According to FNB Chief Economist, Cees Bruggemans, this comes as a bit of a surprise. He elaborates further:

CPI inflation bottomed 18 months ago near 3%, and has ever since been rising, headline faster than core, led by aggressive increases in food, electricity and petrol.

Headline CPI inflation reached 6.3% in January 2012 even as core CPI (excluding food and energy) reached 4.3%. Peaking is probably yet to occur for both, headline near 6.5% and core possibly near 5.5% before both subside.

February brought good news, with headline unexpectedly falling back to 6.1% as food inflation decelerated (from 10.7% to 10.1% y/y) while core stayed unchanged at 4.3%, making the imminent peaks possibly lower and earlier.

There is nothing new or surprising about reaching these levels. For the past twelve months nothing else has been projected (except in the event of global shock scenarios), though minimally differing about precise timing and exact peak levels.

Now that core inflation has reached 4.3%, very much at the sedate pace foreseen for months, to start talking about “broadening” of inflation pressures is surprising.

There are no new forces in evidence. Wage settlements have been glacially drifting lower towards 8%. The Rand is no longer so glaringly overvalued (at 6.60:$) but much more comfortably valued at 7.60:$, with little reason to decry this as a new source of generalised inflation.

BER business opinion surveys do show evidence of price pressure in the trades and manufacturing, but this is reflected in core CPI and is not out of the ordinary in an economy nearly three years into recovery, yet with substantial resource slack remaining.

BER inflation expectation surveys among business, unions and financial analysts remain in predicable ranges, with analysts target-bound and the others slightly to the upside thereof, but all fairly stable for the past year.

If anything, it is remarkable how easily the economy has absorbed 30% petrol price, 25% electricity tariff, 11% food price and 8% average wage increases while keeping core inflation near mid-target and expressed expectations fairly stable near target as these major structural price shifts are absorbed.

Interest rates are not at the right level when looking at inflation trends. Present and projected inflation at 5.5% to 6.5% warrant a prime rate closer to 12% if the economy were at full potential (with zero output gap).

This compares to a current prime rate of 9%, indicative by how much interest rates are bound to rise AT A MINIMUM once the economy reaches full potential if inflation were remain over 5% medium term.

But there is a reason why the prime interest rate sits at 9% and not at 12%. It is our modestly performing economy and a still risky global environment.

Economic performance these past three years has been driven by household income growth as much as important investment and supply side constraints.

Household income growth has been supported by booming global commodity prices, government wages and borrowing largesse, aggressive union demands and professional scarcity premiums.

But public infrastructure spending stagnated due to manpower constraints, while private fixed investment was subdued due to lingering slack, inadequate demand and global uncertainties.

Meanwhile electricity, credit, regulatory interference and the Rand have all constrained output (in heavy industry, building trades, mining and manufacturing).

Recently released 2011 data has shown strength of spending in consumption and fixed investment, with domestic real demand gaining just over 4%.

But will these locomotives keep rolling?

Fixed investment growth may continue at over 4%, with the private sector seeking more new technology and labour-saving, and public infrastructure investment may maintain its pace, between them contributing to nearly 2% job growth (see Quarterly Employment Statistics from employers), but overall real household income growth in 2012 may be less boisterous.

Income from “property” may keep growing lively, but booming commodity prices seem to be tapering off, going by precious metals and Aussie experiences.

Government is imposing some austerity (only 7% public wage increases and 8.8% nominal spending growth), unions aren’t visibly winning bigger wage gains (these are drifting lower) while scarcity premiums may shrink.

With inflation about 1.5% higher in 2012 than in 2011, but nominal income growth about 0.5% slower, and the Finance Minister taking bigger tax bites, real income gains this year may be slower than last year even if “property” income outperforms.

After allowing for an uninspiring net export performance on the back of modest global growth (and relative lack of trade competitiveness), the economy seems unable to outperform 3% GDP growth, with a sizeable output gap remaining.

This supports real interest rates at the level where they are, and likely to remain through 2013 if the government’s newly bold infrastructure ambitions take (much) time to get going.

So by all means worry about where interest rates should be, given a 5%-6% inflation rate medium-term, but do not stop worrying about an underperforming economy and lingering output gap warranting support.

Also, don’t lose track of threatening global risks potentially requiring ‘appropriate’ policy action.

Cees Bruggemans
Chief Economist FNB