With a virtual doubling in the electricity price looming over the next three years, a consumer price index (CPI) that excludes electricity tariffs is being suggested by some policymakers as the new measure of inflation to target.The rationale behind this move is clearly to try to avoid the substantial impact of the electricity tariff hikes on inflation and hence on interest rates and growth.
The proposed 35% hike in the electricity price this year would immediately add 0,65% to the CPI in the month of July, for example. To put it another way, consumer price inflation would come out at 6,0% year on year in July instead of 5,3% y/y. Removing electricity prices from the CPI would mean such an increase could be avoided.
However, the second- and third-round effects of higher electricity prices on inflation would not be cancelled out. These effects will have a greater impact on the cost of living and production than the rise in the electricity price itself.
Specifically, the second-round effect of higher electricity tariffs will be to push up the cost of the manufacture and sale of goods and services in SA, resulting in significantly higher costs of doing business and living.
This will also make goods produced in SA for export less competitive. An additional or third-round effect will occur when the higher cost of living and doing business becomes entrenched in SA, resulting in significant increases in salaries and wages to compensate.
Indeed, the impact on the CPI of the second- and third-round effects is likely to be a lot greater than the direct impact of the electricity price increases themselves, not least because of the minor weighting of electricity tariffs in the measure.
Excluding electricity prices from the calculation of CPI will therefore not stop inflation rising - the targeted measure of inflation will remain at or above 6,0% over the next couple of years, if an annual tariff increase of 35% or more occurs (and in the absence of any countervailing disinflationary or deflationary forces).
Imposing higher interest rates when it is expected that inflation will remain above 6,0% in the period targeted (about six to 18 months ahead) would be ludicrous. Price increases in goods and services produced in SA are unavoidable with substantially higher electricity costs, as electricity is a basic factor of production.
In addition, the resulting higher interest rates would merely eat into already diminished disposable incomes, further delaying economic recovery and employment creation, in the same way as higher taxes would.
It would be far better to widen the inflation target to take account of the effect of higher administered prices, especially as water tariffs are also likely to rise substantially in the future, along with costs to improve SA's infrastructure.
The inflation-targeting band should be temporarily (and only temporarily) widened to 2,0%-2,5% around the midpoint, instead of the current 1,5%, with the midpoint itself at 5,0% or even 5,5%. Ideally, the target band should be narrowed over a few years, eventually bringing it back down to the current 3%-6%.
Merely using CPI minus electricity prices as the targeted measure of inflation will not be enough, though it is a tempting way out at face value.
The national budget will be presented to parliament on February 17 and this would be the earliest that any changes to the inflation-targeting prices could be announced. The medium-term budget towards the end of the year provides a second opportunity.
Bishop is an economist at Investec
