Monetary policy outlook

Weighing in, weighing up: The interest-rate debate

In the current debate around interest-rate prospects, one often hears two key arguments in support of the Reserve Bank not cutting its policy rate. The first is that the latest round of sharp administered price increases will spill over into consumer price inflation more broadly. The second is that fiscal policy is already adequately stimulatory (because of sizeable budget deficits) and will remain so. Both perspectives call for unpacking.

Let us consider the first argument. For costlier electricity, fuel etc. to have wide-spread secondary inflationary consequences would require an increase in consumers’ purchasing power and a related rise in domestic demand. And these requirements could only be met if consumers could recover the income losses suffered from loftier administered prices through higher wages, and companies could recoup related losses in profit via price pass-through. In the case of consumers, this looks improbable as growth in labour compensation continues to slow. And as for companies, signs are that their pricing power is waning from an already restrained position.

Where there is collective wage bargaining, and where wages are indexed to the consumer price index (CPI), pay-increases of more than this year’s “cost-push” related rise in CPI inflation will be secured. But such pay policies only benefit a portion of the labour force. Indeed, many others are unlikely to be this fortunate. What is more, in this lingering weak macroeconomic climate, earnings obtained from bonuses, overtime and commissions should remain depressed, while layoffs look set to continue. The result is that growth in employee compensation defined more broadly will likely not match inflation, so leaving consumers facing another year of diminishing real purchasing power.

Which brings us to companies. Because top-line sales growth is under severe stress and competitive pressures are ever intensifying, firms are in a weak position to raise their selling prices, in response to higher costs originating from imported raw materials, electricity, fuel etc. Also, given this pass-through constraint, companies are forced to constantly adopt efficiency-boosting measures to better control other costs in the system, which often entail wage restraint and, as a last resort, capital-labour substitution. This is the cycle which we are in now, and its disinflationary forces are powerful. Recent business confidence survey results released by the Bureau of Economic Research clearly reflect these dynamics across a wide-range of manufacturers, retailers and wholesalers. No wonder underlying consumer price inflation (CPI excluding fuel, energy etc.) is at 4.4% year-on-year and drifting lower.

As for the second argument – that fiscal policy is sufficiently expansionary – it too must be examined. In recent fiscal years, the main budget deficit has climbed from 4.4% of GDP in 2017/18 to 4.7% in 2018/19, with Treasury projecting it to stick around this level in 2019/20. Hence the claim that fiscal policy, which is already stimulatory, will remain so.

But this is not necessarily true. When it comes to assessing the degree to which fiscal policy is expansionary or contractionary, theory has it that it is not the absolute level of the budget deficit that counts. What matters is the change in the primary (i.e. non-interest) budget deficit, or the so-called fiscal impulse.

Viewed this way, the primary budget deficit remained constant at 1% of GDP in 2018/19, equating to a fiscal impulse of zero. In other words, instead of an expansionary stance, sharp tax hikes and cutbacks in fixed investment left fiscal policy neither adding nor detracting from domestic demand last year.

If we refine things by also excluding the capital outlays to bail out state owned enterprises (like state debt costs, such transfers absorb funds that otherwise could have been used to boost economic growth), the adjusted fiscal impulse in 2018/19 would have been near zero as well. But that was then. As 2019/20 already includes a larger proportion of bail-out spending (an amount which might even end up overshooting original estimates), chances are that the adjusted impulse will be negative. Simply put, fiscal policy looks set to swing from a neutral stance in 2018/19 to being slightly restrictive.

In summary, higher administered prices need not be an obstacle in the way of some interest rate relief. Neither should be fiscal policy, which is often misunderstood to be expansionary, when in fact, it might even slightly detract from whatever little additional economic activity there will be this year.

Separately, the Reserve Bank’s inflation forecast may also look a bit better. CPI inflation averaged 4.2% in the first quarter of 2019, while the Bank had projected 4.4%. And as early as last month, the Bank was still assuming real GDP growth of between 0% to 1% for the first quarter, while economic statistics that have been published since, point instead to a contraction of around 1.5%. Consequently, the economy would need to grow at an annualised pace of more than 3% in the remaining three quarters of the year just for the Bank to achieve its full-year estimate of 1.3%. This looks most unlikely.

As it factors these developments into its CPI inflation model (i.e. a lower 2019 starting-point for inflation and GDP growth that is likely to be even further below its potential than initially anticipated), it is not implausible that the Bank’s revised projection will show CPI inflation averaging around 4.6% this year, and near 4.9% p.a. in the two years thereafter, a prospective higher oil-price assumption regardless.

While the jury is of course out on whether such an inflation forecast will qualify as being sufficiently “close” to the mid-point of the target band to convince the Bank to begin paving the way for a repo rate cut, one thing is sure: the interest-rate debate outside of the Bank is getting livelier.

And as if there were not enough to think about already, there is also the president’s structural reform agenda and its possible monetary-policy implications. For example, although initiatives such as those aimed at restructuring state owned enterprises and reducing the government’s wage bill will stand the country in good stead over the long haul, what should the Reserve Bank be prepared to do given their possible negative growth implications in the interim? Monetary Policy Committee meetings in coming months are gearing up to be anything but dull. There is a lot to weigh up.

Le Roux is chief economist at Rand Merchant Bank.