There is a lot of debate about whether the South African Reserve Bank (SARB) will begin cutting interest rates later this month after headline CPI inflation unexpectedly dropped to 4.6% in July.
Whether the SARB will cut will depend in large part on whether the members of its Monetary Policy Committee expect inflation to return to 4.5%, the mid-point of the inflation target, over the medium term. One way central banks assess the outlook for inflation is using measures of underlying inflation pressures. But there are many ways to measure underlying inflation making this a source of disagreement among economists. Core inflation, that excludes food, non-alcoholic beverages, fuel and energy fell to below the mid-point of the inflation target to 4.3% in July. We showed in an earlier post that the share of 5-digit items growing above the mid-point inflation target of 4.5% fell below 50% in July for the first time in recent months. Codera’s core inflation measure, CPI-Common, however continues to suggest that it is too early to call the abatement of inflation pressures in South Africa. Our measure suggests that there remains more broad-based inflation pressure than implied by the Statistics SA core measure of underlying inflation and its trimmed mean measure. As we argued earlier, measures of trend inflation have also been higher than Statistics South Africa’s core measure.
We have been arguing for the last couple of years that South Africa needs new underlying inflation measures and inflation models to guide monetary policy. So it was good to see SARB recently publish alternative measures of underlying inflation (‘supercore’ and ‘PCCI’) that are meant to capture demand-driven inflation. Unfortunately, they have not conducted out-of-sample forecast assessments to test whether these measures have done a good job of predicting inflation. Our assessments suggest that the core inflation measures the SARB and market analysts focus their analysis on (and unfortunately also our CPI-common measure, which shares some conceptual characteristics with SARB’s PCCI) do not do a good job of predicting inflation. For this reason, new frameworks for measuring underlying inflation and assessing its implications for monetary policy are needed.
Why is this important? For an inflation-targeting central bank, it is crucial to understand whether inflationary pressures stem from supply or demand factors. This is because the appropriate policy response differs significantly depending on the source of inflation. If a decline in inflation is primarily being driven by a decrease in aggregate demand, a lower policy rate is appropriate. If temporarily lower commodity prices or elimination of supply chain disruptions are driving inflation lower, then lowering the policy rate could contribute to higher inflation once such drivers dissipate. SARB has not explicitly used its forecasting model to interpret the drivers of underlying inflation, making it difficult to precisely assess how SARB thinks about inflation dynamics and whether the MPC have a credible economic narrative about the outlook for inflation.
