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Inflation bound to decline further

From the perspective of indebted households and businesses, the latest reading of the producer price index (PPI) is good news indeed.

This price index is a leading indicator for consumer prices, as production travels along various value chains (logistics, wholesalers, retailers and other services industries) to eventually become part of household consumption. In March, the PPI was 41% lower than in July last year, a clear indication that the CPI will also continue on its downward trajectory and, hopefully, signal the end of rising interest rates.

Causes of higher inflation

When analysing the nature of the global surge in higher prices over the past two years, the fairly sharp decline in the PPI over the past nine months is not surprising. Two factors played a major role in the price instability that ensued immediately after the worst of the Covid pandemic, but they have more or less run their course.

It turned out that oil was not the major culprit, but rather the cost of shipping oil and all other traded goods from one port to another. The on-going supply chain disruptions caused by the Covid pandemic and exacerbated by the Russian invasion of Ukraine have provided a stark reminder of the strategic economic importance of maritime container trade.

The sea carries more than 80 percent of the world’s traded goods by volume and 70% by value. Ultimately, too few ships and an explosive recovery of demand conspired to send freight costs into orbit, with the Statista Freight Rate Index (SFRI) increasing from $1,262 per container during the third quarter of 2019 to $10,361 in the third quarter of 2021 – an unheard of increase of more than 700%. Fortunately, these costs have almost normalised, with the Statista Index having declined by 83% from the 2021 peak to below $2,000.

A second reason was the extraordinary spike in energy prices, especially natural gas. Pandemics and wars are not conducive to energy market stability, as witnessed between April 2021 and August 2022. In the space of 17 months, the price of Australian coal increased four-fold and the price of European natural gas increased almost ten-fold. Over this period, the price increase in Brent crude oil was more muted, but nevertheless increased by more than 50%.

Fortunately, however, energy prices have entered a marked downward pattern since the third quarter of last year, with Brent crude, coal and natural gas having declined by 25%; 52% and 81%, respectively.

More importantly, the effect of higher energy prices has played itself out of the official inflation rates in most countries, although lingering indirect effects may still be felt for a couple of months, especially in the form of belated increases in transport costs and, in South Africa’s case, the additional cost of supplementing electricity supply rationing with generators, inverters and solar power.

Currency weakness

In South Africa’s case (as well as several other emerging markets), currency weakness also played a part in raising the prices of imported goods. This was not necessarily related to any significant policy weakness, but rather to the relentless rise in the value of the US dollar. The South African rand lost 23% of its value between the second quarter of 2021 and the second quarter of 2023.

Borrowing costs in the US are at their highest level in 16 years and the Fed has signalled a measure of concern over the possible negative effects on economic activity emanating from the tightening cycle. These comments were contained in the most recent announcement of a 25 basis point increase in the Fed funds rate, suggesting that a turning point in the upward rate cycle may have been reached.

Few, if any economists expect inflation in South Africa to remain above the Reserve Bank’s upper target range for much longer, resulting in a belief that interest rates are bound to be lowered during the second half of the year. This prospect is borne out by the latest survey amongst 33 economists conducted by the Bureau for Market Research at Unisa, with several of them expecting a drop in the prime rate of more than 50 basis points by the 4th quarter.

Hopefully, the Reserve Bank will take notice of these fortuitous developments and start lowering the cost of capital and credit sooner rather than later.

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