South Africa's central bank maintained its benchmark repurchase rate at 5.5 percent but held out the prospect of further rate rises, saying it still believes that it is in a rising interest rate cycle and started the process of normalizing interest rates in January when rates were raised 50 basis points.
"Inflation is currently at uncomfortable levels and a marked deterioration in the outlook may require action that we will not hesitate to take," Gill Marcus, governor of the South African Reserve Bank (SARB) said in a statement.
Although a recent appreciation of the South African rand has eased some of the upward pressure on inflation, Marcus said this respite could be temporary and the risk from the exchange rate "remains a significant source of upside risk," with signs of some acceleration in the pass-through from the exchange rate to inflation.
In addition, the timing and normalization of monetary policy in advanced economies appears to have been pushed out further into the future and may be more moderate than previously believed.
However, Marcus said the SARB was very aware that this could change quickly so future policy decisions would hinge on economic data and the outlook for inflation.
"The MPC reiterates that a rising interest rate cycle does not mean that rates will be raised at each meeting, or by the same amount each time," Marcus said.
South Africa's central bank has been faced with a dilemma for months, with upside risks to inflation and a deteriorating outlook for economic growth.
Headline inflation continued to rise in April, topping expectations at an annual rate of 6.1 percent, and above SARB's target range of 3.0 to 6.0 percent. It was the fifth consecutive month of rising prices, driven by higher costs of housing, utilities, food and non-alcoholic beverages.
SARB trimmed its forecast for 2014 inflation to 6.2 percent from an earlier forecast of 6.3 percent, with a peak expected in the fourth quarter this year of 6.5 percent, down from 6.6 percent.
Inflation is expected to remain outside SARB's target band from the second quarter of this year until the second quarter of 2015, when average inflation is still forecast at 5.8 percent, the same average rate as in 2013.
SARB extended its forecast to cover 2016, with inflation seen averaging 5.5 percent and 5.4 percent in the fourth quarter.
SARB's outlook for core inflation is also largely unchanged, with the measure seen averaging 5.6 percent this year and 5.7 percent next year, easing to 5.5 percent in 2016.
"The upward pressure is assessed to be a response to the lagged effects of the exchange rate depreciation rather than evidence of strong domestic demand pressures," Marcus said, adding that it still considers the risk to the inflation forecast to be skewed to the upside and is concerned that the current low level of pass-through may not persist.
An expected slower pace of normalization of U.S. monetary policy has helped improve the global appetite for risk and capital flows to emerging markets have resumed, apart from sizable outflows from Russia due to the conflict with Ukraine.
The capital inflows has helped boost emerging market currencies, including that of the rand, and led to lower bond yields.
In sync with other emerging market currencies, the rand tumbled in May 2013 and continued to weaken until Jan. 29 this year. From the start of 2013, the rand fell 25 percent before hitting a low of 11.30 to the U.S. dollar.
Since then it has appreciated, trading at 10.38 to the dollar early on Thursday, down only 0.8 percent this year, and up 3.3 percent since SARB's previous meeting in March.
Portfolio flows to South Africa have been in line with global trends, Marcus said, with net inflows to bonds and equities totaling 7.6 billion rand year-to-date.
But the central bank is "mindful" of the rand's sensitivity to global and domestic factors" and expects it to remain vulnerable to changing perceptions of U.S. monetary policy and capital flows.
"However, while the recent appreciation is more a reflection of changing global risk perceptions rather than a specific re-assessment of South African fundamentals, domestic factors have also impacted on the rand," Marcus said, including the current account balance.
The ongoing strike in South Africa's platinum sector is expected to have a significant negative impact on exports now that inventories are reaching low levels, and a further extension of the strike could impede the required improvement in the current account.
South Africa's current account deficit was 178.875 billion in the fourth quarter of last year for a full-year deficit of 5.8 percent of Gross Domestic Product, up from 5.2 percent in 2012 and 3.4 percent in 2011.
The outlook for economic growth has recently deteriorated markedly, Marcus said, with the forecast for growth this year revised down 2.1 percent from a previous 2.6 percent. The forecast for 2015 is unchanged at 3.1 percent and growth in 2016 is seen averaging 3.4 percent.
In 2013 South Africa's economy grew 1.9 percent, down from 2.5 percent in 2012.
Marcus said the risks to the growth forecast are on the downside and growth in the first quarter was negatively affected by contractions in both the mining and manufacturing sectors.
The unemployment rate also remained high at 25.2 percent in the first quarter and consumption expenditure by households is expected to remain constrained by weak credit extension, rising inflation, high debts and the knock-on effects of the mining strike where the cumulative loss of wages is estimated to have exceeded 8 billion rand.