This question is close to the heart of most asset managers and business owners as it affects asset allocation decisions. Inflation has a significant impact on the purchasing power of income and wealth, and we have seen how episodes of hyperinflation can have devastating social consequences. We need look no further than north of our border for evidence of this. Yet, apart from a few notable exceptions, high inflation has not been the global norm for some time. We are far from the double-digit inflation levels that prevailed in the 1970s and 1980s, including in many of the advanced economies.
In 2003, at the influential annual Jackson Hole conference in the US, the focus was on why global inflation was so low. A paper by Kenneth Rogoff showed that at that time, only three countries in the world (Zimbabwe, Myanmar and Angola) had inflation rates in excess of 40%. In the advanced economies, the average inflation rate declined from 9% in the first half of 1980 to 2% in 2000-2003, and from 31% to below 6% in the developing economies over the same period. The reasons for this moderation in inflation were not obvious. One discussant likened it to an Agatha Christie mystery: who killed the victim, and how was the victim killed? But, unlike Agatha Christie mysteries, the most important question was, is the victim really dead? At the conference, central bankers were very quick to claim the credit for the murder, but others were more sceptical, with theories ranging from more prudent fiscal policies and higher productivity growth to increased deregulation and globalisation. The consensus was that inflation, if not dead, had at least been tamed.
Deflation remains a concern in the advanced economies
Today, the victim still appears to be moribund, except in a handful of countries. Currently, very few countries have inflation in double digits. In fact, the problem in the advanced economies is one of inflation being too low, and the fear of deflation is very much alive. This is despite the explosion of central bank balance sheets in the advanced economies during the global financial crisis. The concerns that quantitative easing would be the precursor to renewed bouts of global inflation have been misplaced. Inflation remains below target in most of the advanced economies, and the risk of a global slowdown, fanned by the US-China trade war, has prompted further monetary policy easing in a number of countries. The European Central Bank has stepped up quantitative easing, and the US Federal Reserve has reversed its interest rate normalisation process with (two) policy rate cuts this year, and possibly more to come.
While inflation remains a non-issue, developed market monetary policies continue to be accommodative. Low interest rates and quantitative easing have fuelled asset prices, which means that financial stability risks have increased. Ironically, although low inflation protects the poor from erosion of the purchasing power of their incomes, asset price developments have favoured the wealthy, widening disparities in wealth.
Is the South African experience any different?
Unlike the advanced economies, South Africa’s inflation rate, most recently at 4.3%, is still far from the risk of deflation. The repo rate, at 6.5%, is also far from the zero lower bound. Small, open, emerging market (EM) economies like ours generally face a different set of inflation risks, and inflation dynamics differ from those in the advanced economies. For example, EM inflation rates are more sensitive to exchange rate and volatile food price changes. The structure of the economy and the relatively less developed financial markets imply that the transmission mechanism of monetary policy is also often less effective. Therefore, changes in interest rates may have a smaller impact on cyclical growth, and ultimately, on inflation. Monetary policy is also generally less effective when inflation is driven by supply-side shocks, rather than standard demand-side pressures.
During the past two decades, the significant swings in South Africa’s inflation rate have been driven to a large extent by exogenous shocks, mainly in the form of energy prices (international oil prices and domestic electricity tariffs), food prices and the exchange rate. More recently, inflation appears to be firmly under control, as shown in Figure 1. Headline inflation has been within the target range of 3-6% since April 2017, and at or below the mid-point of the target since December 2018. Core inflation, which gives a better indication of the underlying inflation pressures, has been remarkably stable. Since early 2010, core inflation has been within the 3-6% target range, and since April 2017 it has been below 4.5%. Services price inflation, which is generally stickier than goods prices, has declined gradually to 4.7%. Most forecasts of inflation, including those of the South African Reserve Bank (SARB), have consistently surprised on the downside.
Figure 1: Inflation surprising on the downside
Source: Statistics South Africa and Investec Asset Management, as at 30.09.19. Investec Asset Management forecasts are from 01.09.19 onwards.
This benign inflation environment is a result of several factors. First, domestic demand has been extremely weak, with retailers in particular finding it difficult to pass through price increases. The resulting margin squeeze is clearly reflected in the recent poor financial results of the retail sector. In sharp contrast to much of the inflation targeting era, inflation is being strongly influenced by a lack of domestic demand, rather than exogenous shocks. Reinforcing this trend is the significant moderation in average remuneration growth in South Africa, notwithstanding the high initial wage demands that tend to attract the headlines. Lower wage growth feeds through to lower cost pressures, but also constrains demand.
Second, while the economy is still vulnerable to exogenous shocks, the second-round effects of these shocks have been moderated by the weak demand environment. Additionally, the shocks themselves have also been more muted. The emergence of the US as a major oil exporter has changed the international oil price dynamics. Prices are less subject to the strong moves (in both directions) than was the case in the 2000s, despite continued geopolitical tensions.
Third, the SARB has been focusing more explicitly on the mid-point of the target range in an attempt to entrench inflation and inflation expectations around that level. During the early post-crisis period, monetary policy was more tolerant of inflation at the upper end of the target range. This new focus inevitably results in a tighter policy stance than might otherwise have been the case in the short to medium term. While inflation expectations have been moderating, the downward trajectory has been slower than that of actual inflation. The relative stickiness of inflation expectations is not unusual given that the process of expectations formation is partly backward looking.
So, what is the outlook for inflation?
Investec Asset Management’s model suggests that inflation will remain contained in the absence of any major unexpected shocks (in either direction). Our current forecast is for headline inflation to average 4.2% in 2019 and 4.6% in 2020, compared with the SARB’s forecasts of 4.2% and 5.1%. We expect core inflation to average 4.2% in 2019 and 4.4% in 2020. By historical standards, inflation is subdued, but not dead, and not without risks. We assess these risks, however, to be fairly balanced. This benign inflation outlook can be easily disrupted by unexpected external or internal shocks.
The rand remains a key risk to the inflation outlook, buffeted by global factors (risk-on, risk-off scenarios and monetary policy decisions in the advanced economies), as well as domestic idiosyncratic factors such as burgeoning fiscal risks. However, the risks to inflation from the rand are mitigated by the lower pass-through from the local currency over the past few years.
Much progress has been made to bring South Africa’s inflation rate down closer to global levels. The inflation rate is now less susceptible to the impact of exogenous shocks, including the exchange rate. While weak domestic demand has played a large part, we believe that with appropriate monetary policy responses, this lower pass-through will endure when domestic demand recovers. However, above-average administered price increases, particularly electricity and water tariffs, are likely to be with us for some time. This will make it difficult to realistically reach inflation rates that are more in line with the global experience and targets of around 2-3%. Trying to reduce inflation to lower levels could require a tighter monetary policy to squeeze the other components of the CPI basket. While the benefits of low inflation are clear, the trade-off between lower inflation and tighter monetary policy could become severe against the backdrop of a very weak economy. Asset allocators should assume longer-term inflation rates of below 5%, rather than the 6-7% levels that are currently assumed.