Rising Interest Rates: Are We Close To The End?

The key takeaway from the Reserve Bank’s Monetary Policy Committee (MPC) Statement of 17 March 2016 is that the Bank’s MPC expects inflation to peak in 2016 and to return to within the inflation target band by late next year. Specifically, the Bank’s forecast shows headline CPI increasing to a peak of 7.3% in 4Q16, before returning to within the target range in 4Q17. The forecast also shows inflation averaging 6.6% in 2016 and 6.4% in 2017. Meanwhile, core CPI is expected to average lower than headline inflation at 6.2% in 2016 and 5.7% in 2017.

It seems we are closer to the end than the beginning

This expected inflation profile suggests we are probably closer to the end of the current interest rate hiking cycle than the beginning – if the inflation forecast turns out to be accurate.

The Bank has already hiked its repo rate by a cumulative 200bp since it reached its low point of 5% in 2012. Remember too, in the post-recession environment household debt servicing costs for a given level of the prime overdraft rate has effectively been higher than has been the case historically.

Moreover, final demand in the economy is palpably weak and is expected to remain so for an extended period. Indeed, growth forecasts are broadly in line with the Bank’s calculation of potential growth in the economy (currently 1.5%).

Also note that the Bank’s forecast does not take into account the expected impact of its March 2016 repo rate hike of 25bp on inflation.

But the Bank’s inflation forecast may be too low

No doubt there are risks and the MPC’s Statement is at pains to highlight these. To start, inflation expectations are elevated at 6.2% for both 2016 and 2017, with five-year inflation expectations at 6.1%. At least inflation expectations have been relatively stable.

Importantly, the Bank also highlights the importance of maintaining a prudent, sustainable fiscal policy to assist in containing inflation. Again, at least the National Treasury’s Budget for 2016 shows the desired intent to stabilise and eventually lower government’s debt ratio.

But food price inflation and the rand exchange rate remain key risks. With regards to the latter there is significant uncertainty around the future direction of the currency the likely pass-through impact of currency weakness on headline inflation. So far, as the Bank notes, the pass-through impact has been relatively low. Still, the MPC also warns there are signals that this may be changing.

In addition, we observe some worrying jumps in producer prices. For example, food prices at agriculture level spiked 25.9% in the year to January 2016. Further, among manufactured goods PPI vehicle prices increased no less than 16.5% year-on-year in the same month. Our base case inflation profile for the next two years is similar to the Bank, but we are also wary of potential upside risk. In addition to volatility in the currency and oil prices, uncertainty around the likely pass-through effects from rand weakness to consumer price inflation could prompt significant, frequent changes to inflation forecasts as new information becomes available.

What does the 25bp hike mean for investors?

There is normally a positive relation between an interest rate hike and rand strengthening, while local companies’ earnings forecasts are adjusted downwards due to the negative impact of higher interest rates on the spending patterns of consumers. The current tightening cycle could therefore dampen your returns on offshore and local equity investments in the short term. Bond prices could fall further if the rate hike is larger than anticipated by the market, but normally the event is already priced into bond markets before a rate hike is announced. Importantly, though, tightening monetary policy lays the foundation for economic stability and sustainable longer-term economic growth, which bodes well for your SA portfolio over the long term.