The fast view
- The South African Reserve Bank (SARB) – like most other global central banks – targets inflation to achieve its mandate but has also historically monitored underlying core inflation measures.
- The SARB recently released two research papers on the persistent and common component of inflation (PCCI) and supercore inflation, and both measures will now be considered going forward.
- Supercore inflation, which is monitored globally by central banks like the European Central Bank (ECB), has garnered most attention.
- The papers were written in June when these measures were both above traditional core measures.
- A key question is how they are likely to evolve and the impact they will have on monetary policy outcomes.
The primary purpose of the SARB is to achieve and maintain price stability in the interest of balanced and sustainable economic growth. Like most other central banks, it targets inflation as its anchor for price stability. However, while the SARB targets headline inflation, it also pays significant attention to underlying inflation to get insight into the longer-term direction of headline inflation to ensure it can implement appropriate monetary policy.
The reason for this is that headline inflation is susceptible to short-term shocks. It can be volatile, with a high noise-to-signal ratio. Underlying inflation measures are designed to try and filter out these temporary price movements and identify the sticky parts of inflation.
Central banks most often look at core inflation, which typically removes seasonal fluctuations and volatile inputs such as food and energy prices, and the SARB is no exception. Various other underlying inflation measures have been developed including trimmed mean inflation, weighted median inflation, PCCI (persistent and common component of inflation) and supercore inflation.
The SARB recently released a special occasional bulletin. Two of the three research papers in the bulletin constructed and presented two inflation measures to help unpack underlying inflation pressures that may not be picked up by the traditional measures like headline, core and trimmed mean inflation, which have been the ‘official’ measures that the SARB monitors. Bloomberg reported that both of these new measures will be considered together with Statistics South Africa’s headline and core inflation measures to inform monetary policy in the future.
One of the measures is supercore inflation, which has received the most attention from the media. Largely following the ECB methodology, this new measure is made up of components of core inflation that are highly sensitive to economic conditions. It therefore gives the SARB’s monetary policy committee (MPC) a steer on whether inflationary pressures observed are supply or demand driven.
The other measure presented in the occasional bulletin was the PCCI. The key function of employing the PCCI is to determine persistence in inflation regardless of whether it is driven by supply-side or demand-side pressures.
More on the new inflation measures
- The indices in supercore are a subset of core inflation – the analysis uses disaggregated CPI data at COICOP1 level three. It uses 40 log-transformed quarterly indices. For each of the indices three Phillips curves are estimated, which respectively include the output gap lagged by a quarter, two quarters and the third, a combination of both lags.
- Based on the outcome of the authors’ modelling, 11 components showed statistical significance to the output gap. The three largest components in supercore are rentals, water and other services, and household content – these are heavily skewed towards services.
- Supercore showed that demand-driven inflationary pressures were balanced over the prior year.
- PCCI is a non-exclusion-based measure and therefore no information is lost. It uses factor modelling as a dimensionality reduction technique. There are no macroeconomic assumptions made.
- PCCI being higher than core inflation, is mainly reflective of below-average post-pandemic housing inflation and medical aid inflation.
To be useful to monetary policy decision-making, both these measures must be less volatile than headline inflation and give insight into the direction of headline inflation. The MPC targets headline inflation and not any of these measures (including core inflation). However, the new measures can help to provide a better picture of the balance of risks to the inflation outlook. If the measures show elevated and persistent inflation despite low headline inflation, the MPC could delay a rate-cutting cycle. Conversely, if there is higher headline inflation, but persistent inflation pressures are subdued, it might provide room to maintain the current policy stance.
Even though headline inflation is well behaved (4.6% in July), and core inflation is at 4.3%, both new measures indicate that there are some underlying inflation risks. In our view, this means that at its September meeting, the MPC is likely to be cautious and will only cut 25 basis points (bps). The market is pricing in a maximum cycle of 100/125bps of cuts, without any large moves. While there is room for rates to move lower, these new measures currently point to a slow and steady pace of cutting.
1 The Classification of Individual Consumption According to Purpose (COICOP) is the international reference classification of household expenditure.
