interest rate cuts ahead

FERRIER International sharing the good news. We thank Cees Bruggemans, Chief Economist of FNB for this positive article and outlook for 2009.

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Interest rate cuts ahead

By Cees Bruggemans, Chief Economist FNB
03-?November 2008

Events have marched on to a point where the first of a series of SARB rate cuts are coming into view, timing as always the prerogative of the SARB.

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But do paint in a very high probability for December 2008 and a near certainty for February 2009 for the first cut.

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In contrast, the consensus keeps looking well into 2009 for that first rate cut. I have maintained for some time that events may be moving much too fast for that. Expect rate cutting sooner rather than later.

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And that is with impressive shock absorbers already fully extended. This refers to oil at $60 rather than $150. Also, the fiscal stance becoming supportive by the equivalent of 2% of GDP this year and probably again next year. The Rand’s 40% depreciation so far this year compared to 2007 average (and about 30% depreciation on trade-weighted). And the decline in real interest rates (however calculated), as rising inflation and inflation expectations this year outpaced rate increases.

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So in order to suggest nominal interest rate cuts sooner rather than later, one apparently believes the economy’s decline is worse than what these impressive shock absorbers can handle. Or the inflation rate is about to collapse impressively, in the process boosting the real interest rate to Kingdom come at the very moment that the economy finds itself in the middle of an old-fashioned recession.

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Or more likely one believes both these propositions.

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Let’s test them both before moving the focus to the SARB.

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Could the economy be weaker than thought? Easily so, as economic data and perceptions lag rather badly coming out of a high-performance growth era accompanied by even higher future expectations and dire political need for good news and little interest in bad news.

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But the shock absorbers may not all be what they are cracked up to be at first blush.

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Take oil. Nice, to see it collapse from $150 to $60. But unfortunately our Dollar export commodity prices have fallen even further, starting with platinum, from $2250 to $800.

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That takes care of the Dollar oil windfall. Worse, we produce 40% of our own liquid fuel requirements. That boosted Rand incomes when the oil price was rising, but the oil price fall will be contracting Rand income at our oil producers. That’s growth-suppressive.

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The Rand decline of 40% since 2007 is a great income booster, until one allows for the Dollar export commodity declines, but also declines in export volumes once global recession is fully discounted.

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Exporter Rand incomes may have been partly shielded by Rand decline, but not fully so. Households and businesses will have some benefit from the falling oil price, but most of the benefit is eroded by the depreciated Rand.

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So yes, exporters are not falling off a cliff, but our households are not getting much of an oil price windfall either.

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Meanwhile, the nominal interest rate increases of the past two years are steadily grinding away at household consumption growth, which by this time is probably already negative. Private fixed investment also suffers in part, in addition to the effect of constrained electricity supply. There is evidence of inventories being reduced. Real household income may be under pressure from real wage adjustments, employment and flexible income sources (bonuses, commissions and overtime especially).

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Thus inflation may have outpaced nominal interest rate increases and may thereby have reduced real interest rates this year, but its beneficial effect is yet to start shining through in growth support.

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Indeed, the 40% Rand decline, most of it occurring these past two months, has greatly increased interest rate anxiety, with greater fear of either further nominal rate increases, or delays in rate cuts, prolonging the period of severe household stress, in turn inducing yet greater willingness to postpone durable goods replacement and intensify belt tightening.

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Has enough therefore been done to moderate the cyclical growth interruption? Probably not, indeed increasingly not, as external events keep piling up the pressure.

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If monetary policy has so far chosen to increase nominal rates and keep them elevated, this is very much a reflection of the sharp increase in inflation and inflation expectations these past two years, and the risks of keeping them elevated through next year.

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But that was the musical sheet of the past twelve months. Is it being overtaken by events? I think so.

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CPIX inflation peaked at 13.6% in August, and undershot marginally at 13% in September. Coming months could see more undershooting if oil keeps heading lower, food prices have passed their peak, the Rand proves more resilient than expected and the pass-through from the weaker Rand is less than postulated.

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It is true that OPEC has announced output cuts of 1.5mbd, with more probably to come. But high-cost marginal producers will probably cheat, Saudi will want to keep the Americans friendly (and not forgetting its own long-term interest in optimising oil wealth), and US domestic petrol consumption is now apparently 9% down (but for how long?). Anyway, futures markets are betting on $50 oil next year (though these bets have been wrong before).

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But even if one doesn’t get too bullish on oil (the SARB certainly won’t), one has reason for quiet optimism regarding food, Rand, Rand pass-through, rebasing and reweighting, though rentals could be a bedbug.

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Administered prices excluding oil are 15% of the CPI basket and apparently remain a great pain to the SARB. Government is simply not keeping to the prescribed inflation target of 3%-6%, understandably so for electricity (paying an enormous price for past incompetence), but less excusable elsewhere, especially in local government.

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Despite these obstructionist elements in the inflation basket, recorded inflation could fall very sharply in coming months through mid-2009. Do expect a falloff in inflation expectations to follow as a matter of course. That would take care of many second-round effects, as would the weakening economy and increasing resource slack (though some unions and skills shortages will prove immune, as may some politicians).

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So our real interest rates are now on a steeply rising slope, at the very moment that global interest rates are collapsing in union, with the exception of those few small economies with unsound policy frameworks under interim IMF tutelage.

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The US is on its way to 0.75% (from 1% currently and 5.25% a year ago). Europe is on its way to 2% from 4.25% two weeks ago. Britain is on its way to 2%. Australasia is aggressively cutting rates. India may be aggressively cutting rates after so far moving twice by 1% and 0.5%.

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Things are hotting up out there. The differential with our rates is going through the roof shortly. Do we really need that? It will only depress our inflation even faster, going by the historical record.

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Globally, the financial crisis is finishing off (with the most difficult trillion disorderly written off and another more orderly trillion or so still to go).

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The Fed, ECB, BoJ and IMF have started extending support to the EM universe where liquidity is needed, in the process soothing market anxieties (probably all that is really necessary).

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What is increasingly coming into focus is deep global recession through next year, requiring extensive interest rate easing (where rates are not already at 0.3% as in Japan or 0.75% as in the US shortly), and fiscal support (impressively so in the US but not limited thereto).

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Finance Minister Manuel is doing his bit (or rather the weakening economy and higher wage and infrastructure costs are doing it for him). Now it is the turn of the SARB to indicate where it feels it can contribute.

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Perhaps on this score a useful aside is in order to better understand the forces at work in monetary policy.

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In modern monetary policy there is a battle royal going on between those preferring pure credibility seeking (so-called inflation nutters focusing on inflation pretty much to the exclusion of all else) and those emphasizing flexibility (taking into account to a greater or lesser degree output considerations as well, smoothing policy responses over time rather than hammering things).

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Indeed, when expressed in an equation, the old Taylor rule pops up. One component of this reaction function examines actual inflation and where you want it to be (target), thus defining an inflation gap, while the other component examines the output gap, whether or not output is overshooting or undershooting.

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The inflation nutter simply focuses exclusively on the perceived inflation gap, arguing that if you can get that right everything else will follow.

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The flexible approach, on the other hand, prefers to split the process of containing inflation into a direct and indirect component. It directly wants to address the inflation gap, and indirectly influence inflation by addressing the output gap, but in this manner also preventing undue output variability (and its potentially unfriendly political fallout).

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The flexible approach comes across as perhaps more sophisticated, wanting to reconcile two potentially opposing gaps (inflation and output) simultaneously, optimizing the general economic condition over time while centrally addressing inflation.

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But it is more complex than that.

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Anyone starting out in life has no credibility. Acting strongly for a while in the dominant alpha tradition establishes one’s credentials. Once achieved, there is less need to keep on proving manhood.

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Like Teddy Roosevelt a century ago, you can then move quietly while carrying a big stick. This condition, once achieved, allows one to become more subtle without being penalized for loss of credibility, being less imposing on the economy yet achieving more.

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It would seem our SARB has evolved nicely in this respect, with or without help from political considerations. Our inflation targeting policy is well established, our markets respond well, and even the less flexible parts of our economy respond, if with a lag.

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This has already for some time now allowed more emphasis on policy flexibility rather than credibility. It was explained like this in old Monetary Policy Reviews a few years back (though possibly ignored by too many even today). There is no harm in emphasizing it again today. Especially so as this policy characteristic has been on show the whole year, with interest rates not increased as fast as inflation, the SARB apparently being prepared to smooth the real rate effects over time.

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But this renewed emphasis on monetary policy flexibility could not come at a more appropriate time, with the economy steadily weakening, high inflation now in remission, and external risks greatly diminished (oil), going there (food) or getting there (global financial crisis and EM exposure).

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With the inflation gap about to start closing rapidly (let’s not argue too strenuously as to when we will re-enter the target as nobody really knows, but it may be sooner rather than later), and external risks diminishing daily (though keep a sense of proportion) even as the output gap is steadily deteriorating, it doesn’t require rocket science to see where this may be leading. Soon, too, by all appearances.

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Expect a series of interest rate cuts, starting soon. Along with a more accommodative fiscal stance, this may assist in keeping the looming recession next year mild, meaning shallow and short, despite an increasingly intimidating global recessionary backdrop.

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Politically, that would be extremely good timing, too.-? -?-?-?-?-?-?-?-?-?-?-?

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Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics

FERRIER International keeping you informed thanks to Cess Bruggemans of First National Bank.The tide is turning and we trust that wise investors will see the light.

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Booby-trapped playing fields

FERRIER INTERNATIONAL keeping you updated and thank Cess Bruggemans ; Chief Economist FNB for this article.

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Booby-trapped playing fields

By Cees Bruggemans, Chief Economist FNB
24 June 2008

As inflation rises steeply, central banks everywhere are rallying to give battle with higher interest rates.

But is that the right approach? Is monetary policy the right tool to address what in origin are structural rigidities preventing efficient market functioning created through policy mistakes the world over?

As a blunt copout, perhaps, but as a first option?

Does one correct one mistake by making another?

Does one address the inflation resulting from policy mistakes far and near by incurring growth sacrifice to the point of recession, falling income, wealth and employment?

If this sounds like a leading question to which the answer is so patently obvious it requires no further response, by all means.

But hardly anyone at present apparently thinks along these lines, as much locally as abroad. Many simply don’t see the main problem in these terms.

Instead, people act as if we are engaged in a war, more specifically a monetary policy war. It is a conflict in which most combatants are trying to decide whether they want to intensify the war or scale it down.

Few, if any, are saying perhaps the wrong war is being fought entirely.

That is similar to saying the Americans were wrong to enter Iraq and Afghanistan in response to 911. Instead, a global police effort should have been set in motion aimed at eradicating terrorism.

The combatants also remind of the Boer War (1899-1902). As the small Afrikaans nation took on the mighty British Empire, its people increasingly fell into two camps, bitterly divided over the right course of action.

There were bittereinders, who wished to fight on to the bitter end, no matter the cost. And there were handsuppers (hensoppers), who preferred to surrender and disengage or even collaborate with the enemy (joiners).

In the case of the Boer War, there wasn’t the luxury of deciding that perhaps the wrong war was being fought, and that the British should try to discover Transvaal-sized gold deposits in Antarctica (or whatever).

But before we make that jump by shifting the focus, perhaps first the usefulness of the Boer War analogy as it applied to increasingly divided camps.

At present South Africa has been an early leader to raise interest rates in response to steeply rising inflation outside the SARB target range, primarily caused by shock developments externally (oil, food, Rand).

But as external first-round shocks deepen further, now also reinforced by local first-round shocks (Eskom), these relative price changes boosting reported inflation are starting to lead to second-round price shocks (wage demands and business cost pass-throughs) as changing inflation psychology starts to affect longer term expectations.

The SARB’s classic response of raising interest rates isn’t as yet succeeding in arresting these second-round developments, but it is progressively succeeding in imposing growth sacrifice (slowing the economy down even to the point of entering recession).

The ‘bittereinders’ of the moment are fully committed in terms of monetary policy credibility to keep pushing interest rates higher until such second-round effects are defeated.

They are not dissimilar to Candide’s Pangloss whose every action is always undertaken for the best, no matter how horrific some of the consequences.

It reminds of olden times, when medical techniques were still pitiful. Doctors then, too, often thought nothing of killing the patient in the process of administering the ‘right’ treatments. Sounds familiar?

Unfortunately, given the nature of the inflation shocks and the structure of the economy receiving these shocks, there may well be little initial success in containing inflation by steadily raising interest rate. Not even the second-round effects may be successfully contained.

Instead, we are merely liquidating growth, private fixed investment momentum, formal employment and too many middle class elements, especially newly created ones, by these actions.

The ‘handsuppers’ lose appetite for conflict quickly whenever its rising cost comes into focus. Nobody wants higher inflation, for the costs it imposes on society longer term. But incurring deep prolonged growth sacrifice doesn’t seem to be the sensible way to go about things either. Indeed, it may be a too costly solution, given the nature of what we face here.

Whereas the bittereinders are prepared to keep pushing interest rates higher until the deepening growth sacrifice breaks the back of the second-round inflation forces (the first-round causes by definition can’t be addressed), the handsuppers feel one needs at some point to be pragmatic.

Thus the handsuppers are prepared at some point to stop raising interest rates, acknowledge that inflation is abruptly rising back to a high level for structural reasons, and await the end of the external inflation shocks feeding this process.

Once the commodity-driven price inflation, with second-round effects following in its wake, has peaked out, the long and costly process can resume of gradually converging back to a low inflation norm through limited growth underperformance and global anchoring.

Assisting in this process will be the eventual inevitable unwinding of the commodity price shocks, with its subsidence ultimately also creating a downward pull on second-round effects.

What neither party is really saying too loudly is that perhaps their energies should be focused elsewhere. They should try to obtain social and economic reforms, whose outcome will reduce cost-enhancing inflation shocks, globally as much as locally.

In nearly every instance, this would shift attention back to other sectors of the economy where policy mistakes have been made and continue to be made, feeding the long-term inflation process.

Monetary policy was never designed to fight such insidious structural forces with any hope, other than of incurring massive growth sacrifice. Instead, one should address the underlying, structural, institutional causes of the higher inflation.

There are unfortunately many areas of government failure whose cumulative effect is at the core of the global inflation storm and its local offshoot.

A few examples suffice to illustrate the analysis.

Globally, the tight oil demand/supply balance within a wider energy context has been exacerbated by many policy actions in many countries, such as European and American constraints on new nuclear facilities, environmental restrictions on building new US oil refineries for three decades, low US fuel taxes, unwillingness of Saudi Arabia and other OPEC members to invest in new oil supply (in part reflective of resource nationalism), and the willingness of many Asian countries to subsidise their domestic oil consumption and keep their currencies artificially undervalued.

But it goes much wider than this. When the Dutch Minister of Finance in desperation turns to the unions to do a deal, limiting second-round wage demands, other market rigidities come into focus.

Education, training, immigration, and labour regulations all have elements that contribute to market inefficiency, regarding trade competitiveness and the ability to absorb external price shocks efficiently.

Also, there is global agriculture, food subsidies, land use and regulations, including the unwillingness to accept genetically modified foods and the misplaced enthusiasm for supporting biofuels, including especially US subsidies for the farm lobby, all of which interferes with efficient food production for human consumption.

It is ultimately a very long list of policy failures in many countries that comes into focus, explaining the current global rise in inflation and its perpetuation.

Given the nature and very size of the inflation shocks, this is now even in the process of upsetting monetary policy as a major macro-economic tool, requiring actions from central banks that aren’t suitable at all.

Don’t think that a finely tuned monetary policy can compensate for deep global and domestic institutional and policy flaws, except by ultimately imposing monstrous growth sacrifice.

Isn’t it better to become an interim monetary handsuppper and shift attention and energies to addressing these other policy shortcomings?

This applies as much collectively as individually, and ultimately mobilizes the political process. In the 1970s and 1980s, Den Uyl fell from power in Holland, Callaghan made way for Thatcher in England and Carter made way for Reagan in the US.

The US Congress today should be raising fuel levies and ease environmental and ‘other’ restrictions on new energy supply discoveries, new oil refinery and nuclear power investments.

Instead, we also have Fed chairman Bernanke becoming drawn into fighting fire with fire even as the US economy is hardly in any condition to withstand any policy heat.

At home, the 9% current account deficit creates Rand risk. Too much emigration and too little immigration of skilled labour worsens shortages, adding to salary premiums. Too little training and poor education efforts undersupply the labour market. All this, together with existing labour market regulations, strengthen second-round inflation effects. Just so the political willingness to accommodate public sector unions and the indiscipline with which public sector administrated prices generally are imposed. Also trade protection insulating domestic producers unduly.

This must sound awfully difficult and complicated, especially to politicians seeking easy answers rather than undoing their own mistakes or tackling powerful political interests which won’t easily give way.

Rather bludgeon the economy into recession via indebted households and businesses, in this way getting producers to capitulate and adjust their pricing behaviour?

This suggests the overall policy focus may be all wrong. We are now in the process of superimposing a big new mistake on top of a whole series of big old mistakes.

That’s not even half right. We surely can do better, preventing undue growth sacrifice in response to present challenges, but also meaningfully starting to address a whole legacy of old mistakes we thought we had the luxury of quietly accepting as fait accompli.

What is required is a thorough, fundamental overhaul of government policy and its rules and regulations as it affects the economy in cost-inflation enhancing ways.

Perhaps this sounds ambitious but since when does that make incurring an even more horrendous mistake more acceptable? Those that are financially being duped and are losing their livelihoods or can’t obtain employment because of the deepening growth sacrifice have reason to complain.

Besides other countries and other governments over whom we have no control, we should at least ensure that we have our own house in order. Going by the Rand, Eskom, other administrated prices and second-round effects throughout the economy, especially the labour market, that is hardly the case.

In comparison, especially rich countries such as the US and the UK feel their labour, goods and service markets remain highly efficient, absorbing such relative price changes without creating (much) extra wage demands and core inflation pass-through.

Even so, the Dutch example, and German instances are indicative that wage demands on the European Continent are rising. Not all these industrial country markets are immune to changing inflation psychology, probably one reason why the ECB is so vigilant.

South Africans aren’t the only ones facing the demons of past policy mistakes and consequent market rigidities coming to haunt them via higher inflation and possibly draconian monetary policy responses.

But there should at least be debate about these issues rather than blind acceptance of specific offerings as being all for the best.

Reference:

Professor PDF Strydom, various private communications.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics

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