Cees Bruggemans, chief economist for FNB - one of the major banking groups in South Africa - recently sketched some of his beliefs where interest rates will go in the next couple of years:
There has been some speculation regarding the likely shape of the next cyclical interest rate upswing. First sideways through 2010, thereafter rising gradually through 2013 before peaking.
Such forecasts have tended to expect a long sojourn at low levels through 2010, followed by a slow ascent and a non-violent peaking.
Though a gentle view, this kind of playout is rarely the reality. Either external shocks force up our inflation, potentially quickly and suddenly, through rising import prices and/or Rand plunging, or domestic overheating or other shortcomings push through the surface, reversing the downward inflation drift.
Either way reality comes calling, forcing the SARB into response mode, raising interest rates in killjoy fashion, fully determined to contain inflation expectations and the reimbursement syndrome, especially among labour.
The global condition is set on recovery, perhaps slow in the West, but probably fast in the East. That suggests at some point the return of commodity bottlenecks and renewed commodity price surging.
Domestically, strained budgets and needed infrastructure point towards greater use of increased pricing to generate extra cash flow, besides greater recourse to capital markets. Politically-controlled, non-tradable sectors hint at outsized price pressures for some years.
These are two badly skewed inflation boosters.
Happily (for non-exporters), the recovering world has excess capital and a restored risk appetite, with emerging markets first choice of destination. Also, we have good quality assets and corporates, and our macro policies are receiving rave reviews, encouraging risk upgrades to A-ratings.
This attracts foreign capital. You can see it in our overfunded current account and firming Rand, nowadays on a good day once again contemplating 7.50:$, a mere nine months after seeing a cyclical low near 12:$.
A firming Rand is an important suppressant of inflation and could be a feature through 2010-2014. It is difficult to tell how much of a Rand undershoot we could get this time, with current account deeper in structural overshoot. Still, don't write off a firm Rand as inflation suppressant just yet.
Labour tends to be backward-looking (when inflation was high, though falling rapidly this year and next), but politically it also tends to be forward-looking (payoffs just where you look).
Though the backward-looking inclination tends to get moderated by falling inflation and job losses as employers square high wage demands with labour layoffs, intense political demands create additional cost-push syndrome.
Nothing new in any of this, but possibly more intense in this particular cycle.
So will labour costs, and especially unit costs after job losses and productivity gains have been taken into account, really be such an inflation threat? Probably not, despite all the upfront noise.
Professional skill scarcity is probably getting a one-off shot in the arm from the global recession and slow Western recovery. Global skills have been coming home in droves, from London, Dubai and elsewhere, or are simply no longer leaving in such a hurry, as per FNB Homeloan Barometer readings.
This may only be a temporary respite, as the medical profession is suggesting daily. Any global recovery and no noticeable change in local conditions could see the emigration of scarce skills start up again.
But for now this salary premium source is probably dormant, but a factor to bear in mind again after 2012.
With CPI inflation this week likely falling to 7%, with 5% still the main expectation for next year, a Taylor-based inflation would currently look for a 13% prime rate.
Bearing in mind that banks have tightened their credit criteria, and increased their average interest rates to new borrowers, some of this probably structurally enduring, new borrowers are experiencing a higher interest rate reality than what the current prime 11% may suggest, indeed closer to 13%.
This alone suggests the present 11% interest rate regime to be strongly disciplinary BEFORE we consider incorporating a real sector output gap into the Taylor estimate.
But then we unexpectedly run into trouble, something our labour unions won't like, as it limits the downside to interest rates.
Overseas output gap estimates have run into a lot of flak lately. Traditional estimating, mostly allowing for a rise in unemployment and idled physical plant, suggest US actual output to be 6% below potential GDP. Something similar applies to Europe.
Such resource slack suggests a long period of intense resource competition, capping cost pressures, yielding low inflation.
But alternative output gap estimates suggest the slack resources won't easily compete with actively employed resources, while idle physical plant tends to be slowly written off. Both reduce potential output, to such a degree that the output gap may only be -1% of GDP.
The South African condition poses similar dilemmas. Taking into account idled skilled labour and plant, our output gap today may be -4% to -6% of GDP. But it could be much less, if overseas reasoning is to be believed.
A Taylor estimate incorporating the traditional view of the output gap may suggest a prime of 10%, against an experienced reality today of 13% as previously estimated.
If, however, the effective output gap is smaller, a prime of 11%-12% looks about right, compared to an experienced effective reality today of about 13%.
So what now? Is our existing prime rate at 11% too high, the National Credit Act too tough and/or banks' credit policies too tight?
Either banks ease their credit policies modestly as the economy turns, in which case currently prevailing prime seems to be appropriate, also bearing in mind risk insurance against the inflation forecast being wrong.
Or the SARB should still lower interest rates, policy being still far too tight, given the lower inflation outlook, the large output gap and the sharpened bank credit policies, and not everyone agreeing about such high forecast risk assurance.
On balance, the SARB is not expected to give way.
But then how do we move forward?
CPI inflation will probably ease towards 5% next year, but may move higher again during 2011-12, say towards 6%.
The recovering economy should start reabsorbing skilled labour from next year, gradually reducing the output gap, which may in any case not be as big as traditionally suggested.
Banks may cyclically lighten their credit policies, but not necessarily to any large degree, at most halving the premium increase new borrowers have experienced of late.
And the risk of higher inflation due to global changes could be that much nearer, increasing any risk premium.
If you add all that together, you get a Taylor estimate for prime in the 12% range, with the banks' credit tightness good for at least 1%, suggesting an actual prime of 11%.
That takes care of 2009-2010. No change to prime 11%. Until things start heating up in the external and/or internal environment.
If during 2011 the CPI inflation were to be 6%, possibly rising to 7% in 2012, with a modest positive output gap and risk of inflation accelerating, what would that do to the Taylor advice?
A 14% estimate would come into view, with the banks' credit tightness good for 1%, yielding a prime of 13%.
Does that mean we face risk during 2011-2012 of prime slowly being raised towards 13% from 11% today? On these assumptions, yes, but that is the $64 000 question.
How will external and internal forces change the inflation outlook, including the condition of the economy, the risk (either way) of the inflation forecast being wrong and the credit policy tightness of banks?
That we don't know at this juncture. It could be far worse, suddenly, than surmised here, as happened during 2008. Or it may remain benign. The set of circumstances will presumably be unique, whatever decides to turn up.
That is why the Monetary Policy Committee meets frequently and is likely to keep doing so under new leadership, given the very challenging nature of what we and the world will be facing and to which the SARB will need to respond, given the task given to it by the government.
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