Even before Russian President Vladimir Putin began his bloody invasion of Ukraine, the world was grappling with elevated inflation. Now inflation risk has risen substantially, complicating the conduct of monetary policy and raising the global spectre of stagflation, if not outright recession.
In February 2022, the World Bank noted that "inflation has come back faster, spiked more markedly, and proved to be more stubborn and persistent than major central banks initially thought possible".
US inflation accelerated by 7.9% in February, its highest level since January 1982. According to Citadel Global director Bianca Botes, inflation is now above 5% year on year in 15 advanced economies and 78 developing ones — "a mutual spike that has not been witnessed in over two decades".
Over the past two weeks, the price of oil has spiked briefly, European gas prices have almost trebled, and grain prices have soared along with the price of many of SA’s commodity exports.
"Higher energy and food prices will raise headline inflation rates across the world," says Old Mutual Wealth’s Izak Odendaal. "Supply chain disruptions will likely intensify as Russia is effectively cut out of the global economy and financial system."
This means inflation is going to rise everywhere and place further upward pressure on interest rates. How bad it gets depends on how long the war lasts, whether energy and other commodity prices remain elevated, and how aggressively central banks respond.
It’s become common to see global headlines asking whether oil at $200 a barrel is plausible, or whether the war is going to tip the global economy back into a recession. The answer to both questions remains impossible to call; economists who revised their interest and growth forecasts last week are having to tear them up and revise them again.
"There is so much uncertainty now, forecasts are bound to be wrong," says Odendaal. "If you are going to forecast, forecast often."
Citi economist Gina Schoeman recently upped her 2022 average consumer price index (CPI) forecast for SA to 5.5% from 4.9% previously, due to the oil price moves off the back of the conflict. Last week, she hiked it again — to 5.8%.
Though the situation is highly unpredictable, Schoeman says one thing is certain — inflation risk has risen substantially. "For a central bank that recently helped reduce inflation expectations from the 6% target ceiling to the 4.5% mid-point, this will not be taken lightly."
Whereas before the war, she expected the SA Reserve Bank to hike interest rates by 25 basis points (BPS) at every second meeting this year, she now expects six consecutive 25BP hikes, taking the repo rate to 5.25% by year-end. And she expects the monetary policy committee (MPC) to at least consider a 50BP hike at the March and May meetings, even if it doesn’t deliver that.
"While oil prices have surged, a resilient rand and potential downside GDP growth risks still offset overly hawkish positions somewhat," says Schoeman. "Some MPC members may consider a vote for a one-off 50BP hike, but we believe that on balance 25BP will prevail."
The caveat is how long oil prices remain elevated. Citi is considering two extreme scenarios, which denote a full percentage point range of possibilities for CPI.
Its bear scenario envisages oil peaking at $97 a barrel but falling to $62 a barrel by year-end, in which case SA’s CPI would average 5.6% in 2022, slowing to 4.1% in 2023.
In its super-bull scenario, oil peaks at $150 a barrel in the second quarter and then remains elevated at $125 a barrel to the end of the year. On this take, SA’s CPI would average 6.5% in 2022, slowing to 4.5% in 2023.
Citi’s base case is roughly in the middle. It assumes that oil prices will peak in the second quarter of 2022 at $102 a barrel and fall to $60 a barrel by the second quarter of next year, allowing inflation to moderate over the medium term and the Bank to stop raising the repo rate by mid-2023 once it reaches 5.5%.
Momentum Investments economist Sanisha Packirisamy has also adopted a scenario-based approach.
The Bank will keep a close eye on the Fed’s pace of increases but can be gradual in hiking. Steep rate hikes are not necessary or desirable
— Izak Odendaal
In her base case, devised before the US and Europe declared energy sanctions on Russia, oil and gas prices remain elevated for a few months but their structural supply is unaffected. Europe avoids a recession and though the US Federal Reserve, and probably also the MPC, front-load their rate-hiking cycles, both avoid successive 50BP hikes.
"In SA, as long as the local currency remains resilient and sheltered by higher commodity prices, we would see inflation averaging 5.2% in 2022, with a limited effect on core inflation," says Packirisamy.
Given a relatively unchanged medium-term inflation forecast, and the assumption that inflation expectations remain anchored, she still expects a terminal repo rate of 5.75%, though it would likely be reached a few quarters earlier in 2023.
Packirisamy’s domestic growth forecast also remains unchanged at 2% for 2022 and 1.8% for 2023, given SA’s limited trade and foreign direct investment linkages with Russia and Ukraine, and the fact that SA’s terms of trade has recovered to its previous highs.
Momentum’s downside risk scenario is considerably bleaker. It assumes a complete ban on Russian energy imports, which would cause a major and lasting disruption to global energy markets.
Should international oil prices remain elevated and risk aversion rise, SA’s headline CPI would likely average above 6% in 2022 and inflation expectations would come under threat.
Though higher oil prices would erode consumer purchasing power and could shave up to half a percent off growth, Packirisamy believes "the Bank would nevertheless have to hike into stagflationary conditions as inflation expectations threatened to de-anchor and its credibility came under increased scrutiny".
Inflation is going to rise everywhere. The Reserve Bank could hike six times this year, taking the repo to 5.25% by year-end. It depends on how long oil prices remain elevated
— What it means:
The term "stagflation" — which describes a situation of persistently high inflation coupled with high unemployment and stagnant or slowing growth — is increasingly being invoked to describe current conditions.
Indeed, there are similarities with the 1970s, says Odendaal: a US economy going into a crisis with elevated fiscal spending (thanks to Vietnam), a Fed that was initially dovish on inflation (due to political pressure from US president Richard Nixon), and then conflict (the Yom Kippur War) and the oil embargo of 1973, after which oil prices tripled virtually overnight.
For a world that was used to cheap, abundant oil, this came as "a hammer blow". US inflation rose from 2% at the start of 1972 to peak at 12% in 1975. By 1978 it was climbing again. Then the Iran Revolution caused another oil spike in 1979, and inflation gapped another leg higher.
But here is the crucial bit: instead of prices being pulled down, as would normally occur in a recession, inflation continued to accelerate in the 1970s — perhaps because the US and other advanced economies failed to tackle it quickly enough.
"It took Fed chair Paul Volcker’s crushing interest rate hikes to cause a deep recession and finally break inflation’s back," says Odendaal.
"This is why the 1970s are remembered as such a miserable decade for ordinary people."
However, the world has changed since the 1970s, he notes. Economies were not only much less flexible then, they were also a lot more dependent on oil. (Columbia University estimates that in real terms it required a full barrel of oil to generate $1,000 of global economic output in 1970 compared with less than half a barrel today.)
Moreover, while no-one expected Putin’s war, oil prices north of $100 a barrel are not new. In real terms, the oil price today is quite a bit below its peak a decade ago.
The key question for Odendaal is: when does an oil shock cause inflation to accelerate, and when does it erode real incomes to such an extent that consumers and businesses cut spending elsewhere, and other prices face downward pressure?
As ever, context matters. Unlike the US, SA is not a booming economy with rapid credit growth, labour shortages and a risk of overheating. Yes, commodity prices are giving the economy a boost, but for most South Africans conditions are tough.
Core inflation also remains muted, which is a sign of low demand-pull inflation. And, importantly, the rand is proving resilient, thanks to higher metal and coal prices. Granted, sharp rand depreciation has historically seen the Bank react forcefully, but the pass-through of exchange rate weakness into domestic inflation has declined considerably.
"This time, there is no need for such urgency, even though headline inflation is likely to breach the 6% upper end of the target," says Odendaal. "The Bank will keep a close eye on the Fed’s pace of increases but can be gradual in hiking. Steep rate hikes are not necessary or desirable."
But even if the Bank remains more cautious than hawkish, the stagflationary shock caused by the war has dampened SA’s growth prospects just at the time when both the domestic and global economy were recovering well from the pandemic. It is a calamity SA cannot afford.
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