Big interest rate cuts on the cards for South Africa

South Africa could experience significant interest rate relief if all goes according to the Reserve Bank’s plan, with its forecast model suggesting that up to 100 basis points of cuts are possible. 

These major cuts would be a result of inflation settling in at a lower 3% target, which the bank’s Monetary Policy Committee (MPC) is implicitly targeting. 

The National Treasury and the Reserve Bank are still in discussions regarding the move to an official lower inflation target. 

This move promises to bring significant long-term benefits, such as faster economic growth and lower debt-servicing costs for the government. 

However, it is likely to come with some short-term pain, with interest rates likely to remain elevated for longer to ensure inflation settles in at a lower target point. 

Chief investment strategist and Old Mutual’s Symmetry Izak Odendaal said this was the case with the Reserve Bank keeping rates on hold at the latest MPC meeting despite benign inflation. 

Odendaal explained that the Reserve Bank has to ensure it maintains its credibility in targeting inflation and, with the target implicitly moving down towards 3%, it has to ensure inflation settles at this target. 

At the last MPC meeting, the Reserve Bank’s forecast model indicated that significant interest rate cuts are on the cards if all goes to plan regarding the move to a lower inflation target. 

The Reserve Bank’s forecast model projects where the repo rate is likely to be, given the growth and inflation outlook. 

The MPC always stresses that this forecast of the repo rate is only a guide and that rate decisions will always be based on data as it arrives. 

Nonetheless, the model suggests that up to 100 basis points of cuts are possible if things proceed as expected and confidence grows that inflation will likely trend towards 3%. 

The extent to which the Fed cuts rates will be a key factor. The more it reduces rates, the more likely the dollar is to decline, opening room for other central banks to ease. 

Though further repo rate cuts are unlikely this year, things could look different next year. Despite the impressive performance of the bond market this year, real interest rates remain high across the yield curve.  

Some patience will be required, as the transition to structurally lower inflation won’t happen overnight. However, when lower interest rates eventually arrive, it will undoubtedly be good for the local economy and local financial markets. 

The Reserve Bank’s forecasts can be seen in the graph below. 

Stability is key

One of the key advantages the Reserve Bank has over many central banks around the world, including the US Fed, is its stability and credibility. 

The MPC has effectively targeted inflation over the past 15 years despite a weakening currency and numerous global shocks. In addition, it remains an effective regulator of local financial markets. 

Crucially, the Reserve Bank does not face the same upheaval and uncertainty as the United States Federal Reserve due to US President Donald Trump’s comments and efforts to impose his will on the American central bank. 

All members of the MPC are Reserve Bank staff, which might lead to groupthink, but it avoids political drama, Odendaal said.  

Every now and then there are rumblings of nationalising the bank, one of the few worldwide still privately owned. Private ownership is not a guarantee of good policy, just as public ownership will not necessarily lead to bad policies. 

The main thing is that the bank will continue to be able to make independent, evidence-based decisions in the long-term interest of the economy, a freedom that is enshrined in the Constitution. 

Independence clearly does not guarantee that the Reserve Bank will always make the right decision, but it gives it the ability to take a longer-term view and make unpopular but necessary decisions.

The MPC recently decided to aim for the lower end of its 3% to 6% target range. The National Treasury must still formally change the inflation target to 3%, but the MPC’s focus has already shifted and informed its latest decision to keep the repo rate unchanged at 7%. 

However, two of the seven members preferred to cut rates, suggesting that the MPC will not necessarily be dogmatic as it transitions to the lower target.

For instance, the MPC statement noted that it wanted to see how the 125 basis points in rate cuts over the past year affected the economy. 

So far, inflation remains low. Consumer inflation declined unexpectedly to 3.3% year-on-year in August. This was mainly due to a surprise dip in food inflation. 

Core inflation, which excludes food and fuel prices, rose to 3.1% in August. There are other useful indicators, such as producer inflation (1.5% in July) or the retail sales deflator (2%). 

The broadest measure is the GDP deflator, but it has the drawback of being released quarterly, rather than monthly. It was only 1.4% in the second quarter.

In response to this experience of lower inflation, the Bureau for Economic Research’s latest inflation expectations survey showed a further declined in the third quarter.

Survey participants expect inflation to average 4.1% over the next five years, the lowest since the start of the survey in 2011. This is important since the Reserve Bank wants people to get used to the idea of lower inflation, such that it starts impacting their behaviour. 

The more businesses, consumers and workers believe that inflation will be 3%, the more likely inflation is to converge on 3%.

The Reserve Bank’s own forecasts suggest that this is not impossible. It expects inflation to average 3.4% this year and 3.6% next year, before declining to 3% during 2027. 

The projection includes the recently updated and increased electricity tariffs, which the MPC lambasted as highlighting the “serious dysfunction in administered prices, which undermines purchasing power and weakens growth”.