South Africa’s financial battle between the government and Reserve Bank

The government’s consistent raising of administered prices above headline inflation will complicate the Reserve Bank’s plan to lower its target inflation rate. 

This is feedback from Old Mutual chief investment strategist Izak Odendaal, who outlined some of the problems with the lowering of the Reserve Bank’s inflation target range. 

Set by the National Treasury, the inflation target range is currently 3% to 6% and has been since 2000 when targeting was first implemented. 

Most countries around the world prefer to set specific target points with a range of 1% on either side of that point. 

The debate around South Africa’s inflation target has been ongoing for years, but intensified recently when the Reserve Bank and National Treasury entered official talks.

Inflation targeting is a framework in which a central bank uses monetary policy tools, particularly controlling short-term interest rates, to maintain inflation at a target level.

Governor Lesetja Kganyago has been one of the most vocal proponents of a lower inflation target, aiming to bring South Africa in line with more advanced economies and bolster the rand. 

There appears to be consensus regarding the lowering of the inflation target, with the question being when and how it will be implemented, rather than whether it will be implemented. 

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, Odendaal said. 

While the former is preferable, the latter might be chosen to minimise the short-term impact on economic growth from higher rates. 

The impact of higher interest rates to meet a lower inflation target is one of the main hurdles preventing the lowering of the target. 

Reserve Bank modelling indicates the impact will be minimal, but will still be felt in the short term, with growth in the long run picking up. 

However, there is another major complicating factor, which is the government’s role in driving inflation higher through deficit spending and tariff increases. 

Odendaal explained that the government is the biggest culprit when it comes to elevated inflation and interest rates, with administered price increases running well above the 3% to 6% target range. 

This makes it difficult for the Reserve Bank to keep a lid on inflation as many of these price increases involve products and services which are universal inputs into the economy, such as electricity. 

Thus, when they are raised, the entire cost base of the economy increases. In effect, the Reserve Bank has to limit private credit growth more severely than necessary to keep inflation under control, limiting economic growth. 

Benefits of lower inflation

There seems to be consensus within the National Treasury and the Reserve Bank that the current inflation target range is too wide and out of line with South Africa’s major trading partners. 

For example, South Africa’s three largest trading partners – China, the United States, and the European Union (EU) – all have an inflation target of 2%. 

This is far lower than South Africa’s target range and results in a weaker currency to make up for the increased cost of producing goods in the country. 

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

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%.

That makes a huge difference in terms of global trade, with South African goods becoming effectively 20% more expensive in that scenario. 

In theory, this is cancelled out by a weaker currency, which should keep the country’s exports competitive. However, this has other implications, such as making the cost of importing goods more expensive. 

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

There will still be cycles, but the peaks and troughs should be lower, translating into lower interest rates for a longer period of time.  

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.

Kganyago, in the latest Monetary Policy Committee (MPC) statement, said that the Reserve Bank’s analysis shows these benefits outweigh the short-term costs. 

“Now that inflation has slowed, we have a chance to lock in lower inflation at low cost. This scenario illustrates that opportunity,” he said. 

Therefore, for a 3% objective, the central bank’s Quarterly Projection Model shows a lower path for interest rates. 

He explained that both the central bank’s baseline and the 3% scenario have a cut in this quarter. 

“However, rates move steadily lower in the scenario as inflation comes down. The policy rate falls to just under 6%, rather than staying above 7%, as in the baseline,” he said. 

“Inflation expectations stabilise at 3% during 2026, helped by the experience of lower inflation.”

He warned that growth in this scenario would be somewhat slower at first because real rates are initially higher. However, he said the economy does better later in the forecast, as rates ease further.

“The MPC is of the view that the 3% scenario is more attractive than the 4.5% baseline, and we would like to see inflation expectations move lower, towards the bottom end of our target range,” he said.