Reserve Bank can cut interest rates now – but there’s a catch

The Reserve Bank can begin cutting interest rates at its next meeting as inflation steadily declines to the midpoint of its target range. 

However, it will be unable to cut rates significantly, with only a few rate cuts expected next year, as a reduction in interest rates will weaken the rand, potentially reigniting inflation.

The Reserve Bank’s Monetary Policy Committee (MPC) left the repo rate unchanged at its July meeting, keeping rates at 15-year highs. 

This is despite the bank’s forecasting that inflation will hit its 4.5% objective next year. 

Old Mutual Wealth investment strategist Izak Odendaal said if they skate to where the puck is going, they can start cutting already. Two of the six MPC members favoured a cut and are skating in that direction.

The other MPC members who voted to keep rates unchanged were concerned that inflation expectations were still above the target point. 

However, expectations tend to follow actual inflation and have already declined meaningfully, Odendaal said. 

The other concern is that a divergence in interest rates between South Africa and other major economies, notably the US, can result in rand weakness as capital tends to flow to where risk-adjusted returns are highest. 

Rand weakness can place upward pressure on inflation as it will increase the cost of importing goods into South Africa, particularly oil. 

However, backward-looking inflation data continues to improve. Consumer inflation declined to 5.1% year-on-year in June from 5.2% in May. 

Odendaal cautioned that this doesn’t mean prices are falling. It just means that they are rising at a slower rate. 

Core inflation, excluding volatile food and fuel prices, declined to 4.5%, which aligns with the Reserve Bank’s objective. 

Food and fuel prices matter most to consumers and are very visible, being items that are purchased regularly. Together, they account for a quarter of the consumer price index. 

However, core inflation is useful for underlying domestic inflationary pressures since food and fuel prices are largely set in global markets.

Notably, rental inflation, which is surveyed quarterly, remains subdued. Owners’ equivalents and actual rent make up 15% of the CPI basket and have risen from very low levels.

However, annual inflation rates of 2.7% and 3.2%, respectively, still imply soft economic conditions and make the case for lower rates.

This suggests that the SARB will be able to cut rates in September and November, the last two meetings for the year, and a few times next year. 

This turning point will ease pressure on consumers and indebted businesses, but in South Africa, rates are unlikely to decline too much.

Odendaal’s comments echo those of Stanlib chief economist Kevin Lings very closely. Lings also said the Reserve Bank may begin cutting rates soon, but the cutting cycle will likely be short and shallow. 

Lings identified rising prices for administered services, such as electricity tariffs, as being a driver of inflation that is unlikely to come down in the next 12 months. 

He said that interest rates are likely to only come down by a cumulative 100 basis points in the next year, providing little relief for consumers. Rates have risen by 475 basis points since November 2021. 

For example, the cost of electricity averaged a growth of 15.2% year-on-year in the first five months of 2024 and has not been below 6% for many years. 

The cost of water rose by an average of 7.9% in the first five months of 2024, education by 6.1% and medical aid by 10.6%.

Thus, bringing inflation towards the midpoint of the Reserve Bank’s 3% to 6% target range is heavily dependent on limiting the increases in the price of basic services. 

Lings also highlighted the consistent weakening of the rand by 5.5% a year versus the dollar, which drives inflation by making imports more expensive. 

Another major factor in keeping inflation higher for longer is the repeated above-inflation wage increases for government employees and union members. 

This is coupled with declining labour productivity, reducing South Africa’s competitiveness and increasing the cost base of the economy.