Reserve Bank interest rate dilemma

The Reserve Bank finds itself in a difficult position – low inflation points to interest rate cuts, but a volatile global environment and a potential weakening of the rand if rates are cut force it to adopt a wait-and-see approach. 

Old Mutual Wealth investment strategist Izak Odendaal recently outlined some of the key reasons why the Reserve Bank’s Monetary Policy Committee (MPC) decided to keep rates steady in March. 

At its March meeting, the MPC voted four to two to keep the repo rate unchanged at 7.50% after three consecutive 25 basis point cuts. 

This is despite consumer inflation surprising to the downside in February, remaining unchanged at 3.2% year-on-year, well below the midpoint of the 3% to 6% target range. 

Core inflation, excluding food, fuel and energy prices, was 3.4% in February. 

The Reserve Bank also lowered its inflation forecast for 2025 to an average of 3.6%, while 2026 and 2027 remain at 4.5%. 

A lower assumed oil price and somewhat stronger currency more than make up for the 0.2 percentage points the National Treasury’s proposed VAT increases are likely to add.

Odendaal explained that if you take the current repo rate and subtract the Reserve Bank’s inflation forecast, you get a forward-looking real repo rate of 3.9% this year. As inflation rises somewhat, it declines to 3% in 2026 and 2027. 

This is still high, given that the Reserve Bank’s estimate of the neutral real rate – which is already high – hovers slightly above 2.5%. Real rates are, therefore, closer to being “restrictive” than being “accommodative”. 

In fact, the MPC statement has dropped any reference to whether rates are “restrictive” or “accommodative”. It is all about the global environment. 

This implies that if the global situation settles down, South Africa will likely see a couple more interest rate cuts. 

Significant global risks

While the inflation outlook has improved, the Reserve Bank’s MPC was unwilling to cut interest rates at its most recent meeting due to global factors. 

Odendaal explained that this simply boils down to the MPC being unwilling to add any further volatility to markets and adopting a wait-and-see approach. 

With the United States administration proposing a radical overhaul of its trade policy, which could potentially ignite a trade war, the Reserve Bank wants to wait to see if any of these proposals become policy. 

This is a very similar approach to the United States Federal Reserve, which has signalled its intention to wait and see the effects of US President Donald Trump’s stated policies on inflation and economic growth. 

The Fed’s problem is that it does not know how tariff increases will impact economic growth and inflation since no one knows exactly what will be implemented as yet. 

Odendaal said Trump has a habit of announcing and then postponing tariff increases, and it is unclear what threat is meant to extract concessions and what is likely to stay. 

Thus, the inflation outlook has improved, but the uncertainty around that outlook has widened. Like the Fed, MPC members do not know exactly what lies ahead and are following a cautious approach. 

It should be noted that the Bank of England’s MPC also kept rates unchanged last week for broadly similar reasons. 

Another major concern for the Reserve Bank is the potential for an interest rate cut to lead to a rapid weakening of the rand. 

This is a potential effect because if the US Fed were to keep its rates on hold and the Reserve Bank were to cut rates, the interest rate differential between the two countries would narrow, making local assets less attractive to investors. 

Odendaal explained that if the gap between South African and US interest rates is too small, money will leave our shores and flow to the US.  

This could lead to a disorderly depreciation of the rand, higher inflation, and unmoored inflation expectations. 

The appropriate spread will depend on market conditions. The more anxious investors are, the higher the interest rate required for the risk of investing in an emerging market like South Africa.  

This is the main reason the Reserve Bank’s estimate of the neutral real rate is so high.

Nonetheless, if things settle down internationally, it implies that there is room for another rate cut.