Steep electricity price hikes and double-digit pay settlements will put upward pressure on inflation in the coming months, limiting the scope for more interest rate cuts this year.

Most analysts expect the Reserve Bank to cut its key repo rate by a full percentage point to 7.5 percent at its policy meeting this month, to help pull SA out of its first recession in 17 years.

But after that – assuming there are no radical changes in economic policy – the scope for further easing looks limited.

It takes interest rate cuts more than a year to make themselves fully felt, so the Bank targets inflation over a one- to two-year horizon.

Economic output is likely to shift back into gear later this year, and at the same time inflation is not falling as fast as expected.

One of the culprits is administered prices, which are at least partly set by government agencies. They have a combined weighting of about 15 percent in the consumer price index (CPI) targeted for interest rates.

Near-term outlook has worsened

At its twice-yearly monetary policy review last week, the Bank revealed more detail on its latest inflation forecasts, which show the near-term outlook has worsened.

Inflation measured by the annual rise in the consumer price index (CPI) is now seen exceeding its 3 percent 6 percent target range until next year.

"I must admit that there is some stickiness of the rate of the decline (of inflation) and some of the problem is administered prices," the Bank's governor, Tito Mboweni, said last week. Speaking at the release of the Bank's monetary policy review, he repeated his appeal to price setting authorities to keep inflation targeting in mind.

But electricity utility Eskom has applied for a 34 percent rise in tariffs this year, which if granted may keep inflation out of its target range for longer than expected.

Inflation has exceeded its official target range for two years, but has subsided to 8.5 percent from a peak of 13.7 percent last August. The Bank sees it at 5.4 percent by the end of next year. But Nomura analyst Peter Attard Montalto sees it stuck at 6.2 percent.

The other smoking dragon for SA's inflation rate is wage hikes, which amounted to an average 10.2 percent for the first quarter of this year, up from 9.8 percent last year and 7.3 percent in 2007.

Staff were granted a 10% pay rise

Mboweni admitted last week that even staff at the Bank had been granted a 10 percent pay rise for this year. The overall trend does not augur well for the inflation outlook.

Citigroup economist Jean-Francois Mercier believes that the Bank is approaching a point where it should be prudent with its rate cuts. "There's quite a few scenarios where inflation could still be above six percent at the end of 2010," he said. "They will be taking a bit of a risk if they cut by a percentage point this month."

One of the problems is inflation expectations, which tend to become a self-fulfilling prophecy. The latest survey from the independent Bureau for Economic Research shows that trade unions see inflation at 10.1 percent next year – almost double the level predicted by financial analysts.

The Bank is betting heavily on the "output gap" – the difference between the potential and actual growth rate - to keep price pressures at bay. This seems fair enough, with the economy likely to have contracted more sharply in the first quarter of this year than it did in the final quarter of last year.

But even Bank officials point out that the risks to its inflation forecasts are higher than usual, given extreme global volatility and uncertainty.

That is the main reason why the Bank has decided to hold policy meetings every month this year, except July. Mboweni has pointed out that this does not mean there will be a rate cut every time.

Credit Guarantee economist Luke Doig says the steep pace of company failures is abating, which also indicates the end of the rate cutting cycle may be within sight.

Nonetheless, analysts believe that interest rates will fall by another one-and-a-half percentage points in the next few months, taking the prime lending rates of commercial banks to their previous low of 10.5 percent.

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