South Africa’s plan to lower inflation target

South African Reserve Bank Governor Lesetja Kganyago wants to lower the country’s inflation target to 3%, which can significantly impact the economy and markets.

Kganyago said in a statement that he wants to lower South Africa’s target inflation rate from its current range of 3% to 6% before 2025.

He noted that South Africa implemented the 3% to 6% target in 2000, with the goal of lowering it to 3% to 5% and then to 2% to 4%. However, this did not happen.

Kganyago mentioned that he thinks it was a mistake not to lower the inflation targets as initially planned.

With economic policy, it is difficult to predict what impact changes like lowering the inflation target would have.

Lower inflation rates have advantages despite the unpredictability of the impact on the economy.

One benefit is that South African consumers will be able to preserve more of their purchasing power.

Wages typically adjust slowly to high inflation. This means higher target inflation rates erode purchasing power quicker.

The nature of employment contracts and adjustments to employed positions make wages much less reactive to rapid price changes to goods and services.

Price stability may also give international investors more confidence to invest in South Africa, which can strengthen the rand.

A lower expected inflation can also push up the prices of long term government bonds thereby lowering long-term rates.

This would be the ideal scenario with lowering the target inflation rate.

However, the biggest problem with lowering the target inflation rate in South Africa is how policymakers will achieve it.

Lower inflation rates would lead to tighter monetary policies, which would raise South Africa’s interest rates even higher than they are now.

This may positively impact the rand as more offshore investors would pour money into South Africa to take advantage of these higher rates.

However, there are also big drawbacks to higher interest rates in South Africa.

The obvious problem is that higher interest rates increase the cost of borrowing capital within the economy. This inhibits expansion and lowers economic growth.

Another troubling aspect, specific to South Africa, is its high levels of debt. At 74.1% of annual GDP, South Africa is at the very limit of its debt capacity.

The issue flowing from this is the interest that South Africa needs to pay on this debt.

In the 2024/25 budget, interest on debt formed 16% of the National Treasury’s planned expenditure.

The higher interest rates required to lower the target inflation would further increase this line item.

Together with this, South Africa’s economy is experiencing very low to no economic growth. The average annual GDP growth is around 0.5% since Q2 2019.

With higher interest rates and low economic growth, South Africa risks losing control of its debt.

This scenario would risk South Africa getting further credit downgrades which would raise our longer term interest rates instead of lowering it.

This can have the complete opposite effect with offshore investors pulling funds out of South Africa in fear of government defaults, further weakening the rand.

South Africa’s main problem is not that its target inflation rates are set too high. It is its heavy debt burden, which must be reduced before target inflation rates are lowered.

Higher economic growth will also make it much easier for South Africa to implement a lower inflation target.

The main inhibitor for economic growth in South Africa is government overregulation and business unfriendly policies.

The solution is for the government to unshackle the private sector to encourage business and economic growth.

Economic growth will generate more tax revenue, enabling the state to reduce its debt. This, in turn, will give it the freedom to lower the inflation target.