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Reserve Bank Governor Gill Marcus has hinted that “second round” effects from the high oil price will lead to an interest rate hike. What are second round effects and should they necessarily lead to an increase in rates?
Marcus said at the end of her Monetary Policy Committee (MPC) statement: “Given the significant upside risks to the inflation outlook, the MPC will closely monitor any indications of second round effects on inflation emanating from... cost pressures.” By cost pressures she was referring to the high oil price, which she said was the biggest risk to South Africa’s inflation outlook.
In economic theory, an increase in the petrol price isn’t inflation but a one-off increase in the price level. It’s only when it’s passed on and a price/wage spiral is set in motion that it becomes inflation. But in practice, the increase in the oil price will push up the consumer price index (CPI) – and hence inflation, as is generally understood.
Second round effects occur when, instead of a one-off increase in the price level, the price increases are passed on to consumers. It’s difficult to imagine that not happening: retailers may be unable to absorb the pain of the increase in the oil price and not pass it on. In an ideal world they wouldn’t be able to pass it on and the textbook definition of inflation wouldn’t occur. But if they didn’t pass it on retailers could make losses – which would lead to job losses.
We have to accept some second round effects will take place. How, after all, will a minibus taxi continue to generate profits if it can’t push up prices after a petrol price increase? But unfortunately, prices are sticky downward: we find if petrol prices fall minibus taxis don’t drop their fares.
If we accept some second round effects are bound to occur, the question then becomes: How much is tolerable? At which point should Reserve Bank action be triggered? To answer that question the Bank must look at measures such as the CPI excluding food and fuel (food being the other major potential cost/push pressure on inflation).
The Bank must also look at credit demand and wages. That’s because retailers will find it easier to pass on price increases if wages are being raised in excess of the increase in the CPI and/or people are buying a lot on credit. It’s something organised labour doesn’t want to hear, but if workers are more than compensated for increases in the petrol price that improves retailers’ pricing power. However, wage restraint in the face of rising prices is a step too far for Cosatu. Only if workers increase their productivity can the increase in wages be justified – and that’s rarely the case.
A throwaway line in one of Sanlam economist Jac Laubscher’s reports on interest rates is food for thought. He said the Reserve Bank should do more to explain the “transmission mechanism” of monetary policy. By “transmission mechanism” is meant the way an increase in interest rates affects the price level.
The short answer to the transmission mechanism conundrum is that interest rates affect prices through demand. By making it more expensive to borrow to spend it becomes more difficult for retailers to pass on price increases. The second round effects are curbed.
Second round effects aren’t just going to take place because of the high oil price. Sky-high electricity tariffs are another cost that will be passed on. In an interesting study of the effects of the proposed new road toll fees for Gauteng, economist Mike Schüssler found that bread and milk prices would rise as a result.
The issue of second round effects again raises the question of targeting a different measure of inflation: say CPI, excluding food and fuel prices. But then we’d also have to exclude electricity prices. Best to take note of those measures but leave the inflation target of overall CPI intact.
Marcus said at the end of her Monetary Policy Committee (MPC) statement: “Given the significant upside risks to the inflation outlook, the MPC will closely monitor any indications of second round effects on inflation emanating from... cost pressures.” By cost pressures she was referring to the high oil price, which she said was the biggest risk to South Africa’s inflation outlook.
In economic theory, an increase in the petrol price isn’t inflation but a one-off increase in the price level. It’s only when it’s passed on and a price/wage spiral is set in motion that it becomes inflation. But in practice, the increase in the oil price will push up the consumer price index (CPI) – and hence inflation, as is generally understood.
Second round effects occur when, instead of a one-off increase in the price level, the price increases are passed on to consumers. It’s difficult to imagine that not happening: retailers may be unable to absorb the pain of the increase in the oil price and not pass it on. In an ideal world they wouldn’t be able to pass it on and the textbook definition of inflation wouldn’t occur. But if they didn’t pass it on retailers could make losses – which would lead to job losses.
We have to accept some second round effects will take place. How, after all, will a minibus taxi continue to generate profits if it can’t push up prices after a petrol price increase? But unfortunately, prices are sticky downward: we find if petrol prices fall minibus taxis don’t drop their fares.
If we accept some second round effects are bound to occur, the question then becomes: How much is tolerable? At which point should Reserve Bank action be triggered? To answer that question the Bank must look at measures such as the CPI excluding food and fuel (food being the other major potential cost/push pressure on inflation).
The Bank must also look at credit demand and wages. That’s because retailers will find it easier to pass on price increases if wages are being raised in excess of the increase in the CPI and/or people are buying a lot on credit. It’s something organised labour doesn’t want to hear, but if workers are more than compensated for increases in the petrol price that improves retailers’ pricing power. However, wage restraint in the face of rising prices is a step too far for Cosatu. Only if workers increase their productivity can the increase in wages be justified – and that’s rarely the case.
A throwaway line in one of Sanlam economist Jac Laubscher’s reports on interest rates is food for thought. He said the Reserve Bank should do more to explain the “transmission mechanism” of monetary policy. By “transmission mechanism” is meant the way an increase in interest rates affects the price level.
The short answer to the transmission mechanism conundrum is that interest rates affect prices through demand. By making it more expensive to borrow to spend it becomes more difficult for retailers to pass on price increases. The second round effects are curbed.
Second round effects aren’t just going to take place because of the high oil price. Sky-high electricity tariffs are another cost that will be passed on. In an interesting study of the effects of the proposed new road toll fees for Gauteng, economist Mike Schüssler found that bread and milk prices would rise as a result.
The issue of second round effects again raises the question of targeting a different measure of inflation: say CPI, excluding food and fuel prices. But then we’d also have to exclude electricity prices. Best to take note of those measures but leave the inflation target of overall CPI intact.
