three percent of 2008. But infrastructure efforts are still building up, with increased importation needs still ahead.

It is a safe bet, however, with oil at $125 and other commodity prices less generous than expected, that our current-account deficit will remain a problematically high eight to ten percent of GDP, even if a growing share of it will be funded via long-term export credits.

Sweet inflation dreams

All of this suggests ‘sweet dreams’ CPIX by late 2009 approaching six percent, core-CPIX easing back to within the target zone, with the current account deficit remaining unceasingly high.

What interest rate adjustments should this warrant?

We shouldn’t apparently pay too much attention to the headline CPIX, because it would be mainly first-round unwinding. What you largely ignore on the way up should presumably also largely be ignored on the way down.

That leaves a choice between second-round effects, also goodly down, and the current-account deficit, presumably still unceasingly high.

Split the difference once again, shall we?

But that would mean only a 2.5 percent drop in interest rates next year, and a rise in real interest rates of a similar magnitude, to keep the consumption spending modest, fixed investment the lead growth driver and the balance of payments condition contained.

As to whether the SARB should still raise rates this month or leave rates unchanged, one is left choosing between future ‘blue sky’ and ‘sweet dreams’ scenarios, between reaching CPIX six percent or 15 percent in late 2009.

Given this difficult choice, it would make sense to go on hold once again with our interest rates for now, granting the world more time to show us what it is going to be next year, blue sky or sweet dreams.

If the latter, the SARB could hold back until early 2009, for the high core-CPIX will be with us for some while, but then to start cutting rates in 0.5 percent moves, reaching prime 13 percent by yearend 2009.

Pity that there is a general election in April 2009, which could remind some people of Primrose prime in 1984 and could inhibit a SARB concerned about its credibility.

But then one would hope the state of the economy counts for a lot more?

Cees Bruggemans is chief economist of First National Bank.


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