The MPC May Keep Policy Rate Steady Next Week, But What Happens Next?

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Next week Thursday the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) will decide its monetary policy stance. The July MPC meeting occurs within a highly fluid economic environment characterised by the third wave of Covid-19 and the unrest that has inflicted economic damage in KwaZulu-Natal and parts of Gauteng. Nevertheless, we expect the MPC to keep the interest (policy) rate steady at 3.50%, in line with the Bloomberg consensus.

At the previous MPC meeting, the SARB’s Quarterly Projection Model (QPM) had portrayed an interest rate path of two 25bps hikes this year, one in 2Q21 and another one in 4Q21. While we had previously expected the first hike to be in 2H22, we recently moved it forward to 4Q21. Still, this was before the unrest, which now poses downside risk to our already below-consensus 4.1% growth forecast. Though the pricing decisions and mechanism are arguably complicated, we suspect the unrest could be inflationary and, if so, it is unclear whether this will be once-off or more pervasive. This makes the call for the timing of the first interest rate hike more challenging.

There are compelling arguments for both stances: either hiking interest rates now or at a slightly later stage. This week’s report attempts to present those arguments.

Upcoming interest rate hikes,  gradual and limited

Hiking this year

As shown in the April 2021 Monetary Policy Review, the SARB’s core model elasticities indicated that the peak impact of reduced rates on credit would have materialised in 2H21. And so, with this in mind, policymakers may now want to focus on building policy space and ensuring that inflation expectations remain anchored. As consumer inflation started accelerating from March 2021, the spot real repo rate turned negative in April after remaining positive since June 2020. On a forward-looking basis, unchanged at 3.50%, the real repo rate implied by our consumer inflation forecast will remain negative throughout the period to 2023. In addition, a rise in the country risk premium following the recent civil unrest may place some pressure on the neutral interest rate. This puts the SARB in a difficult position and, in the context of imminent global interest rate increases, it strengthens the case for the SARB to avoid falling behind the curve. Under these conditions, there is an argument for the SARB to start gradually hiking rates and building some policy space.

Delaying the hike to at least 2H22

Arguably, the SARB would also be justified in delaying interest rate hikes until at least 2H22. The recent rise in inflation is broadly seen as being driven by transitory factors related to last year’s pandemic-induced low base. Our view is that inflation peaked at 5.2% in May, and we expect June’s inflation (to be published next week Wednesday) to print at 4.8% y/y (0.1% m/m). Upside risk from the civil unrest may mostly affect supply-side inflation, which, the SARB should look through as usual. Throughout our forecast horizon, and by consensus predictions, inflation remains benign around the preferred 4.5% midpoint of the SARB’s inflation target range of 3% to 6%. Demand-pull inflationary pressures are assessed to be subdued, and this is echoed in the SARB’s forecast of the output gap. There are still pandemic-induced structural weaknesses in the economy and significant slack in the labour market, further exacerbated by the unrest. Additionally, the fiscal space to support the economy is minimal and the future path of the pandemic is unknown. The cyclical growth rebound expected this year marks a protracted recovery to the pre-pandemic 2019 level – we expect real GDP to return to 2019 levels in 2023.

Overall, while the call for when the SARB should start hiking interest rates is difficult for the reasons presented here, the policy rate should ultimately rise. But more importantly, regardless of when the imminent hiking cycle starts, the policy rate will still be below pre-lockdown levels by the end of our forecast horizon. At 4.25% by the end of 2023, the policy rate will be 2.0% below the pre-lockdown level of 6.25%, reflecting a still moderately accommodative stance.

Weekly highlights

Social unrest: Effect on our growth projections

The ongoing recovery in the South African economy has, in recent days, been muddied by the unrest within an already fluid economic environment. While we had assessed the risks to our below-consensus 4.1% cyclical growth rebound this year to be balanced prior to the unrest, we now think the risks are biased to the downside.

First, these riots could turn out to be super spreader events, prompting an extension (or even escalation to level 5) of current restrictions as infections spike. In addition, the vaccination programme has been disrupted and the recent positive momentum derailed. A combination of these could see hospitalisations spike, further stretching the already frail health system.

Another concern is the impact on foreign trade and fuel availability, as activity at the Durban port and oil refinery were disrupted. Further, the export value chain has been disrupted as cold storage facilities, port container terminals, and roads leading to exit points for export were mostly either closed or inaccessible in KZN. These disruptions may constrain distribution networks, negatively affecting retail trade and placing upward pressure on food inflation as availability becomes limited. Although raw food commodities are in abundance due to good harvests, the challenge will be up the value chain in terms of processing and distribution where higher costs are likely to be passed on to the consumer

The destruction of infrastructure and trade systems forced most businesses in KwaZulu-Natal and some parts of Gauteng to close temporarily, effectively putting them in a level 5-like lockdown. We expect that the resulting impact on sentiment will be long lasting, which could further delay recovery in investment by private business enterprises, and by extension, the labour market. While our current (already bearish) forecast incorporates some of this weakness, it does not include a level 5-like lockdown situation. As such, if the stand-off persists, it poses a significant downside risk to our short-term forecast. However, we are more concerned about the consequences on the medium-term growth profile, suggesting a more protracted recovery to real GDP 2019 levels than initially envisaged.

The third wave of Covid-19 infections may have peaked

Last week cabinet decided to extend the level 4 lockdown by another two weeks, but relaxed some restrictions, such as allowing gyms and restaurants to reopen, though at restricted capacity. Since then, the third wave of Covid-19 infections appears to have peaked, with the week-on-week infections down by 15.5% as at 15 July 2021.
At peak, the third wave surpassed the first and second waves by 58.8% and 4.8% respectively, using the seven-day moving average.

The slowing infection rate is mainly on the back of slowing infections in Gauteng, where cases peaked last week and which was behind the spike in numbers as well as, to a lesser extent, in KZN. On a week-on-week basis, infections were lower in Gauteng and KZN by approximately 26% and 18% respectively. However, recent riots in KZN and some parts of Gauteng likely affected testing and could derail the slowing trend in infections. If these turn out to be super-spreader events, and hospitalisations put further strain on our health system, cabinet could further extend the current restrictions, or even escalate lockdown to level 5. This is compounded by the fact that cases continue to rise in two other populous provinces, namely the Western Cape and the Eastern Cape. As at 15 July, cases in these provinces were up by approximately 6% and 10% w/w respectively.
At this stage, however, we do not expect an upward adjustment to current restrictions
– we think an extension is a more likely scenario.

Covid-19 infections may have  peaked

Manufacturing production up by 35.3% y/y in May

Total manufacturing output (not seasonally adjusted) grew strongly by 35.3% y/y in May, following an upwardly revised 88.1% y/y (previously 87.9% y/y) in April. This was below our prediction of 40.0% y/y. As highlighted in last week’s report, the high year-on-year growth reflects last year’s pandemic-induced low base, but this should subside going forward. More importantly, seasonally adjusted manufacturing output, critical for the official calculation of quarterly GDP growth, contracted sharply by 2.6% m/m in May after contracting by 1.2% m/m in April. This does not bode well for the 2Q21 real GDP growth outcome, which we currently expect at 2.7% q/q seasonally adjusted and annualised compared to the 4.6% q/q for 1Q21.

Manufacturing production

Mining output up by 21.9% y/y in May

Total mining output (not seasonally adjusted) grew by 21.9% y/y in May, reflecting a moderation from an upwardly revised 117.4% y/y (originally 116.5% y/y) in April. Non-gold mining production grew by 19.1% y/y compared to 111.3% y/y in April.

The out-turn was below our forecast of 30% y/y. Year-to-date (January to May), mining production is up by 20.6% compared to the corresponding period in 2020 and 1.6% compared to the corresponding period in 2019. Seasonally adjusted mining production declined sharply by 3.5% m/m after a mere 0.2% m/m growth in April. These mining outcomes also do not bode well for 2Q21 real GDP growth. Our near-term outlook for the mining sector remains positive. Mining activity should be supported by the sustained higher commodity prices from last year and the ongoing global economic recovery, mainly from South Africa’s major trading partners. Nevertheless, economic disruptions related to the pandemic, social unrest, and loadshedding could limit the upside to the anticipated cyclical economic growth rebound.

Mining production

May retails sales show monthly momentum

In line with the diminishing base effects, retail sales volumes growth moderated to 15.8% y/y in May 2021, from the lockdown-induced spike of 95.7% in April. Encouragingly, month-on-month seasonally adjusted sales volumes jumped to 2.1%, following declines of 0.6% and 4.4% in April and March respectively. This will partially offset the loss in momentum in mining and manufacturing output. Looking ahead, rising Covid-19 infections and the subsequent implementation of harsher lockdown restrictions could subdue retail sales performance. This will be exacerbated by the recent social unrest in some parts of the country that have caused damage to retail property, stock and supply chain networks. While the slight improvement in consumption credit uptake (credit cards and general loans) is encouraging, these factors, combined with souring consumer sentiment and the slow re-adjustments in the labour market, pose downside risk to consumption expenditure.

Retail sales

Building plans recovering from 2020 lockdown but still below pre-pandemic levels

Completions

The year-to-date (to May) housing completions increased by 75.4% to 11 691 units, from 6 667 units in the same period last year. Still, this period includes two months of relative inactivity in 2020, due to lockdown restrictions that brought construction activity to a halt in 2Q20. Compared to the pre-pandemic period (2019), the year-todate volume of housing completions lags by 42.2%, showing relatively tight supply of new housing units coming onto the market. When disaggregating by type, the increase in volume is mainly driven by larger freestanding units (> 80 m2), as well as flats and townhouses. These components are up 51.2% and 22.2% respectively, compared to the same period last year. However, both these are also significantly below their 2019 levels.

 Housing units completed (YTD)

Pipeline supply

The year-to-date building units passed (pipeline supply) increased by 35.4% compared to the same period last year. Nevertheless, pipeline supply is still 8.3% below 2019 levels, indicating relatively tight future supply.
We will watch these developments and assess how investment into the sector evolves, especially in the context of pandemic-induced shifts in housing needs and preferences. This also has implications for house price growth.

Week ahead

The leading business cycle indicator data for April will be published on Tuesday.

The leading indicator posted 3.7% m/m growth in April, following an upwardly revised 2.2% in March, supported by improving trading partner growth and higher 2Q21 business confidence. After rising by 18.2% y/y in March, the leading indicator accelerated further in April, recording 31.4% y/y. The leading indicator has been on an upward trend since the hard lockdown and is driven by higher domestic and international activity, with the opening of economies as well as easier funding conditions.

SARB leading indicator

Stats SA will release the June Consumer Price Index ( CPI) outcome on Wednesday. CPI inflation accelerated to 5.2% in May, after posting 4.4% in April. We expect inflation to moderate to 4.8% in June supported by slowing fuel inflation and weak core inflation. Core inflation has been hovering around the bottom of the SARB’s 3% to 6% inflation target range since the start of lockdown in April 2020, mostly driven by falling housing inflation which accounts for 23% of core CPI. Forecast risks this month emanate from the new housing survey for 2Q21 and vehicle price inflation. – while we expect muted housing inflation this year, vehicle price inflation is a significant source of upside risk. Food inflation should remain above 6% this month, only tapering off in the last quarter of this year but risks here are also to the upside.

CPI

On Thursday the 2Q21 BER inflation expectations survey outcome will be published. In the 1Q21 survey inflation expectations were 3.9% for 2021, 4.2% for 2022, and 4.4% for 2023. Expected inflation over the next five years was 4.6%, quite close to the midpoint of the SARB’s inflation target range – the preferred anchor for inflation over the long term. Analysts and trade unions expected inflation over the next five years to be 4.4%, while businesses projected 4.9%. Salaries, on average, were expected to grow by 4.3% in 2021 and 4.7% in 2022

Export and Import Unit Value Indices for May 2021 will also be out on Thursday. The unit value of exported goods in April 2021 was over 18% stronger than the level in December 2019 and 3.8% higher than in April 2020. Export values were down 0.5% on a month-on-month basis, after growing 2.1% in the month prior. The unit value of imported goods was down 3.7% compared to April 2020, but up 1.7% since March 2021. This was the second month of positive m/m pressure and possibly the start of stronger import price pressures – in light of global reflation fears amid loose financial conditions, rising oil and transportation costs, as well as supply shortages (for example of food products).

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