Reserve Bank left with little choice but to increase repo rate again

The South African Reserve Bank will have no choice but increase the repo rate tomorrow, after a GDP contraction in the second quarter, persistent high inflation and continuing high frequency of load shedding.

Members of the Monetary Policy Committee (MPC) of the South African Reserve Bank (Sarb) will be keenly aware of the negative impact of supply shocks on the economy when they meet tomorrow, says Arthur Kamp, chief economist at Sanlam Investments.

“After all, real GDP contracted – 0.7% in the second quarter compared to the first quarter, in response to intense electricity supply disruptions and flooding in Kwazulu-Natal. The third quarter continued with severe load shedding that remains a material constraint on production.”

Kamp says it is reasonable to argue economic activity should lift once one-off supply shocks fade, but the tailwind provided by buoyant commodity prices is waning as South Africa’s terms of trade, although still elevated, decreases in response to weakening global production and recession fears in some countries.

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Spike in inflation chasing repo rate

The spike in headline consumer price inflation to an annual increase of 7.8% in July 2022, eroded real personal disposable income growth and households will likely need to borrow more to maintain their spending level in real terms, although there is limited evidence of this to date.

“Admittedly, the annual advance in credit extended to households increased from 5.4% in December 2021 and to 7.2% in July 2022. However, after taking inflation into account, household credit is declining in real terms.”

Kamp says despite these developments, the Sarb is unlikely to be deterred from its path of “normalising” monetary policy.

“Although headline consumer price inflation is expected to slow to around 5% a year from now, it is forecast to average around 6.5% over the next twelve months, given current information. Hence, at 5.5%, the Bank’s repo rate is not overly restrictive.”

He says the US Federal Reserve can also not be ignored, especially since our current account balance slipped into a deficit of -1.3% of GDP in the second quarter from a surplus of +2.4% in the first quarter.

“The US Federal Open Market Committee (FOMC) is clearly determined to rein in US inflation. Although global supply chains appear to be mending, which should help lower inflation, the US labour market remains tight and it seems a significant increase in the US unemployment rate is required to dampen wage inflation.”

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Why the US Fed is important for SA

Kamp says this implies the FOMC has more work to do and accordingly US interest rate hike expectations have continued to drift higher with another material increase in the Federal Funds Target Rate, in the region of 75 basis points, expected at the conclusion of the US FOMC meeting on Wednesday.

This is important because South Africa benchmarks off the US interest rate and aggressive US monetary policy tightening has been reflected in persistent Rand weakness.

Although the Rand’s fall on a trade weighted basis has not been especially sharp, we are heading into uncomfortable territory as sustained Rand weakness can lift inflation expectations and eventually feed through into upward pressure on core inflation.

He says ultimately, the choice for the MPC members is either to hike the repo rate, despite economic headwinds and improve the likelihood of hitting the inflation target over the medium term or to do nothing and risk entrenching high inflation expectations, and inflation outcomes amidst sustained currency weakness. 

“Given the debilitating impact of high and volatile inflation on economic growth outcomes, the Sarb is expected to stay the course and do the prudent thing. Hence, a repo rate hike of 75 basis points tomorrow would not be especially surprising.”