You have to get inflation right ‚ at least at our end of the market. For a fixed income fund manager, an inflation view is non-negotiable because so many other issues are derived from it.

Inflation in South Africa is a very interesting and sensitive subject. I will try and give you some of the opposing views and issues that exist in the economic and political environment, followed by our own view on inflation and monetary policy.

Inflation is measured by the change in the CPI (Consumer Price Index) over time. The CPI basket is composed of various different components, including food, transport and housing. Its purpose is to approximate the speed at which prices change in our economy.

Like most of us, economists prefer it when prices don‚t increase too quickly (though their reasoning is a bit different). To try and achieve this, the South African Reserve Bank (SARB) uses interest rates to ‚push‚Äù/‚Äùpull‚Äù inflation into the required band. At the moment, that band is between 3-6%.

There is however a contrary view. It is held primarily by COSATU and some of its allies. The argument is that in a small open economy, there is little use in trying to combat inflation, when it is determined to a large extent by external forces ‚ the oil price and currency being dominant. They further argue that trying to combat inflation by raising interest rates, knowing that they will have little effect, is irresponsible because it lowers growth and employment. As such they argue for significantly lower interest rates and a higher/non-existent inflation target.

While on the face of it, their argument may have some merit, empirically it fails. Internationally it has been shown that while low stable inflation may not be a sufficient ingredient for a stable economy, it is certainly necessary. Secondly, in a high inflation scenario, it is the poor and those in poverty who suffer the most, as they have little or no recourse to protect themselves from it. The rich can buy real assets as inflation hedges and ride out the storm, the poor cannot.

Luckily for us, we have been blessed with good men (and women) with sound judgement in the relevant positions of power that determine financial policy. And while some may point to the recent comments in the budget speech about more flexible inflation targeting and see capitulation, we would argue that it is only confirmation of the strategy that the Reserve Bank has followed for a while.

As things stand, we are targeting inflation with growth in mind…….Quo Vadis?

The next MPC meeting in March is going to be interesting from several perspectives. It is the first meeting after the official pronouncement of increasingly positive growth expectations. Secondly, with some of the comments in the previous MPC meeting there are some market participants positioning themselves to profit from the cut they expect; and because it is after the NERSA announcement on the approved hikes in electricity price (24.8%). In our opinion the last issue is the most important and the only piece of data that could legitimately have allowed Governor Marcus to cut ‚ had it differed from expectations

During the final months of last year and the beginning of this year the relevant policy figures were:

1. Inflation around the top of the band and falling, with expectations that it would be inside the band for most of the year.
2. The Treasury GDP forecast was below 2% and the MPC‚s was at 2%
3. Electricity hikes used in inflation forecasting was 25%.

On the inflation front there have been some recent developments. Both the unexpected stability in the Rand along with the almost 30% drop in the maize price will help inflation going forward. Some market commentators have speculated that inflation may surprise on the downside over the next few months with the potential to come in below 4%. However it must be remembered that reserve bank policy is FORWARD-LOOKING (12 ‚ 18 months forward). The inflation expectations of the next 6 months are per definition not their concern ‚ and while there have been some shorter term developments, the long term inflation views have not changed materially. This argues against a change in policy.

Growth expectations have improved and many expect them to continue to do so. Treasury recently released growth expectations for 2010 at 2.5%. Elsewhere we are seeing reports of forecasts for 2010 GDP growth to be in the 3.5-3.7% band. This development invalidates arguments for a ‚growth-focussed‚Äù cut.

NERSA came in at 0.2% lower than expected. And while that 0.2% has caused a bit of a ruckus in the markets, in the bigger scheme of things it is almost negligible.

What has happened is that medium term inflation expectations has not changed, growth expectations are improving and NERSA came in where the SARB expected it. What has changed since last year and January to justify a cut in interest rates?

Another issue that argues against a cut is the continual barraging of the SARB by the SACP and COSATU for a cut. In an economy like ours and in the current global environment, a Reserve Bank must be seen to have its independence. A change in stance by the Governor now when very little has changed (and nothing in the negative) would allow doubts to form internationally about SARB independence.

Looking at this it is difficult to argue in favour of a cut. We realise that our view does not drive markets and does not set MPC policy, and although we do not expect it, we have expressed the possibility that there exists a 40-50% chance of a cut.

Albert Botha

Atlantic Asset Management