Interest rate hikes not the only solution to inflation

Lesetja Kganyago

PSG Wealth’s chief investment officer, Adriaan Pask, said interest rate hikes are not the right mechanism for fighting inflation in all environments – particularly in South Africa, where economic growth is limited.

The South African Reserve Bank (SARB) recently decided to pause its hiking cycle for the first time since November 2021, when it started.

Since the beginning of its hiking cycle, the SARB has implemented ten consecutive interest rate hikes and a cumulative 475 basis points of hikes. This has brought the country’s repo rate to a 14-year high of 8.25%.

As the hiking cycle continued, experts questioned whether interest rates were the most effective method to manage South Africa’s inflation. It is a blunt tool with the potential to hamper economic growth significantly.

In response to these concerns, SARB governor Lesetja Kganyago has acknowledged that interest rates are a blunt tool used to control inflation. However, he asked, “Interest rates are a blunt instrument – but is there a sharper one I can use?”

While acknowledging they are blunt, he denied that interest rates are ineffective, saying the recent downward trend in South Africa’s inflation is due to the SARB’s rate hikes.

Local interest rate compared with consumer confidence. Source: PSG Wealth/FactSet

However, Pask said the drivers of supply-side inflation and demand-side inflation are fundamentally different.

The SARB’s website defines demand-side and supply-side inflation as follows:

  • Demand-side inflation: When consumers spend more money, prices tend to rise faster. By contrast, when consumers are under pressure and spend less, prices rise more slowly. 
  • Supply-side inflation: Inflation tends to decrease if it becomes cheaper to produce a good or service. For example, globalisation made it cheaper to produce manufactured goods such as clothes and electronics. Conversely, inflation could increase if it becomes more expensive to produce a good or service. For example, a drought raises food prices

Pask said monetary policy theory suggests higher prices are reduced by muting what is assumed to be cyclically higher demand. In other words, by targeting demand-side inflation.

However, in South Africa, “we don’t have too much demand, we clearly have too little, the economy is under significant pressure”, he said. 

Pask said much of what South Africans are experiencing in the form of higher prices is related to issues on the supply side rather than driven by higher demand. 

“The inflationary effects caused by a lack of a steady and stable supply of energy globally has been exacerbated locally by the impact of electricity shortages and load-shedding,” he explained.

“Businesses are increasing prices to offset the additional costs they have to incur, in the form of diesel for generators, for example.”

The country’s weak currency, projected to average more than R18/USD in 2023, is another factor driving inflation.

According to Pask, sales volumes are suffering with economic growth under pressure. 

Businesses are, therefore, unable to take on additional margin pressure and pass these costs on to consumers, who are already feeling the brunt of increased costs. 

“In such an environment, hitting the economy with higher interest rates is hardly going to do much to reduce the prevailing inflation drivers.”

Adriaan Pask

Pask specified that there are legitimate reasons for increasing interest rates beyond just fighting inflation.

However, “it does seem that the interest rate mechanism is a rather blunt tool for reducing inflation”. 

He said that, rather than merely hiking interest rates, the focus should be on managing supply-side issues more effectively, which would help address inflation without hindering economic growth.

For example, supportive policies, such as reducing cumbersome application processes for Independent Power Producers (IPPs) and temporary reductions in the general fuel levy, can reduce supply-side inflation while promoting economic growth and job creation.

Another useful approach could be improved fiscal discipline, he said. The cost of funding is increasing as the perceived risk of lending in South Africa has increased. 

Therefore, by improving fiscal discipline, lending cost decreases, effectively reducing input costs.

Lessons from the UK

History of UK inflation and monetary policy action. Source: PSG Wealth/FactSet

Pask said a good example of where monetary policymakers were willing to tolerate higher inflation while supply-side challenges subsided can be seen in the United Kingdom.

The UK experienced higher inflation and strained growth for periods between 2007 and 2012.

Over this period, inflation surged twice from 2% to 5%, high by developed market standards, yet the Bank of England either reduced interest rates or kept them stable to support economic stimulus.


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