Understanding CPI, Inflation and Rates

The calculation of CPI inflation is of crucial importance for South Africans, as it determines the outcome of inflation and so the decision to change interest rates at the Reserve Bank.

CPI inflation, or consumer price inflation, is the measure targeted by the South African Reserve Bank, and as such it is the survey method, choice of items included and weighting of the prices consumers face at the tills that count.

Administered price inflation, or state controlled inflation, has seen a heady increase of 64.6 percent since the start of 2009 compared to the 29.5 percent increase in the overall CPI inflation rate in the same period.

State controlled prices include electricity tariffs, water tariffs, property rates and taxes, petrol and diesel prices and the cost of public transport. Indeed, according to the publication ‘2013 State of City Finances’ households living in properties of over R1 million in value in major metropolitan areas have seen the cost of their municipal services rise by 37 percent in real terms (over and above inflation) between 2009 and 2012.

This implies close to an 80 percent increase in the combined cost of water, electricity, sanitation, refuse removal, property rates and taxes, et cetera between 2009 and 2012.

Statistics SA data shows that the cost of electricity has risen by 103 percent since 2009 and the cost of water by close to 70 percent on average, which has driven administered price inflation higher.

In its monetary policy deliberations the SA Reserve Bank pays close attention to what is deemed the core rate of inflation, namely CPI excluding the prices of food, petrol, electricity and non-alcoholic beverages.

This is because core inflation provides a better estimation of the underlying trend of inflationary pressures driven by demand. Food (and non-alcoholic beverage) prices can be affected by drought, rand volatility or global supply issues, while the petrol price is determined by the US dollar price of international petroleum products, electricity prices are set by the public authorities.

The latest data shows this measure of core inflation was running at 5.3 percent y/y in December last year, but the question is whether it is indeed the most appropriate measure given that it does not exclude all state administered prices.

CPI inflation excluding all administered prices was 4.8 percent y/y in December, and is clearly a better measure of demand pressures in the economy as both electricity and water tariffs are rising due to the expansion of infrastructure.

Free basic provision of water and electricity to poor households is usually made by municipalities.

Municipalities increase rates and service charges, electricity and water tariffs for the relatively small base of households that can pay.

The South African Reserve Bank itself said recently that “should the interest rate cycle turn, at the current elevated debt levels, the household sector and related credit providers exposed to this sector could be very vulnerable.”

On average 6 000 litres of clean water is provided to poor households per month, while the Department of Energy says free basic electricity “is the amount of electricity, deemed sufficient to provide basic lighting, basic water heating using a kettle and basic ironing in terms of grid electricity and basic lighting and basic media access for non-grid systems.”

Free basic levels of sanitation and refuse removal are also provided by the municipalities for the poor and funded by rate paying households.

Even using a core inflation rate excluding the cost of water, as well as the prices of food, petrol, electricity and non-alcoholic beverages, would provide a better measure of demand driven inflation pressures.

The reason this is key is that the Reserve Bank hikes interest rates in order to attempt to quell future increases in inflation, i.e. to attempt to keep CPI inflation running between 3-6 percent.

Specifically, if the monetary authorities think that CPI inflation will exceed the 3-6 percent target band for a sustained period over the next six months to two years they will likely increase the repo rate.

However, if it is state administered prices that are driving CPI inflation toward the 6.0 percent mark, as can be seen by the difference between CPI inflation excluding administered prices which is 4.8 percent y/y and the CPI inflation rate which is 5.4 percent y/y, then increasing interest rates to bring down mainly the state controlled inflationary pressures in CPI inflation makes less sense. Administered price inflation is high, at 7.8 percent y/y, well above the CPI inflation rate targeted by the Reserve Bank.

CPI inflation excluding administered prices had fallen to 4.8 percent y/y by the end of 2013, from 5.3 percent y/y in August 2013 and this considerable decline in demand led inflation shows that individuals are already tightening their belts due to slowing real growth in disposable incomes, high debt levels, rising delinquencies (60 percent of credit active individuals are 30 days or more in arrears in repayment of a debt) and rising impairments (50 percent of credit active individuals are 90 or more days in areas of repayment of a debt or have a listing or judgement against their name).

Growth in consumer spending has been weakening significantly due also to deteriorating sentiment about the future as employment conditions in the private sector remained weak, and a tightening in lending criteria.

With consumers already showing some self limiting behaviour in demand for goods and services, with many consuming less as evidenced by lower reported volumes by many retailers, it would appear the Reserve Bank does not need to tighten interest rates materially, unless this nascent trend of falling demand led inflation reverses.

However, rand weakness has had a negative impact on sentiment, with many now of the view that interest rates will rise further this year.

Given that the true measure of core inflation, CPI less administered prices is falling, such interest rate hikes would be in response to the rand weakness, not demand levels in the South African economy which are proving to be relatively muted, demonstrated also by the fact that there has so far been no pass through or second round effects from the rand’s depreciation on CPI inflation.

The effective rand has weakened by 19 percent y/y, namely against the currencies of South Africa’s key trading partners, and this weakness has caused concern that it could lead to higher inflation expectations in 2014, and higher future CPI inflation.

Meanwhile, the effective rand depreciated by 18 percent y/y in 2013 and this depreciation was not translated through into higher CPI inflation, with CPI inflation falling instead from 6.4 percent y/y to 5.4 percent y/y.

The Reserve Bank has said it does not target the rand, stating “There is no particular level of the exchange rate that would trigger a monetary policy response by the MPC. … the MPC would have to take a view on the extent and duration of the exchange rate depreciation, and the extent and duration of its impact on inflation.

The latter depends on the strength of domestic demand and the pricing power of firms, which have been exceptionally muted in recent times.

A depreciation that is short-lived and expected to reverse quickly is unlikely to have much impact on the medium-term inflation path.”

The latest inflation expectations survey shows expectations are anchored, and the rand is expected to return to R10.00/USD by year end.- Annabel Bishop

Annabel Bishop is Investec Bank Limited’s Chief Economist in South Africa

View article : http://www.property24.com/articles/understanding-cpi-inflation-and-rates/19397

05 Aug 2015
Author Annabel Bishop

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