Russia’s invasion of Ukraine and tightening sanctions on Russia have sent commodity prices soaring, and will have adverse implications for South Africa’s headline consumer price inflation (CPI), says senior economist at Absa CIB, Peter Worthington.
The invasion has directly led to higher oil and grain prices, which directly push up prices of key goods within the CPI such as fuel and bread, he said in a research note on Tuesday (15 March).
“In addition, sharply higher commodity prices could also lead to second-order inflationary effects, for example as public transport or food prices are increased to offset firms’ higher fuel costs.”
Worthington said ongoing supply chain disruptions to semiconductor chips could also push up prices of cars, TVs and computers in the coming months.
Absa’s data shows that the following CPI basket components are most likely to be affected by the war (% weight in CPI):
- New vehicle purchases: 5.42%
- Fuel: 4.82%
- Bread and cereals: 3.16%
- Public transport: 2.43%
- Recreational equipment: (including TVs and computers): 0.60%
- Oils and fats: 0.45%
- Household appliances: 0.44%
How the fuel price leads to inflation
Each 10% rise in the price of crude oil equates to an additional 0.2 percentage points directly on the CPI, said Worthington.
“Fuel prices in South Africa are set according to a formula, which essentially leaves fuel prices as a direct function of crude oil prices, the exchange rate and a wedge of taxes, administered distribution margins, and the like.”
As of January, this wedge accounted for 54% of the pump price of fuel – for Gauteng 93 specifically, he said.
“With fuel accounting for 4.82% of the CPI, a 10% increase in the price of crude – all other things being equal – translates to a 4.6% increase in the pump fuel price, which in turn translates to an additional 0.2pp directly on the headline CPI.
“Thus, assuming that Brent crude oil now tracks sideways at $130/bbl out to the end of 2023, instead of the $85.5/bbl average we assumed for 2022 and $73.7/bbl for 2023 when we ran our forecast, the headline CPI average would be 0.8pp higher in 2022 and 0.6pp higher in 2023 – purely as a function of pump petrol prices.”
Of course, other prices within the CPI basket could also rise due to knock-on effects of fuel price increases, he said.
One of the most obvious of these is public transport prices, which account for 2.4% of the CPI basket, but a much higher share of the consumption basket of low-income households.
Surprisingly, the correlation between fuel prices and public transport prices is not very close, perhaps because of threshold effects and some downward stickiness in public transit prices, said Worthington.
Despite this, he noted that in the past couple of years, big increases in fuel prices seem to have sparked higher transit prices.
“These second-order inflationary effects are not limited to just public transport. For example, food retailing has some costs that are intrinsically tied to the fuel price. Bread products, for instance, have distribution costs that are somewhere between a quarter to a third of the shelf price.
“Despite the weakness of demand, if fuel prices surge, food producers may have no alternative but to pass on at least some of the cost increases to consumers.”
Another example of a potential second-order inflationary effect could be higher wage settlements as workers demand compensation for the increase in commuting and staple food costs, he said.
Absa now forecasts that food price inflation could average 6.5% this year and 7.7% next year, with a peak of over 9% in early 2023.
“Food prices are another big upside risk to South African consumer inflation, Worthington said. “In the long run, South Africa’s food price inflation roughly mirrors the big turning points in global food price inflation.”
Currently, higher global grain and oilseed prices globally are pushing up South African grain prices as well, but the transmission of this into food shelf prices is complex, and not as clear cut as the set formula used to adjust fuel prices each month, he said.
“For instance, one might expect the relationship between ‘bread and cereals’ – which is predominantly wheat-based products – and wheat futures prices to be pretty close, but in fact, the correlation seems to vary over time.
“Ultimately, the magnitude of cost increases that food manufacturers pass on is a function of many factors that are not constant, including their assessment of demand sensitivity, substitutability, profit margins, and market share threat from competitors, amongst other factors.
This makes it difficult to build rule-of-thumb estimates for how much of the changes in prices of certain crops transmit to CPI inflation, he said.
“That said, although the relationship between crop prices and shelf food prices is not straightforward, we can still observe from historical data that crop-sensitive food items often tend to move about six months after the point of a sustained increase in crop prices.
“Moreover, since the current crop price increases are coming together with higher fuel costs and prices of other raw materials, we believe that the pressure to adjust prices may be stronger than usual.”