It would seem our macro policymaking team effectively faces four scenario options shortly.

Option One (sharp disinflation under gradually dissolving external constraints) is the most hopeful one. This scenario sees the likelihood of steeply falling inflation over the next 18 months becoming more certain, as the external risks to the inflation outlook become less threatening while internal resource slack expands.

With oil testing $50 on the downside, food inflation easing, the global financial crisis finishing off, and global institutional safeguards explicitly or even only implicitly in place, thereby limiting rand downside risk in the medium-term, the external risks to the inflation forecast should diminish.

Enormous currency rollercoaster

Also bear in mind that the dollar may be currently firming as capital is pulled home and foreigners try to cover dollar liabilities. But when this tide crests, the enormous expansion in US money supply should start weighing on the dollar, lifting most other boats. It promises to be an enormous currency rollercoaster, possibly also for the rand and (some) commodities.

Meanwhile our steadily weakening economy, as per a gradually widening output gap (difference between potential and actual GDP), suggests increasing resource slack and less domestic inflation pressure.

As these realities bolster conviction that inflation will be plunging next year, the SARB may feel strongly enough to start cutting interest rates from December 2008.

How much of a first cut (0.5 percent or one percent) will depend on SARB perception of reality and its own convictions. And not forgetting inflation expectations as per surveys and bond market discounting.

Central bank DNA

Kiwi, Aussie, India and the UK each in turn abruptly shifted monetary policy in a major way in recent months. Institutionally we carry the same DNA of all four central banks and their monetary policies. And we waited the longest.

Option Two (unchanging severe external risks to the inflation outlook and a sacrificing mentality) still sees the domestic economy weakening, a widening output gap and downward domestic pressure on inflation (along with $50 oil the only true constants in all four scenarios).

But the global financial crisis and the deep global recession following it aren’t finished showing their teeth, and carry material risks, as ECB President Trichet pointed out in a Wall Street article last week. It could keep the rand exposed to episodic hits. Fear of still considerable rand weakening ahead continues to prevail, informing many decisions, public and private.

Despite limited actual pass-through to inflation, the sheer extent of this potential Rand risk would make the forecast of declining inflation next year doubtful, even in a generally deflating world.

This scenario does not expect global financial assistance being offered or requested.

SARB decides to keep interest rates unchanged, not forever, but certainly indefinitely into 2009, continuously weighing Rand risks for inflation, accepting weakening growth while outwaiting the global risk game and its implications for our inflation. The implied growth sacrifice is accepted, if not joyfully (not least because the political season will be advancing).

Option Three (rand and inflation disappointment, but global rescue) is factually worse in outcome than option Two, with the rand actually being hit by global events and threatening to weaken considerably further. But there is a happy ending. A safety net is ultimately provided by IMF and World Bank access, limiting Rand weakness and inflation upside.

SARB keeps interest rates unchanged, possibly even on IMF advice, aimed at containing inflation while the weaker rand shields and boosts the economy.

Option Four is from hell

Option Four is from hell (Project Independence) and is on a par with 1985.

External events deteriorate, global risk aversion increases, foreign capital flows out strongly and the rand falls victim. Our policymakers refuse foreign assistance, and decide on forcefully rearranging the economy, raising interest rates, cutting back domestic demand, deeply cutting imports while boosting exports (the interaction between weak rand and higher interest rates), aiming to restore a current account surplus.

And this into the teeth of a political hurricane (otherwise known as a general election).

Of these four scenarios, number four (the one from hell) appears least likely. The world is already post-crisis. If markets were to clobber the Rand, global institutions are on standby. And if dire circumstances were to come about, our policymakers would probably ultimately accept such international financial assistance rather than force a wrenching adjustment on the economy at such a sensitive moment in our collective lives.

We are no longer politically the bud-end of the world. We are not without understanding friends in a world under siege. Our politicians aren’t masochists.

That leaves Options One (65 percent), Two (25 percent) and Three (10 percent) as the likely ones, but each of us will have our own sense of relative probabilities.

Option four doesn’t carry a zero percent probability, but it is far from obvious what would be a realistic probability under present circumstances.

It promises to be a bleak Christmas this year, going by recent economic data releases, but potentially with silver linings, possibly even with gold oak leaves as decorations. Christmas 2009 should be better.

Cees Bruggemans is FNB's chief economist.


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