Why (slowly) nudging up interest rates makes sense
It’s interest rate decision week again, and while FNB expects an unchanged decision, there are a few good reasons why it would probably be a good idea for the SARB to keep on nudging rates up slowly, argues FNB household and property sector strategist John Loos.
There exists little current pressure on the SARB (South African Reserve Bank) MPC (Monetary Policy Committee) to hike interest rates this week, at least from a current inflation point of view.
Global Commodity Price levels remain suppressed, and although certain upside risks to inflation remain, including ongoing high wage demands and a vulnerable rand, nothing has manifested itself in “runaway” inflation to date. CPI (Consumer Price Index) inflation remains firmly in the 3-6% target range, hovering at 4.6% year-on-year for both August and September.
However, from a “forward looking” consumer and property point of view, and a longer term stability point of view, continuing to slowly “nudge” rates higher in the near future may make a whole lot of sense.
It is old news that South Africa flirts with sovereign rating downgrades, with much speculation as to whether the country will be downgraded to so-called “Junk Bond” status. Such a move raises the risk of a more rapid increase in a variety of interest rates, as investor confidence and net capital flows deteriorate.
Couple this to the possibility of the US Federal Reserve starting to hike interest rates in that country, a move which can adversely affect capital flows from especially Emerging Market (EM) nations such as South Africa, and one has the potential recipe for an environment in which the SARB is ultimately pressured to hike its policy Repo Rate more rapidly at future some point.
Any “rapid” hiking in interest rates would not be good news for the household sector/consumer, or for the broader economy for that matter, which has become accustomed to operating in an environment of “abnormally low” interest rates.
Rather than delay the “upward normalisation” of interest rates until it is forced to, I would believe it more desirable to continue gradually raising interest rates at the current snail’s pace, in order to complete the adjustment process while still not under undue pressure.
Important to understand is that “normalising” interest rates is not merely about quickly raising the Repo Rate by 1 or 2 or 3 percentage points. Many things have to adjust in response, and the pace of interest rate hiking can determine whether the adjustment is painful or not.
Important in this regard is to remember that South Africa’s household debt-to-disposable income ratio remains at very high levels by the country’s historic standards, still rendering it vulnerable to any normal interest rate hiking cycle (“normal” in SA terms probably meaning at least 3-4, and maybe 5 percentage points).
The good news in recent years has been that this ratio has been declining, from a 2008 high of 88.8% to a 2015 level of 77.8%
Since 2011, however, there has been a broad slowing in the pace of growth in household disposable income. This means that, in order to continue with the “right sizing” process in the debt-to-disposable income ratio, it is crucial that household credit growth remains pedestrian, at rates below the disposable income growth rate.
The SARB can greatly assist in this process by continuing to promote healthy “consumer/borrower caution” by continuing to nudge rates higher, but doing it a pace so slow that it allows ample time for adaptation by the consumer.
This continued gradual pace of rate hiking is, to me, first prize. The consumer “credit health” situation at present is relatively good. Contrary to the belief of some, financial stress is not widespread (yet), and banks are not in a position where bad debt is at unmanageable levels.
The household sector debt-service ratio (the interest cost on household debt expressed as a percentage of household sector disposable income) is arguably the best single macro predictor of consumer bad debt levels.
Its level is obviously determined by the level of borrowing rates along with the level of indebtedness.
The debt-service ratio has risen mildly, from 8.5% late in 2012 to 9.4% by the 1st half of 2015, helped higher by mild SARB interest rate hiking. This rise should normally lead to some rise in household sector bad debt levels.
However, this level in the debt-service ratio would by now have been higher, had it not been for slow household credit growth and further decline during this time in the level of household indebtedness relative to disposable income.
And so, we see that the level of insolvencies has not even begun to rise yet, and in our FNB Estate Agent Survey estimate of the percentage of sellers believed to be “selling in order to downscale due to financial pressure”, we also see no obvious sign of an increase yet.
The household/consumer is being allowed lots of time to adjust behaviour in response to rising interest rates.
If the SARB can get it right to continue to engineer a declining debt-to-disposable income ratio gradually over the next few years, it could greatly assist in achieving a “soft landing” in terms of how we extract ourselves from the “bubbly” levels of indebtedness that were an integral part of last decade’s property and consumer “bubble”.
Achieving this in a gradual and orderly fashion could in turn assist in the correction of other crucial levels, and by this I am referring to the high level of real housing values.
I believe that much of the post-bubble real house price correction still has to take place, being postponed by the SARB’s move to abnormally low rates from around 2009. This has been a different scenario to the “taking the pain upfront” approach of the bank back in the early-1980s, where real residential prices corrected sharply as interest rates rose rapidly.
But ultimately, as the country’s economic fundamentals continue on their long-term deteriorating path, we would expect real house price levels to ultimately “correct” to levels that better reflect these weak economic fundamentals.
Important, though, is HOW they will correct. Sharp downward nominal house price corrections can impose significant stress on both the household and the banking sector. Slow corrections, where nominal house prices still rise but at a slower rate than CPI inflation, translating into a gradual REAL price correction, can be far less severe.
The point is that at present, we still appear to have choices in terms of being able to “engineer the soft landing”. At some later stage this may not be the case, given the mounting investor confidence risks.
Some may ask, “what does all this have to do with inflation, the primary target of the SARB”?
The answer is, “A lot”. How the SARB proactively manages other “key variables” in an economy up and down has major implications in terms of how much leeway it has at a later stage to go about its core business of inflation targeting.
While inflation is its main focus, the bank cannot be entirely insensitive to near term economic growth pressures. Given that the consumer is the largest source of final demand in an economy, the consumer matters to economy performance greatly.
A highly indebted consumer who is sensitive to even mild interest rate hiking (such as is currently the case), therefore, makes it very difficult for the SARB to go about its business should certain sources of inflationary pressures at some stage become troublesome. This is because a high level of consumer indebtedness can imply severe short-term pain should rate hiking take place.
That can then lead to central banks being “held at ransom” by the high level of indebtedness of not only the consumer, but by the commercial and government sectors too.
Sound familiar? This is arguably where many of the world’s central banks are today, notably a US Federal Reserve stuck with its policy rate at almost zero, and terrified to move.