Taming the inflation beast

Monetary authorities push back against rate cut expectations

At its January policy meeting, the Federal Open Market Committee (Fed) voted to retain the Fed Funds target rate range at 5.25% - 5.50% and to maintain the pace of quantitative tightening, as expected. Less predictable was the about turn in the policy guidance from the dovish December policy statement. The latest policy statement arrested market expectations of an imminent interest rate cutting phase, foreclosing March as a “live” policy meeting. We still expect a gradual and shallow cutting cycle to commence towards midyear, led by a softening labour market, moderating consumer spending and a depleting savings pool – but these policy moves will be highly data/state dependent.

On the other side of the Atlantic, while the European Central Bank also held its key lending rates steady in January, the relatively dovish policy guidance highlights the strained macroeconomic prospects in the region. Here too, the policy direction remains highly data dependent, but the hurdle to policy cuts is lower, in our estimation. While the West wages its war on the “inflation beast”, the People’s Bank of China (PBoC) continues to ward off deflationary consumer prices. Policy action to this effect in January included the 50 basis point (bps) reduction in the reserve requirement ratio and cuts to SME and rural development funding.

 Figure 1: Federal Reserve Bank Dot Plot

Source: Bloomberg, Futuregrowth

Domestic food and fuel price pressures eased in December

Headline consumer price inflation (CPI) moderated to 5.1% year on year in December from 5.5% in November. Disinflation was driven by moderating food and fuel price pressures, with food inflation easing by 0.5 percentage points to 8.5% year on year and fuel prices declining by 2.5% year on year.

Although the factors underpinning recent price pressures are already easing, forecast risk remains to the upside due to the forecast El Niño weather pattern, and continued irrigation challenges presented by unreliable electricity generation, Core inflation, on the other hand, remained unchanged and muted at 4.5% year on year in December, reflecting the weak underlying demand-pull pressure on inflation.

Inflation at the producer level also slowed in December, with final manufactured goods inflation retreating to 4.0% year on year from 4.6% in November. Producer inflation was led lower by receding food prices and transport costs.

 Stubbornly elevated inflation expectations, anchored above the South African Reserve Bank’s (SARB’s) increasingly explicit 4.5% consumer price inflation target, supported a continually hawkish policy stance by the Monetary Policy Committee (MPC) in January. David Fowkes, replacing outgoing SARB Deputy Governor Kuben Naidoo, voted alongside his four other MPC colleagues for the first time – with the committee retaining the 8.25% repo rate in a unanimous policy decision. While the hurdle to domestic interest rate cuts remains high, we expect easing global and domestic price pressures combined with the underlying weakness in domestic demand to support the commencement of a shallow interest rate cutting cycle towards the middle of 2024.

 Figure 2: South Africa monetary policy expectations

Source: Bloomberg, Futuregrowth

High frequency data paints a mixed picture

While far too soon to call a trend, mining production continued its recent ascent in November – growing at a gravity defying 6.77% year on year. This marks a 28-month high. While the year-on-year growth rate masks supportive base effects, a buoyant 2.13% month-on-month growth rate highlights the improved momentum in the mining production statistics. Manufacturing production data has not shown the same resilience, growing by a comparatively sluggish 1.9% year on year in November.

Improved electricity generation in December, accelerating to a 3-year high of 4.3% year on year, will lend hope to improved prospects in the productive sectors of the economy, but insufficient and unreliable electricity production, increasingly accompanied by acute Transnet-related logistics challenges will continue to stalk both sectors in the medium-term.

Monthly private sector credit extension accelerated to 4.9% year on year in December from 3.8% in October. Aggregate credit growth was underpinned by the corporate sector’s general loans and advances. Household credit growth weakened further, moderating to 4.5% year on year. These data prints have not been key determinants of monetary policy in the current hiking cycle, but they nonetheless highlight the weakness of aggregated demand (particularly for households) and will lend support to the arguments for monetary policy easing in 2024.

Medium-term fiscal risks persist

Following the publishing of the December fiscal metrics, year-to-date tracking relative to preceding years points to the risk of marginal fiscal slippage relative to the estimates tabled in the Medium-Term Budget Policy Statement (MTBPS). Without improved economic growth, the risk of fiscal underperformance also threatens the outer years of the medium-term expenditure framework.

We remain particularly concerned about the high debt service costs and their consequent crowding-out effect on growth-enhancing expenditure, as well as the spiraling demands of mismanaged state-owned enterprises (SOEs) on the fiscus. Moreover, an already burdensome budget deficit in the medium term is accompanied by the logjam in the sovereign debt redemption profile, buoying the funding requirement. 

Figure 3: South Africa Gross borrowing requirement

Source: National Treasury, Futuregrowth

 Global rates lead the local bond market recovery

The domestic nominal yield curve bear steepened in January, spurred by the reinvigoration of the “higher for longer” theme by international and domestic market participants. ALBI 3-7 was the best performing segment of the nominal bond curve, rendering a total return of 0.83% for the month relative to the ALBI total return of 0.71%. Cash, proxied by the STeFI Call Deposit Index, returned 0.67% for the month, with the IGOV Index, comprised of sovereign issued local currency inflation-linked bonds (ILBs), rendering a monthly return of 0.08%. The real yield curve bear-flattened in the month, with short-dated bond yields increasing faster than long-dated yields.

 Figure 4: Bond market index returns (periods ending 31 December 2023)

Source: IRESS, Futuregrowth

/// THE TAKEOUT: Predictably, the Fed and ECB left their key policy rates unchanged at their respective policy meetings in January. However, the Fed’s policy statement arrested market expectations of an imminent interest rate cutting phase, foreclosing March as a “live” policy meeting. We still expect a gradual and shallow cutting cycle to commence towards midyear, led by a softening labour market, moderating consumer spending and a depleting savings pool – but these policy moves will be highly data/state dependent. Domestically, consumer price pressures eased towards the increasingly explicit 4.5% SARB inflation target. However, inflation expectations remain sticky and elevated. Against this backdrop, the SARB MPC remains decidedly hawkish. We share the SARB’s concerns about the near-term risk to consumer prices but believe that the 8.25% repo rate marks the peak of the current interest rate cycle, with a cutting cycle to commence towards midyear. From a government finance perspective, expenditure pressure and slowing corporate income tax receipts have contributed to weakened fiscal metrics. While the MTBPS largely accounted for these realities, we believe the extent of fiscal slippage is still underestimated in the outer years of the Medium-Term Expenditure Framework (MTEF).