HOW do you predict inflation and make monetary policy decisions if you don't know which measure of inflation the target is?
That's the dilemma the Reserve Bank faces this week when its monetary policy committee (MPC) meets.
The problem that the Reserve Bank - and all other forecasters of inflation - faces is the fact that the current targeted measure of inflation, the CPIX rate, will cease to exist from January next year.
CPIX is the consumer price index (CPI) excluding the cost of mortgage bonds. (Mortgage bonds were excluded from the target in 2000 so that one didn't get the paradoxical effect of inflation rising as a result of interest rates being raised.)
From next year, the CPI calculation will no longer contain mortgage bonds. Instead, it will include owners' occupied rent - the estimated rental that a homeowner would pay if he rented his home instead of owned it.
For those who have paid off their mortgage bonds, the new approach is the opportunity cost of the rent foregone as a result of living in your house instead of renting it out.
Statistics SA will base the calculation of this rental on surveys of letting agents.
Sense
If the current (CPIX equivalent) target for inflation is to be retained next year, it would have to become CPI excluding owners' occupied rent. That would be the same as the current CPIX.
But this wouldn't make sense, as the whole idea behind inflation targeting is to target as broad a measure of inflation as possible. This raises the distinct possibility that CPI will become the new target.
The trouble is that only government can announce a new target measure for inflation. And a treasury spokesperson has said that such an announcement will only be made in the medium-term budget policy statement (MTBPS). The MTBPS usually takes place in October. What happens between now and then?
The trouble is that the Reserve Bank has to forecast inflation as a major input into its monetary policy decisions. Does the Bank assume that rentals for homeowners are included and that CPI becomes the new target? Or does it continue to work on the old measure of inflation?
Explanation?
Presumably, the bank and the treasury have discussed the issue among themselves.
A crucial question is why these discussions have been secret, and why Finance Minister Trevor Manuel won't make an announcement before October.
There is no sound reason for the delay; it would take away the anomalous situation of forcing the Reserve Bank to make predictions without a formal new target having been put in place.
The importance of CPI becoming the new target can't be underestimated. If CPIX had continued to exist, there was a chance that inflation could move to within the target band next year, which would be bullish for interest rates.
The market has priced in such a scenario, with the forward rate agreement market pricing in 200 basis points of interest rate cuts for next year.
The main reason for the bullishness over inflation and interest rates is the reweighting and rebasing of the inflation basket next year, which will see a smaller weighting for food and fuel - currently the main drivers of inflation. The reweighting of the basket could slice two percentage points off the inflation rate in January next year.
If CPI is used as the new target, there will still be a large once-off reduction in the inflation rate in January.
What then?
But, after that, the picture becomes murky. Chances are good that the new CPI rate won't fall as fast as the old CPIX rate would have done, which changes the interest rate outlook.
Rand Merchant Bank economist Etienne le Roux estimates CPI inflation will average 8.1% in 2009 and 6.2% in 2010. If these forecasts are correct, then the market is currently too bullish over interest rates.
It goes without saying that the Reserve Bank should raise all these issues in its MPC statement this week. (Though how it will be able to come up with a formal forecast for inflation when Manuel hasn't yet made a formal announcement on the target is a mystery to me.)
Given the possibility of a new target, the Reserve Bank's old inflation forecasts, which saw inflation only reaching back within the target by the third quarter of 2010, no longer seem wildly off the mark.
The market might have to scale back its interest rate optimism after Thursday's meeting.
- Fin24.com