Inflation here to stay – spelling trouble for interest rates

Inflation has become entrenched in parts of the South African economy, and the second-round effect is starting to be felt. This will result in interest rates being higher for much longer than expected. 

This is feedback from Stanlib chief economist Kevin Lings, who outlined the Reserve Bank’s difficult situation regarding rate cuts. 

He explained that the South African economy is very weak, which would typically trigger interest rate cuts, but numerous upside risks to inflation are preventing this. 

Although the country avoided slipping into a technical recession at the end of 2023, the economy is stagnating.

Unemployment remains extremely high at over 30%, the government debt to GDP ratio now exceeds 75%, and the government’s debt servicing cost is more than 20% of total tax revenue.

Encouragingly, Lings said good progress, albeit slow, has been made in implementing the government’s reform agenda, which should see economic activity pick up. 

However, persistently high inflation is set to constrain this potential uplift, as this will cause interest rates to remain high and suppress demand. 

In 2023, South Africa’s inflation rate averaged 5.9%, down from 6.9% in 2022 but up from 4.5% in 2021, 3.3% in 2020, and 4.1% in 2019. 

For 2024, inflation is forecast to average 5.2%, although this has been revised up from an expected average of 4.9% as recently as December 2023. 

Lings said further upside risks to inflation linger, including second-round effects related to higher electricity and water prices, the recent upward pressure on the oil price, and rand weakness. 

Fortunately, some of these risks are being mitigated by the already high interest rates and the fact that sluggish economic activity makes it harder for companies to pass on some of these price pressures. 

These mitigating factors could allow the Reserve Bank to start to cut interest rates in the second half of 2024, but these rate cuts will be pushed back a few months towards the middle of the third quarter. 

At its most recent monetary policy meeting towards the end of March 2024, the Reserve Bank decided to keep the repo rate unchanged at 8.25%. 

It highlighted that although interest rates are restrictive, service inflation has become more entrenched at a higher level, and inflation expectations remain relatively elevated. 

Since November 2021, the repo rate has increased by 475 bps, taking it to its highest level since April 2009 – the highest interest rate in 14 years. 

The Reserve Bank governor also emphasised that 4.5% is the real inflation target and that the current inflation rate of 5.6% is closer to the top end of the 3% to 6% target range than the midpoint.

The combination of upside risks to inflation, coupled with a desire to see SA’s inflation rate revert to 4.5%, suggests that although interest rates have peaked, the repo rate is likely to stay elevated for at least a few more months than previously expected. 

“At this stage, we expect interest will remain unchanged well into the second half of 2024, with a cut in rates possible by the middle of Q3 2024, especially if the US continues to delay its own rate-cutting cycle,” Lings said.