South Africa
Conditions for an Unchanged Policy Stance in August
July 22, 2008

By Michael Kafe & Andrea Masia | Johannesburg

The debate on whether the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) should stick to the existing CPIX series or jump ship and start focusing on the proposed series (which would be introduced in January 2009) as early as the August MPC meeting was heightened this week. This was after the local press gave prominence to an article by a local bank alleging that the SARB would probably have refrained from raising interest rates this year if the re-weighted CPIX series were introduced in 2007. While we agree that the re-weighting (and re-basing to 2008) of the CPIX series will no doubt lead to a lower inflation print (see South Africa: Unpacking the Proposed CPIX, July 4, 2008), we would like to reiterate that, at this stage of the tightening cycle, the policy rate decision will most likely be driven by the SARB’s tolerance period, rather than a short-term undershoot in inflation as a result of a technical re-weighting/re-basing exercise. In any case, we do not believe that the SARB will focus on the new series just yet.

Too Early to Move to New CPIX Series

As we argued a fortnight ago, it is simply too early for the SARB to base policy on the proposed CPI series, not least because of the numerous assumptions that one has to make to arrive at what would be no more than a fictitious index; but, more importantly, because the Ministry of Finance has not yet provided clarity on which of the two new indices – headline CPI or CPIX – would be adopted as the inflation target index. Consideration here, in our view, is necessary, as neither of the two indices have a mortgage component (again see our July 4 note for a full discussion). Such clarity is likely to be provided only in October, when the National Treasury presents the Medium-Term Budget Policy Framework.

Second, it is important to note that, although the rebased CPIX could come in as much as 300bp below the existing index when it is released on January 1, 2009, that gap narrows very quickly over the course of the year. We estimate that, by the end of 2009, the gap would have narrowed to 60bp, before disappearing in 2011. Given our view that the SARB’s tolerance period (i.e., the time period that the SARB is willing to tolerate above-target CPIX readings) will have greater importance in the policy decision at this stage of the tightening cycle, we believe that the MPC will look beyond the immediate undershoot in inflation as a result of the re-weighting, and focus instead on its inflation forecasts 12-24 months out. In fact, for this particular MPC meeting, the SARB may need to extend its forecast horizon to 36 months, as inflation could well remain above target for as many months.

Under What Conditions Will the SARB Leave Rates Unchanged?

We believe that the SARB will leave rates unchanged at the August MPC only if inflation is still expected to return to target around 3Q10 (or earlier). For this to happen, we need sharply lower oil prices, and/or a stronger currency. We present three scenarios below:

In scenario I, we maintain our base case oil price and ZAR assumptions. Here we assume that oil prices level out at around US$137/bbl into 2010/11, while the ZAR weakens to 8.50 by year-end, 9.00 by end-2009 and 9.20 at end-2010. However, we mark August petrol prices to market, to accommodate the fact that the domestic regulated price of petrol is likely to come in broadly unchanged from its July level, given the significant decline in oil prices over the past fortnight, as well as the currency’s surprising resilience. In this scenario, our model suggests that CPIX would peak around 13.5% in November 2008, and fall back to the target range in 2H11. However, the fictitious (new) CPIX index should fall within the target range earlier, in April 2011.

For scenario II, we assume that oil prices stay around current levels of US$130/bbl, and that the ZAR closes the year at 8.00, before weakening to 8.50 at the end of 2009 and 8.70 at the end of 2010. As in scenario I, we assume a flat petrol price for August 2008. Here, CPIX falls back within the target range in April 2011, while the fictitious index falls within the target range in 4Q10.

Finally, in scenario III, we maintain all the non-oil assumptions in scenario II, and constrain the model to allow CPIX to return to target no later than 3Q10, by adjusting the oil price profile. Implicit in this analysis, is the question ‘given the stronger ZAR profile, by how much do oil prices need to fall to fully offset the impact of the electricity tariff hikes on South Africa’s inflation trajectory?’ Using this reverse engineering process, we find that, were oil prices to fall back to US$100 by year-end and remain at similar levels in 2009/10, then CPIX would peak just below 13% in September 2008, and fall back to the target range in 3Q10 as forecast by the SARB at the June MPC meeting. In our opinion, it is only under this scenario that the SARB would leave interest rates unchanged in August.

As scenario III is not our base case, we hold on to our view that the policy repo rate will likely be raised by 50bp in August. We do acknowledge, however, that the probability of piecemeal monetary policy easing, a quarter or two earlier than our current forecast of mid-2010, is rising.

Latin America
Latin Hawks versus Global Doves
July 22, 2008

By Gray Newman & Daniel Volberg | New York

When the US announced that June inflation had risen by more than expected and had produced the highest annual inflation in 17 years, it looked as if Latin America and the US were trading places.   After all, the US’s monthly jump in inflation − up 1.1% − was larger than that seen in Mexico in June (0.41%), Peru (0.77%), Colombia (0.88%) and Brazil (0.74%), and indeed even larger than the official release in Argentina (0.6%). 

Of course, focusing exclusively on the US June headline number is probably unfair. After all, June was a particularly difficult month for the US − soaring food and energy prices had conspired to produce the largest monthly jump since 1982.  In contrast, US core inflation in June (although also above expectations) was much more in line with what we are seeing in Latin America.  Moreover, although US annual inflation (5.0%) is now at a 17-year high, the US is hardly alone.  Annual inflation has also been rising in Latin America and is now running in the 5-7% range in most major Latin countries as well.

Still, the comparison between the US and Latin America’s inflation problem is instructive.   For years, Latin America was faulted for running large fiscal and balance of payments deficits.  When the US did the same, the explanation was that many of the rules we learned in Latin America did not apply because the US has a reserve currency.  Now with the arrival of a significant uptick in inflation in the US, the comparison with Latin America is once again worth reviewing. 

In both Latin America and the US, the driver of inflation is similar; the response, however, could not be more different.   In both Latin America and the US, the principal driver of the uptick in prices has been spiraling food and energy prices − courtesy of strong global demand and limited supply.  With US demand slumping, it is hard to blame US aggregate demand pressures alone for rising prices.  While growth in Latin America is much stronger, it is unlikely that Latin demand is the principal driver for the run-up in food and energy quotes. But the similarities end as soon as we look at the policy response.  Since last October when the Fed began to cut interest rates, Latin America’s inflation-targeters − Brazil, Mexico, Chile, Colombia and Peru − have hiked interest rates 15 times.  And across the region, more hikes seem to be in store.  The Fed, of course, has signaled that it is through easing, but there is no clarity when it will actually hike. 

The contrast between Latin America’s monetary tightening and the lax monetary policy outside the region not only holds when the region is compared with the US, but also holds up against developed economies as well as the major blocs of emerging economies (see Joachim Fels’ and Manoj Pradhan’s, “Emerging Inflation”, Global Monetary Analyst, July 9, 2008). Whether one looks at G10, Asia ex-Japan or the EMEA countries, one sees a common trend: policy rates have not kept up with the upturn in inflation.  The net impact: across the globe, in the face of the most serious global uptick in inflation in decades − real policy rates have been falling and are now negative. The only regional exception is Latin America.  But we fear that Latin hawks are no match for the dovishness that appears to have set in around the globe.  Until that changes, we are likely to see Latin central banks hiking by more than expected.

But first, let’s take a look at what explains the contrast between the response from Latin American central banks and their counterparts elsewhere. We highlight three principal reasons for the emergence of the Latin hawks:

Don’t Blame Brazil

First, a significant amount of the heavy lifting on the interest rate front in Latin America comes from Brazil.   Even though Brazil’s real interest rates have dipped during the past year − as inflation has risen more quickly (up 232bp in the past 12 months) than the central bank has been hiking interest rates (up 100bp) − Brazil’s real and nominal rates are among the highest in the globe.  Overnight rates in Brazil stand at 12.25%, and our Brazil economist, Marcelo Carvalho, expects the central bank to hike the overnight interest rate to 13.00% on Wednesday, July 23.  But Brazil alone does not explain the Latin hawkish stance.  Even without Brazil, our regional measure of inflation and interest rates shows Latin America with positive real policy rates in contrast with the rest of the globe.

The Hyperinflation Legacy

Part of the impetus behind the hawkish stance of Latin central banks probably stems from the region’s unfortunate past when hyperinflation ruled the day.   While Zimbabwe’s inflation of 2.2 million percent is in the news today, hyperinflation was common in Latin America not long ago.  While Germany suffered in the 1920s and Hungary in the 1940s, much of Latin America was facing a serious bout of hyperinflation in the 1980s and into the early 1990s. Those memories have taken their toll on central bank policymakers − the lack of a credible track record in tackling inflation leaves central bankers in the region more willing to respond to an uptick in prices to limit the risks that a change in relative prices unleashes a disturbing wage-price spiral.

But Latin America is hardly alone in its failure to deal with inflation.   While Hungary’s greatest bout of hyperinflation was in 1946, Israel suffered from soaring inflation in the mid-1980s, while then-Yugoslavia saw hyperinflation in the mid-1990s.  Why then has Latin America stood out from its fellow inflation sufferers in the emerging markets?

The Era of Abundance

Latin America’s central banks are more hawkish − we argue − because they can afford to be so, thanks to the improvement in growth due in part to the abundance in commodity-related inflows.   While Latin America has been hit by rising energy and food prices − indeed the impact on the consumer price index in Latin America is much greater than in the developed world, given the higher weight of food in the CPI basket − the uptick in inflation has been accompanied by a remarkable improvement in terms of trade (price) and external demand (volume) for Latin exports.  The improvement in external conditions has boosted exporters’ volumes, created new jobs, strengthened fiscal results and produced the longest string of strong growth that the region has seen in decades.

Indeed, if we offset the negative impact from higher inflation with the positive gains from a favorable terms-of-trade shock, we find that Latin America’s major economies are among the most benefited in the globe.  We created a set of metrics which compare the change in an economy’s terms of trade with the change in the rate of inflation − in both cases comparing 1Q08 by the median for the previous five years.  We are calling the metrics an ‘Abundance’ Misery Index.  Unlike the usual misery index which looks at inflation and unemployment, our index offsets the rise in inflation with the terms-of-trade shock.  The more positive the terms-of-trade shock, the less damaging the inflation shock may be to near-term growth.  In our index, the higher the score, the lower misery.  In our survey of 21 emerging economies, Latin America held four of the top six positions.  

Abundance in Overdrive

Eventually, we expect US weakness to spillover to other developed economies − we appear to be seeing this already in Europe − and then to emerging economies and Latin America as well.  But until that takes place, we are likely to continue in the current era of ‘abundance in overdrive’ (see “Latin America: The Decoupling Paradox”, This Week in Latin America, April 21, 2008). 

Until we see a substantial slowing in global demand, commodity prices are likely to continue to fuel the abundance in Latin America − keeping inflation as a concern for central banks and growth strong enough to keep tightening.   Our Andean economist, Boris Segura, sees another hike from the Colombian central bank to raise the policy rate to 10% as early as this week and more hikes to come from Peru.  Marcelo Carvalho sees Brazil’s central bank hiking until 14.25%. 

Here’s my concern: until the central banks of Latin America are joined by central bankers in the rest of the globe with significant tightening, the efforts in Latin America are unlikely to accomplish much to bring down inflation.  After all, financial intermediation is extremely low in Latin America, providing monetary policy with less traction, while the source of the uptick is strong demand elsewhere being imported to the region.

In April when we highlighted the risk of ‘abundance in overdrive’, we argued that Banco de Mexico’s next move could be a hike rather than a cut (see “Latin America: The Decoupling Paradox”, This Week in Latin America, April 21, 2008).  However, it took us another two months to conclude in early June − and even then, as part of a small minority − that the first hike would begin in June (see “Mexico: Time to Hike”, This Week in Latin America, June 16, 2008).  As long as ‘abundance in overdrive’ is in effect − and Latin central banks are alone in supporting positive real policy rates − the inflation risk facing Mexico is likely to continue, with the actions of Mexico’s central bank having little direct impact on inflation. 

The monetary tightening is likely, however, to have one effect in Latin America − continued currency strength as widening interest rate differentials keep the carry trade alive and well.  And consumers are likely to find that the hit to their purchasing power for food and energy is being partially offset by the strength of their currencies.

In turn, we are concerned that we could see more tensions between policymakers over how to respond to the ‘abundance in overdrive’. We have already seen central banks engage in massive dollar-buying sprees in an attempt to limit the currency impact from higher interest rates. Strong currencies are almost certain to prompt more calls for capital controls, intervention in the currency markets and new taxes to limit inflows. 

Perhaps nowhere is the risk of a conflict greater than in Brazil, where over 30% of the public sector’s total (domestic and external) debt stock is linked to the overnight interest rates.  Add in short-term debt (coming due in less than one year) and nearly 60% of Brazil’s total debt is vulnerable.  Every 100bp of Selic hikes, all other things being equal, represents the equivalent of nearly 1% of the federal government’s budgeted primary spending.

Bottom Line

We expect a global slowing, which should ultimately subdue inflation as well. But we have been calling for that since late last year.  Until then, Latin America is likely to enjoy the two-edged consequences of ‘abundance in overdrive’. The uptick in inflation is likely to be offset somewhat by good growth from favorable terms of trade, which, in turn, provides more room for continued monetary tightening.  Latin America’s hawks are unlikely to retreat just yet.

Colombia
A Case for Hiking Rates without Delay
July 22, 2008

By Boris Segura | New York

Last month, we argued that Colombia’s central bank should hike its intervention rate, but probably would not (see “Colombia: Between a Rock and a Hard Place”, EM Economist, June 20, 2008). That controversial call was later validated, as the Banco de la Republica (BanRep) decided to prolong its pause at the June monetary policy meeting, even while hiking reserve requirements on bank deposits and announcing a more aggressive intervention in the currency market.

The inflation outlook has clearly deteriorated since then.   Headline inflation is on the rise, but perhaps more worrisome is the fact that measures of core inflation are all above the upper band of the central bank’s target (4.5%), and inflation expectations have broken out of their recent tight range.

We see a strong case for the central bank to hike its intervention rate to 10% at the July 25 monetary policy meeting. Delaying a hike would only risk additional deterioration in inflation expectations, further complicating the central bank’s achievement of its inflation target in 2009.

The Economy Is Decelerating but Not Collapsing

Some might argue that the central bank should remain on hold. After all, interest rates are already high and the economy is showing clear signs of deceleration. In the months ahead, the lagged effect of past rate hikes is likely to be felt.  From industrial production to retail sales and measures of business and consumer confidence, the economy has decelerated sharply vis-à-vis record-high growth achieved in late 2006.

It’s true that the economy is slowing, but it is hardly collapsing. Part of the recent 1Q weakness may have been exaggerated; indeed, we expect some (positive) payback in the 2Q GDP readings. Nonetheless, we recognize that the economy is likely to be slower than we thought at the start of the year. Given softer-than-expected economic activity data during 1H08 and weaker US and global growth, we are revising downward our GDP growth forecasts for Colombia to 4.6% from 5.5% in 2008 and to 3.4% from 5.3% in 2009.

The flipside of this GDP forecast revision is that the positive output gap is likely to dissipate earlier than expected. With slower GDP and domestic demand going forward, we suspect that inflation pressures (ex-food and regulated prices) are likely to subside soon.

Inflation Dynamics Are Worrisome

Despite the slowing growth dynamic, headline inflation has shot upwards. Clearly pushed by rising food and regulated prices, headline inflation is running at 7.2% − its highest level since 3Q03. But inflation excluding food has been drifting higher since last September, and at 4.9% is now above the upper bound of the central bank’s inflation target. And our favorite core inflation gauge, non-tradables inflation excluding food and regulated prices, is having a tough time breaking the 5% level (currently 5.3%).

We have three related worries, which could further complicate inflation converging to the central bank’s target next year:

•           The first is inflation expectations becoming unhinged.  Since mid-2005, 12-month-ahead inflation expectations haven’t breached the 5% mark, and actually have fluctuated inside a narrow range. However, given the latest high inflation prints, they have jumped noticeably; at 5.5%, they are the highest since 2004, when the inflation target was less demanding. Our concern is that elevated inflation expectations may start to contaminate the price-setting process itself, making the target even harder to reach.

•           The second concern is the evolution of wages. Increases of nominal wages for retail and manufacturing are converging around the 7% level. This level is hardly consistent with a 4% inflation target. The risk is that higher expectations are incorporated into wage negotiations and could complicate the outlook for 2009 minimum wages, which are negotiated later in the year.

•           Third, we are concerned about inflation becoming more ‘diffused’. We constructed a ‘diffusion index’ for inflation ex-food items. While ex-food inflation has steadily become less generalized since mid-2007, and the June rebound may be a fluke, we are worried that the longer inflation remains elevated, the more widespread inflation might become, again making inflation convergence to the target more traumatic and costly.

Inflation-Targeting: Not Growth-Targeting or Exchange Rate-Targeting

The monetary policy minutes of the June meeting came across as dovish. The central bank seems to imply that, given the ongoing deceleration in economic activity, it is not necessary to hike rates − despite the worrisome inflation dynamics explained above.

The crux of an inflation-targeting regime is, not surprisingly, inflation. When choosing among competing objectives, a central bank following an inflation-targeting strategy should give priority to inflation. Or, in other words, a central bank could pursue other objectives inasmuch as they don’t conflict with its main goal (inflation).

Despite some volatility, we still sense that a strong Colombian peso remains a factor holding back the central bank from further monetary tightening. This behavior coincides with more aggressive intervention in the currency market and other measures taken afterwards by the central bank. However, we suspect that current levels of the peso might still be below what policymakers consider to be a sustainable level (around 1900).

We doubt that another rate hike would cause a major rally in the Colombian peso. Plentiful FDI and stronger-than-expected terms of trade are the main drivers behind a sturdy peso, not portfolio inflows given capital controls. In any case, the NDF curve has an implied yield of 11.5%, well above the level of the intervention rate (9.75%), which provides enough cushion for an additional rate hike by the central bank. In short, we believe that the central bank should have both eyes focused on inflation − not one eye on growth and the other on the currency. This is particularly true under current circumstances when inflation poses a clear and imminent danger.

The Silent Majority

Several powerful lobbies want the central bank to remain on hold. In particular, labor-intensive tradable sectors complain about the economic ‘collapse’ and unsustainable appreciation of the peso. Therefore, they oppose any further monetary tightening as, in their view, it would bring about further deceleration of economic activity and a stronger currency.

But anxiety on the state of the economy appears to be rising among a ‘silent majority’. Public opinion polls reflect this point, with ‘inflation/economy’ cited as the single most pressing issue facing Colombia. In net terms, 57% of those polled consider that the cost of living is getting worse, whereas only 4% think that the economy is worsening.

Credibility: So Hard to Build Up, So Easy to Lose

A major ingredient of an inflation-targeting regime is the credibility of monetary policymakers. Inflation-targeting has been praised precisely because it is perceived as a reasonable compromise between ‘rules’ and ‘discretion’ in the conduct of monetary policy. It has worked best in countries with independent central banks that are perceived to be committed to achieving their inflation targets and have credibility.

However, gauging a central bank’s credibility is highly subjective. ANIF, a Colombian think-tank, has developed a survey that tries to measure the market’s expectations regarding the evolution of the central bank’s intervention rate.  By asking analysts what they think the central bank should and will do with its intervention rate, ANIF aims to develop a ‘credibility index’.

There is a credibility gap emerging. During the last monetary policy meeting, a majority of analysts thought that the central bank should hike its intervention rate, but that it wouldn’t (and that’s how it turned out). This is a signal of emerging perceptions of a lack of credibility on the part of the central bank in the conduct of monetary policy in Colombia.

Bottom Line

We see valid reasons for the central bank to hike rates on July 25. The inflation outburst is contaminating inflation expectations and could become unhinged and then spread to wages and the overall price formation − in the context of an economy that, while decelerating, is not collapsing. There is another reason as well:  the central bank needs to safeguard the credibility of its inflation-targeting regime.

Any near-term rate hike could be billed as ‘insurance’.   As the economy is already slowing down and aggregate demand pressures on inflation are likely to dissipate soon, any extra monetary tightening could be withdrawn relatively easily once inflation has convincingly turned around.