South Africa is often seen as a high-beta play, be it regarding financial market risk aversion, or political uncertainty and corruption. Yet we have displayed remarkable exceptionalism over the past year, rarely featuring on the global political risk radar or suffering from capital flight. South Africa has, however, stood out on the inflation front. Alongside China, Indonesia and Vietnam, we are one of only a few countries where inflation is in line with the official target.
Despite near-record grain and oil prices, South Africa’s inflation rate has not (yet) breached the 6% upper target limit. While this is largely thanks to the fuel levy reprieve, which was recently extended, it is nevertheless exceptional in the context of high global inflation. Moreover, South Africa’s inflation rate is below that of the US, eurozone, and UK, where inflation rates are above 8.0%. Even in more developed emerging markets, such as Czechia, Poland and Hungary, consumers are facing double-digit price increases. And spare a thought for Turkey, where prices have risen by 70% over the past year.
Chart 1: Surging commodity prices
Chart 2: Consumer Price Index (CPI, % y/y)
What accounts for this exceptionalism?
The weighting of expenditure in South Africa’s consumer price index (CPI) basket is similar to developed markets, with a relatively low share assigned to fuel and food, and a relatively high share falling under services. This reduces the direct sensitivity to global oil and food price dynamics, at least as measured by the CPI.
Structurally lower economic growth since 2015 has reduced firms’ pricing power as weak employment and wage growth have resulted in more price-sensitive consumers. Importantly, constrained credit growth, due to stricter banking sector regulations in the wake of the 2008/09 global financial crisis and the collapse of African Bank Investment Ltd (ABIL) in 2014, has further dampened demand and thus inflation pressure. Similarly, attempts at fiscal consolidation through lower spending and higher taxes have put further pressure on consumption demand.
While much of the disinflation from 2016 to 2020 reflected weak demand, we should give credit to the South African Reserve Bank (SARB). Since 2015, under Governor Lesetja Kganyago, prudent monetary policy with an emphasis on inflation expectations has steadily lowered longer-term inflation expectations towards the mid-point target of 4.5%.
Since the Covid-19 pandemic lockdown began in early 2020, South Africa’s inflation rate has been constrained by imported deflation and weak demand. Many domestic sectors are yet to recover to their pre-pandemic levels. This negative output gap – where economic activity is running below its potential – has continued to dampen pricing power.
In contrast, many economies in the rest of the world have recovered to or are running above their pre-Covid levels, thanks to extremely loose monetary and fiscal policies. These supportive policies were maintained in the face of intensifying supply disruptions, which have now been exacerbated by the Russia/Ukraine war. Excessively high money supply growth led to the traditional “too much money chasing too few goods” in many developed markets, whereas the SARB maintained tight control of the local printing press.
But what about the rand?
Also perplexing is the fact that inflation has been muted despite significant rand depreciation during March and April 2020. This can be explained by lower exchange-rate pass-through due to greater competition, weaker demand, import price deflation, and a rapid recovery in the rand. The rand has traded sideways, admittedly in a broad range, since 2015. In addition, the inclusion of owner equivalent rent in the CPI basket in 2009 and its relatively large weight in the index has increased the importance of services and so reduced the direct sensitivity to the currency.
Can it last?
The extent of the global inflation shock, particularly in the wake of Russia’s invasion of Ukraine, will make it difficult for South Africa to continue to buck the trend of surging inflation. However, how high the inflation rate rises will depend on a few things. If the rand remains resilient, then it will mitigate some import price pressure. If the SARB’s credibility remains intact, which we think it will, then longer-term inflation expectations will be capped and so too will wage growth.
While the housing market showed some signs of life following aggressive rate cuts in 2020, this has been short-lived. The credit channel remains somewhat clogged, and the SARB commenced its hiking cycle in November last year. Moreover, there is increasing risk of even more aggressive front-loaded policy tightening. House price momentum has already softened and rental growth remains muted. Given the substantial weight of housing costs in the CPI basket, a weak housing market will offset part of the mounting food and fuel price pressures.
A tough time lies ahead.
Large increases in the prices of basic items, such as food and transport, act as tax hikes on consumers as they cannot easily consume less of these items. That means they have to cut back elsewhere to make ends meet. This will dampen economic growth, particularly for more discretionary goods and services.
The big debate globally is whether we are witnessing a regime shift as the inflation psyche adjusts from low and stable inflation to expecting higher and more volatile prices in the future.
In South Africa, the SARB is still fighting the inflation battle on the expectations front. The MPC’s hawkishness is to prevent us from returning to the high-inflation psyche that prevailed before and during the early years of inflation targeting.
A tough time lies ahead as policy makers try to convince us that South Africa must remain exceptional. While the scales are tipped in their favour, we should expect continued hawkish rhetoric and potential action to ensure that the message takes hold.