Interest rate pain for South Africa

South Africa is likely to experience some short-term interest rate pain as the Reserve Bank’s target is set to be revised lower to around 3%. 

Over time, this will be replaced with longer-term gains for the country as it will benefit from having an inflation target in line with developed economies, a stronger currency, and enhanced economic growth. 

However, there are still significant hurdles to overcome before this change is made official, with plans to lower the target being considered since 2000. 

This is feedback from Old Mutual chief investment strategist Izak Odendaal, who outlined some of the drawbacks and positives of a lower inflation target in a recent research note. 

The Reserve Bank has been making the case for a lower inflation target for years, with it releasing a white paper on the impact of a 3% target. 

Ultimately, the National Treasury determines the inflation target, and all the Reserve Bank can do is use its tools to achieve its stated target. 

Discussions between the two institutions have been ongoing, but the latest Monetary Policy Committee (MPC) statement notes that they are at an advanced stage. 

When the inflation target was first adopted in 2000, Odendaal explained that it was to move from 3% to 6% to 2% to 4% within a few years.

That never happened because there was a massive inflation spike not long after implementation, requiring some flexibility in implementation. 

The most likely option today seems to be a 3% target with a 1% tolerance band on either side, but it could also be a 4% target that moves lower after a few years. 

The former is preferable, based on the earlier failure to lower the target as promised. Either way, inflation will still be cyclical, and so will interest rates, Odendaal said. 

The transition to lower implies some short-term pain for longer-term gain. In the short term, rates remain higher with a lower target than if the current target remained in place. 

Simply put, if the aim was 3%, then inflation is currently on target and will rise above target over the medium term, limiting the case for rate cuts. 

If the goal is 4.5%, inflation sits well below target, and will only rise towards the target over time, creating more room for cuts.

This implies some sacrifice of economic growth to achieve lower inflation, hence the Treasury’s reluctance to move too quickly. 

There is disagreement on how big this “sacrifice ratio” is, but the Reserve Bank’s own modelling suggests it is small. 

Interest rates are only somewhat higher in the short term, and economic growth is only somewhat lower. By 2027, rates are lower and growth is higher than projected in the baseline forecast.

The benefits 

The long-term benefits fall into three categories, with varying degree of impact on the South African economy and consumers. 

Firstly, when inflation is high, price signals get muddled, with it being increasingly difficult for individuals to determine if prices are rising because of demand for a product, a supply problem, or if everything is rising.  

When prices are generally stable, but the price of one item jumps, it says something about that product. There is obviously a rising demand for it, or there is a supply problem. 

However, if prices consistently rise across a broad front, it becomes difficult to know what signal and noise are. At worst, this can distort incentives and reduce economic efficiency.

Secondly, if a country’s price level rises more than its peers, it will lose competitiveness over time, as its exports will increase in price faster than its competitors. 

Most members of South Africa’s emerging market peer group moved towards a 3% inflation target. If South Africa’s price level rises 4.5% per year and the peer group by 3% per year, the difference over 10 years will be 20%. 

Compared to developed countries with a 2% inflation target, the difference will be 35%. Seemingly minor differences compound over time.

The theory of purchasing power parity (PPP) suggests that exchange rates must ultimately adjust to compensate for this loss of competitiveness. 

While PPP does not hold in the short term when sentiment and capital flows dominate, it tends to hold over the long term, and indeed, the experience with the rand since it became a truly free-floating currency has been a long-term depreciation. 

In other words, sustained lower inflation will reduce the pace at which the rand loses value in foreign exchange markets over time.

Thirdly, and quite simply, sustained lower inflation should help maintain the purchasing power of households over time, particularly low-income households. Interest rates will also decline. 

There will still be cycles, but the peaks and troughs should be lower. Lower borrowing costs will raise economic activity. It will also make South African bonds, equities and real estate more valuable over time, all else being equal.