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Thursday, December 4, 2008

Will the SARB cut by 0.5% or 0.75% or 1%

By Cees Bruggemans, Chief Economist FNB
03 December 2008

The local interest rate debate still seems to be mired in the idea of having no December cut as opposed to perhaps having a 0.5% cut.

But what if the SARB is preparing a surprise for next week’s interest rate decision, joining a lengthening global queue, including the Fed, BOE, Switzerland, Sweden, probably the ECB, but also Aussie, Kiwi, India, Turkey, Hungary, and others?

It is a long list of countries that have recently done more, much more than expected in cutting rates, and abruptly too in bigger dollops than foreseen.

Happily, we don’t have a malfunctioning banking system, even if bank bad debts are cyclically rising.

We also aren’t as yet experiencing a dire drop off in economic activity as some other countries are, although our motor trade, building trades, real estate agents, platinum miners, purchasing managers in manufacturing and a few others could be forgiven for thinking they are being made to walk the plank.

So yes, we have a weakening economy which when excluding agriculture may already have been experiencing mild recession as of 3Q2008, and in which momentum is probably still being lost steadily on a daily basis.

Yet the real question for the SARB pertains to inflation. How low will CPI go next year and in 2010, given the global backdrop and domestic conditions, and what risks remain potentially affecting the outcome?

As things stand today, CPI may drop back into the 3%-6% target by 3Q2008, and fall towards 5% (or lower) by mid-2010. This view takes cognizance of lower priced oil, falling food price inflation, the coming statistical rebasing and reweighting, including the important owner equivalent rental, the second-round salary effects, still somewhat elevated inflationary expectations among labour and business (though probably eroding) but much lower already in the bond market, higher Eskom tariffs, and not forgetting the weak Rand at 10.30:$.

The main upside risk for inflation during 2009-2010 is the large current account deficit, the still unfolding global financial adjustment and the severest global recession since WW2 and the manner in which these could impact still on the Rand.

This risk is not entirely negative for the Rand, for if the Dollar were to weaken anew later in 2009 under the weight of excessive US government debt and Fed-provided liquidity, the Rand could conceivably be impacted positively, and so to our inflation.

It would seem that today, unlike prior to October, the world has moved on in important ways. Following the Lehman fiasco, no other major global bank is likely to be allowed to go bankrupt.

Similarly, the Fed, the ECB, the European Union, the IMF and World Bank have all become very active in providing Dollar swap lines to emerging market countries or provide other loan facilities to countries experiencing external funding strains, again with the apparent understanding that no country will be without a sympathetic ear in case of problems under present global circumstances.

This probably changes the nature of the Rand risk scenario somewhat from the far direr expectations ruling earlier in the year. Besides, the Rand today is already some 30% undervalued in fundamental terms. How low could one go from here on a persistent basis?

If the SARB adjusts its October economic and inflation forecasts lower for its December meeting, the question is by how much? What will guide it?

CPI at 12.1% is already down from its 13.7% peak, but effectively level pegging with the SARB intervention rate at 12%.

Supposedly, the SARB wants to maintain real rates. Prime at 15.5% is only showing a minimal 3.5% real rate, as opposed to a more comfortable 5.5% longer term.

But then consider the six month forecast in which CPI could fall by 6% and possibly more. That would take the real rate environment uncomfortably higher, by as much as 400 points if we use long-term norms.

So starting the rate cutting cycle early, by next week for instance, would seem a foregone conclusion. But there are only four SARB meetings through June 2009.

If the SARB were to cut by 0.5% at each of these meetings, it would lower interest rates by a cumulative 2% by mid-2009, during which period CPI inflation is projected to fall by 6% from present levels. Thus real rates would rise by 4%, and probably still be 2% too high by mid-2009, and that in a very weak economy by then.

The financial markets are handling this conundrum by discounting BIGGER rate cuts than 0.5% per meeting. For December 2008 there is already 0.75% discounted, and by the February 2009 meeting the market is discounting a cumulative 2%, with 400-450 points of cuts on a two year view through 2010.

That may be too fast and too far for the SARB, bearing in mind our large current account deficit (even if this may shrink somewhat next year, despite falling commodity export prices) and reduced Rand exposure to global crisis (even if difficult to quantify).

But how much rate cutting is too much?

Cutting by 1% next week, in the excellent company of so many central banks overseas, would be impressive, except that we don’t quite have their problems, only an impressively collapsing inflation forecast.

Also, what kind of expectations would one create for future SARB meetings, presumably immediately discounted in today’s yields? More, Sir, give us ever more? And that is precisely not what the SARB would want, given its sensitive awareness of lingering risks globally and over the balance of payments.

So the SARB could ‘disappoint’ with a base case of an 0.5% cut, considering such a move already enough in an environment where so many people still expect a late and slow start to rate cutting from February, April or even June 2009.

But then again the market is signaling a view of inflation and risks that isn’t unrealistic in today’s global environment. The SARB may well share this key premise, that inflation will decline strongly next year and that the risks preventing it doing so are milder than assessed before.

Under these circumstances a ‘compromise’ trajectory would be to settle for 0.75% rate cuts, next week and in February, April and June 2009, provided the inflation outlook remains as benign as what it now looks.

This would lower rates by a cumulative 3% by mid-2009, prime falling to 12.5%, compared to a CPI inflation rate by then of 6% or lower, still making for a real prime of 6.5% by then, still well above the longer term norm and that in a very weak economy, though one exposed to some external risks.

Such a move would acknowledge the lingering upside risks to the inflation outlook, as well as the deteriorating domestic and global outlook for economic activity and its potential to depress future inflation yet more than expected (and also capable of setting in motion negative feedback loops if foreign investors no longer like our depressed growth outlook).

In summary, the two outlier surprises next week would be a decision to leave rates unchanged (prime staying at 15.5%) or to cut by 100 points (prime falling to 14.5%).

The most likely outcome remains a middle-of-the-road, steady-as-she-goes, let’s-not-get-anyone-overly-excited decision of cutting by 0.5%, followed by similar cuts in February, April and June, and possibly beyond, if prospects continue benign. This could target prime of 13% by 3Q2009 and possibly 12% by late 2009, if everything plays out according to current expectations.

A pleasant-but-feasible surprise would be a cut of 0.75%, prime easing to 14.75%, except to the financial markets which have already priced in just such a move.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on

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