Warning about changes to Reserve Bank’s inflation target

The lowering of the Reserve Bank’s inflation target will have significant implications for interest rates, which will most likely be kept higher for longer. 

This will have significant implications for the local economy, with higher interest rates constraining spending and, thus, growth. 

Furthermore, if the new target is not consistently met, which will be more difficult than the current range of 3% to 6%, then the Reserve Bank’s credibility may be diminished, as may South Africa’s attractiveness as an investment destination. 

This is feedback from Pieter Koekemoer, the head of personal investments at Coronation, who outlined some of the trends influencing interest rates towards the end of the year. 

Interest rates are firmly on the way down in South Africa and worldwide, with the US Federal Reserve kicking off its cutting cycle with an aggressive 50 basis points cut in September. 

The Reserve Bank followed a day later with a 25 basis points cut. Coronation expects another 25 basis points cut in November and 75 basis points more in 2025. 

While domestic demand remains weak and inflation is well contained due to a strengthening rand and declining oil prices, some are making the case that domestic interest rates are still too high, Koekemoer said.  

The current prime rate of 11.5% is still significantly higher than the 10% just before the onset of the Covid pandemic in early 2020. 

This is partly due to the Reserve Bank’s hawkish approach to monetary policy, with it preferring smaller rate cuts to avoid reigniting inflation. 

A tighter, more hawkish policy stance typically acts as a headwind for financial markets, while a looser, more dovish stance is often supportive of asset prices.

Another reason policymakers may keep rates higher than historical norms is the debate about lowering the inflation target.

The rationale for a formal inflation target is to enhance transparency and credibility and to make it easier to manage inflation expectations in the economy. 

South Africa introduced a formal target in 2000, with a target range of 3% to 6%. This was intended to gradually reduce to between 2% and 4%, but this reduction was never implemented.

Since 2021, the Reserve Bank has revived the debate, arguing that the target should be reduced to 3% to better align South Africa with global norms. 

One of the key arguments in favour of a lower target is that lower inflation will lead to a more stable rand, which will make domestic investment more attractive.

Reserve Bank Governor Lesetja Kganyago recently made the argument for a lower inflation target, saying it can be achieved at relatively little cost. 

“We were clear that we wanted inflation at 4.5%, and we delivered,” Kganyago said. Still, South Africa’s inflation rate has remained relatively high compared to its international peers. 

“We have a relatively high inflation rate. We often speak as if this is a structural, inevitable thing and not a policy choice.” 

“But the fact is, we could have a lower inflation target, like almost all our peers, and with it, lower inflation.”

In February, the Treasury said the goals were under review, with the process being complex and involving political buy-in. 

While Kganyago said achieving a lower inflation rate can be done at little cost, Koekemoer thinks there may be some short-term and potential long-term costs. 

In the short term, some economic growth needs to be sacrificed as interest rates will remain higher for longer to meet the lower target. 

In the longer term, credibility will be sacrificed if the new target is not consistently met, reducing the attractiveness of South Africa as an investment destination. 

Elevated public debt levels and a track record of government inefficiency, expressed in consistent above-inflation increases in administered prices, such as water and electricity, increase the long-term risks. 

Weaker economic growth in the short term could test the patience of the factions required to keep the ruling coalition together. 

As always, economic policy remains a complex trade-off that needs to be made under uncertain conditions, Koekemoer said.