CAPE TOWN – Last week the South African Reserve Bank (Sarb) increased the repo rate for the second time this year. The move took the repo rate to 6.25% and prime lending rate to 9.75%.
Before the decision, the market was almost evenly divided on whether the Monetary Policy Committee (MPC) would decide to hike or not. Mainly this is because the Reserve Bank finds itself in the difficult position of having to meet its mandate of keeping inflation within the target band at a time when inflationary pressures are almost entirely external. It also has to deal with a rather fragile local economy that will be negatively affected by tighter monetary policy.
Ultimately, the MPC took the view that it has to respond to the likelihood that the US Federal Reserve will begin to raise rates before the end of this year. That will have a negative impact on the currency and it is therefore necessary to provide some protection.
It is abundantly clear that the Sarb wants to stay ahead of the US Fed. And that will probably continue to be the deciding factor in how it acts over the next 12 months.
“It is very much dependent on the US Federal Reserve,” says Nadir Thokan, investment strategist at 27Four Investment Managers. “If the Fed hikes in December, the Monetary Policy Committee is almost compelled to hike at its next meeting.”
He points out that the Reserve Bank has already begun raising rates when inflation hasn’t even started coming through yet, so it has indicated its intention to stay ahead of the cycle.
“They proved their credibility by hiking rates last week,” Thokan says. “They are moving pre-emptively in expectation of what the Fed is going to do.”
The effect of a hike from the Fed on global capital flows will be profound and, since foreigners own 40% of the South African bond market, there will be a local impact. Outflows will see the rand weaken and therefore see the inflation outlook deteriorating.
Economist at Momentum Asset Management, Sanisha Packirisamy, agrees that the Reserve Bank has to consider the likely impact of higher rates in the US.
“We think the most recent hike was justified in an environment where we face inflationary pressures,” Packirisamy says. “Even in an environment with quite a benign growth profile, we are expecting another interest rate increase in March 2016.”
With inflation moving towards the upper end of the target band, any currency shock will push it beyond the 6% range. However, the Reserve Bank also has to consider the effect that further hikes will have on local economic growth.
“We think it’s very hard for the Sarb to do much more than another 25-basis point hike,” Packirisamy argues. “They can’t affect growth by hiking too aggressively.”
Thokan agrees that the rate tightening cycle will probably be shallow, but he expects more than just a further 25 basis points. In addition to currency weakness, he points out that the break-even on government inflation-linked bonds is currently around 6.65%, which indicates that the market is expecting inflation to peak around that level in the coming year. That shows that the inflationary outlook is negative and the Sarb has to respond to that.
“I think 50 to 75 basis points is more the target range,” he says. “If the rand wasn’t significantly weak and if break-evens weren’t so high it might be lower, but we could have at least another two rate hikes ahead of us.”
Thokan however says that it is very difficult to predict what might happen beyond 2016 because so much depends on what the Fed does. And the decisions made at the US central bank are very dependent on economic numbers in the that country, such as unemployment figures and inflation, which cannot be predicted.
“Because the Fed is so data dependent, it’s very difficult to say further out than next year what is going to happen,” he says. “But I do believe that we are not going to see rates climbing aggressively and that this is going to be a shallow cycle.”
He points out that this tightening cycle is not taking place for the usual reasons. The Fed is not looking to raise rates to prevent the US economy from over-heating, as inflation there is under 2%.
“The Fed is just trying to get the world used to the idea that interest rates are not going to be zero forever,” Thokan argues. “The unintended consequences of having low interest rates for this long is that it has created capital allocation distortions. The Fed hiking is really an attempt to prevent these consequences from manifesting further.”
It can’t afford to be too aggressive either, as while the US economy is showing positive signs, growth is not yet secure. The path it takes will therefore be a balancing act of returning monetary policy to ‘normal’ while not taking too much out of the still-fragile recovery.