RESERVE Bank governor Gill Marcus
used up quite a bit of space in the latest monetary policy committee (MPC) statement on the seriousness of the eurozone debt crisis. What is the link between the eurozone debt crisis and SA interest rates?
The debt crisis seems to have been postponed for now. But should interest rates rise if the debt crisis deepens, or should a deepening crisis stave off a rise in interest rates? It's not entirely clear from Marcus' statement which way she leans, although one can draw some inferences. Her comments and statement have been interpreted as saying that a deep eurozone crisis means an unchanged repo rate.
"The global systemic risks posed by any failure to overcome the sovereign debt crisis are enormous, and are exacerbated by the potential failure to resolve the debt ceiling crisis in the United States. These events are taking place against the backdrop of a slowdown in growth in many of the advanced economies," the statement's first paragraph reads.
By linking the crisis to the slowdown in the global economy, Marcus appears to be signalling a postponement in SA interest rate increases due to the vulnerability of the local economy to an implosion in global growth.
The statement gives an inflation forecast, and then assesses the "risks" to the forecast. These risks refer to the danger that the forecast might be wrong, with downside risks meaning that inflation will come out lower than forecast, and upside risks meaning inflation will come out higher than forecast.
The inflation forecast of the bank has shown a slight near-term deterioration since the previous MPC meeting. Inflation is now expected to marginally breach the upper end of the target range in the final quarter of 2011, and to average 6.3% in the first quarter of 2012.
Thereafter it's expected to remain at the upper end of the target range for the next two quarters, before declining somewhat in the final quarter of the year.
The forecast period has been extended to the end of 2013, with inflation expected to decline gradually during the year to measure 5.6% in the final quarter of 2013. The bank's forecast of core inflation – excluding food and fuel – shows a modestly rising trend, peaking at around 5% in the second quarter of 2012.
The statement says: "The MPC assesses the risks to the global economic environment to be on the downside ... Risks relating to debt sustainability in peripheral Europe have intensified, with further ratings downgrades to some countries.
"The focus has also moved beyond the periphery to larger countries such as Spain and Italy. As long as the sovereign debt crisis is unresolved, confidence will not be restored, and periodic bouts of risk aversion can be expected to contribute to a high degree of volatility in financial markets.
"There are concerns that a disorderly write-down of this debt could have systemic implications because of the high exposure of European banks to the debt of these countries." The statement goes on to say that the crisis has contributed to volatility in the rand.
When it comes to risks to the inflation outlook, Marcus says there are cost-push factors that represent upside risks. She continues: "The MPC sees a number of downside risks to the inflation outlook, with the risks seen as delicately balanced. If the euro crashes, so will the rand
"These risks include the continued fragile nature of the domestic recovery, as well as risks posed by the ramifications of a possible disorderly debt default in the eurozone."
It's not 100% clear that she sees debt default in the eurozone as a downside risk to inflation. After all, just before that she talks about the upside and downside risks being delicately balanced.
The trouble with a disorderly debt default in the eurozone is that it will cause the rand to crash. The unit recently blipped above R7/$ before gaining ground again. But if the eurozone debt crisis deepens, the euro will crash and SA's currency with it. This can only be bad for the inflation target, and it makes the eurozone crisis an upside risk.
Yet it seems Marcus is paying more attention to the growth implications of a blow-out in Europe. Europe is SA's second-largest export destination after Asia, and deep crisis there will have an effect on the country's growth in SA.
In making monetary policy decisions, the Reserve Bank has to find a trade-off between weak growth and high inflation. It seems that, even if the rand had crashed, Marcus would have focused on the growth aspect and allowed inflation to rise without raising rates.
She may believe that the growth implications would overshadow a possible weak rand, making the eurozone crisis a downside risk to inflation forecasts. That could still happen, because the Greek crisis has simply been postponed.
It would be the right course of action for Marcus not to simply respond to a crashing rand with a kneejerk hike in interest rates. But the credibility of the inflation target would come into question.
She must be very relieved that a deal was done to "save" Greece, as her inflation targeting credentials will probably not be tested in the near term because of the eurozone crisis.