Deflation threat could send interest rates tumbling

The global economic outlook is worsening by the day. Forecasts for global growth and inflation have been scaled down by most prominent institutions, following the effects of the financial markets meltdown since around mid-2008.

Analysts are getting more and more concerned with the possibility of deflation (a sustained drop in the general price level) taking hold and this could also spell the end of hopes that stimulatory monetary policies will support economic growth rates.

Until now, most South African analysts have not given any consideration to the possibility that price declines may also occur in South Africa. They usually cite the downward stickiness of prices, high wage demands and the tendency of the rand to depreciate in times of international uncertainty, as reasons why deflation is unlikely to be of any concern to the South African economy.

To test the potential for much lower inflation (and perhaps deflation) developing in South Africa, we "shocked" the macro-economic model with the assumption of a fairly grim international scenario unfolding over the next few years, by assuming a severe global recession. Specifically the following assumptions were made:

• World GDP growth will be negative in each of the next three years (2009-2011).
• This will lead to a significant decline in inflation and even global deflation by 2010.
• The impact on commodity prices will be severe, with around 30% declines, on average, occurring in dollar gold (and by implication also platinum, etc) and oil prices over the next two years.
• Monetary policies will be adjusted aggressively to try and cope with these conditions.

Apart from adjustments in the repo rate to align with the changed inflation environment, no other adjustments were made to any of the South African macro assumptions. The results of this simulation can be summarised as follows:

• Real GDP growth will be much weaker than anticipated under the base scenario, and could become negative in 2010. The major reason for this would be as a result of the severe impact of the global recession and low commodity prices on SA exports.
• Some counter-cyclical spending on the part of government will occur, and would most likely be in the form of a continuation in public sector capital expansion programmes.
• Household spending is also expected to be remain fairly buoyant, supported by the considerable reduction in nominal interest rates.
• As a result of the continued growth in real gross domestic expenditure, imports will remain high despite the massive drop in oil prices.
• The balance of payments impact will most likely be severe, with the current account deficit exploding to more than 13% of GDP by 2011.
• The adverse international conditions and drop in commodity prices will most likely lead to more downward pressure on the rand, although such pressure will be moderated by a significant drop in SA inflation, and the continuation of positive growth and interest rate differentials with the rest of the world.
• CPI inflation is likely to decline to below 2% in 2010, while PPI might register deflation.
• Formal sector employment will continue to grow, but at a somewhat slower rate than in the base case. However, unemployment is likely to increase.

The positive effect of lower oil prices, the capital expansion programme currently underway and the significant relief which could occur in the form of lower interest rates, may cause the impact of a severe global recession to be less severe on the SA economy. But the potential for much lower inflation — and therefore interest rates — appears to be significant. Most economists are predicting up to 300 basis points worth of cuts to occur during the the next year or so. However, the impact of much lower oil prices should not be underestimated and this could, together with some recovery in the rand, lead to much sharper interest rate declines — perhaps amounting to as much as 800 basis points in 2009/10.

The probability of an outcome approximating the base case scenario still seems bigger than that of a prolonged and deep global recession with deflation, but conditions are changing fast and at this stage these changes are mostly negative.

Share this article on