US economy fuels debate on interest rates

17 July 2023

This article first appeared on timeslive.co.za on 16 July 2023

US economy fuels debate on interest rates

By Isaah Mhlanga

A global debate is emerging about whether the lag in the effect of monetary policy on inflation has become longer, or whether inflation is just sticky.

The debate received a new thrust from better-than-expected US inflation figures, and a broader reassessment of the US economy is taking place. How the debate ends and what eventually happens will have an impact on South African policymakers' response and macroeconomic adjustment. 

This week’s annual US inflation for June came out at 3%, which was down from 4% in May and lower than the 3.1% markets had expected — the lowest since March 2021. Core inflation, which excludes food and energy, also surprised to the downside, printing 4.8% from 5.3% the previous month and lower than markets expectations of 5%. 

Looking at these inflation figures combined with still strong US growth and employment, there is a sense that the US economy is headed for a soft landing; it will slow down but avoid a recession while recording low inflation. 

We fluctuated from expectations of a hard landing due to aggressive interest rate hikes by the US Federal Reserve, to a soft landing when the Fed paused rates, and back to a hard landing when the Fed pencilled in two more hikes by the end of this year.

This week’s inflation figure takes us back to a soft landing as it revives the view that rate hikes are done.

There are three implications. First, the rand is stronger now against the dollar than when the Reserve Bank ran the quarterly projection model for the May monetary policy committee (MPC) meeting.

Second, when the MPC last met the environment was worrying — the rand was declining sharply on the back of diplomatic fallout between the South African and US governments. It is now more stable.

Third, global central banks have started to diverge from the Fed, and the fallout has been minimal. In the first half of 2023 currency markets were highly sensitive to interest rate increases, which is no longer the case.

What does it mean for domestic monetary policy ahead of this week’s MPC meeting?

From an inflation perspective, there is a clear consensus that inflation in South Africa has peaked and it’s on its way back into the target band. Headline inflation fell to 6.3% year on year in May, lower than market expectations of 6.5%. The May outcome brought headline inflation near the upper end of the Bank's inflation target band of 3%-6% and was the second consecutive downward surprise following April’s rate that came in at 6.8%, again, below market expectations of 7%.

The downward CPI surprises in April and May were driven primarily by continued moderation in fuel prices and a sharp fall in food price inflation. There is still uncertainty on both fuel and food price inflation, with the latter potentially impacted by load-shedding and El Niño.

When CPI for June 2023 is released next week, headline inflation is expected to have decelerated further into the Reserve Bank's target band, to as low as 5.4% year on year. If this is the case, the Bank will likely revise its inflation forecast for 2023 down from 6.2%. 

For June, food price inflation will likely continue to moderate from 11.8% year on year in May. Despite the projected slowdown, this will mark 11 months of annual double-digit food price increases.

Fuel prices will likely enter deflationary territory, largely on the back of base effects and a generally lower Brent crude oil price that offsets recent rand weakness.

June is a survey month for housing and utilities, but there should be minimal changes from the previous month as the housing market remains constrained as a result of tight lending rates and oversupply in the rental market.

While the fall in inflation and the turn in global factors will be positive for the interest rate outlook, inflation expectations have moved in the opposite direction, which presents a conundrum for the MPC.

The case for the MPC to pause and assess has become stronger since its last meeting, although the risks of another hike remain due to high inflation expectations. 

Mhlanga is Chief Economist and Head of Research at RMB