Unsurprisingly, South Africans keep a close eye on the outlook for interest rates. Local consumers are highly indebted: for every R100 in disposable income, South Africans carry a debt burden of about R75. So changes in the cost of loans directly impact their cost of living and financial viability. In fact, changes in interest rates have implications for practically all aspects of economic life.
Not all central banks adopt as predictable an approach to monetary policy as the South African Reserve Bank (SARB). However, some misconceptions about our interest rate policy remain widespread. For example, if inflation falls back into the target band of 3% to 6%, why would this not immediately prompt lower interest rates? Conversely, when inflation is above the target range, why are interest rates not immediately increased? Furthermore, do the downgrades of SA’s sovereign debt to non-investment grade inevitably mean higher interest rates? Lastly, could the SARB lower interest rates to lift SA’s growth performance?
Below I debunk four of the most common monetary policy misconceptions.
SA’s central bank pursues an inflation target of 3 percent to 6 percent. When inflation comes in below 6 percent, this means lower interest rates, right?
Yes, and no.
Through changes to the policy rate, the SARB adopts a monetary policy stance to preserve the value of the currency by keeping inflation in check at between 3 percent and 6 percent year-on-year (y-o-y). SARB Governor Lesetja Kganyago has previously stated that he would like to see annual inflation become anchored in the middle of the target band at around 4.5 percent y-o-y. Since inflation targeting was introduced in 2000, inflation has remained anchored at the upper end of the target range above 5 percent. As a result, renewed price pressures generally entailed a breach of the upper limit, prompting the central bank to adopt a tighter monetary policy stance.
Structural rigidities, including upward pressure on wages and energy prices, are partly to blame for inflation consistently coming in at the upper end of the target range. The SARB can progressively help to soften these price rigidities by adopting a transparent and predictable approach to its interest rate policy. This entails that the SARB assures wage and price setters of a largely predetermined, muted price trajectory that should prompt inflation-linked increases in wages and administered prices.
“As long as this remuneration-price dynamic persists, our ability to lower interest rates is constrained.” SARB Governor Lesetja Kganyago, September 2016.
Read also: Rates cut expected later in year
The ultimate target of 4.5 percent y-o-y is not the only reason the SARB may not immediately lower interest rates as inflation initially falls below 6 percent y-o-y. In addition, the central bank’s decision on interest rates is forward looking. While the SARB can influence future inflationary outcomes, interest rate movements have a limited effect on current price changes. A shift in monetary policy can take as long as 18 months to filter through various sections of the economy to effect price changes. As a result, while a current reading of inflation could fall into the SARB’s target range, only if the outlook for inflation is also within the target band, would the central bank consider lowering interest rates.
When inflation comes in above 6 percent y-o-y, the SARB categorically increases interest rates
This will also depend on the outlook for inflation. Since interest rates must filter through the economy to impact prices, the central bank watches closely how domestic and global events may influence the outlook for various drivers of inflation. Key inflation drivers have recently included food and non-alcoholic beverages at an average inflation rate of 10.7 percent y-o-y and transport costs at 6.9 percent y-o-y in the first three months of 2017. Only when the outlook for these inflationary drivers suggests inflation may fall within the target range, will the SARB move towards a more lax monetary policy stance.
Furthermore, SA’s central bank would consider whether these inflationary drivers are reactive to changes in interest rates. The historic drought in 2016 drove up food price inflation to levels above 12 percent y-o-y for the majority of last year. However, the SARB was restrained in the degree of monetary tightening it adopted. Increases in interest rates would have done little to allay food price pressures triggered by supply shortages.
Lastly, Governor Kganyago has emphasised the monetary policy committee (MPC) is highly sensitive to the possible adverse implications of stricter monetary policy on South Africa’s fledgling growth recovery. The SARB is cautious about raising interest rates in a low-growth environment, given the economy is no danger of overheating as a result of heightened demand pressures. The central bank is concerned about the local economy slipping into stagflation, that is, high unemployment, high inflation and negligible economic growth.
Downgrades inevitably mean higher interest rates
Possibly, but not directly.
In short, recent downgrades of SA’s sovereign debt rating imply the state faces growing borrowing costs and therefore reduced fiscal space for growth-enhancing spending programmes. General government net debt as a percentage of GDP increased in recent years from a low of 22 percent in 2008 to an estimated 45 percent in 2016. The cost of interest payments relative to SA’s debt burden decreased from the recent high of 11.6 percent in 2007 to 8 percent in 2015. The downgrades of SA’s creditworthiness prompt elevated risk perceptions and imply higher government interest payments that take resources away from essential growth projects. Already, the interest burden equates to the annual salaries of about 700 000 social workers or teachers, 5 500 community centres, or 3 100 schools.
This potentially places SA on a lower long-term growth trajectory and implies muted employment creation and higher poverty rates, undermining the objectives of the National Development Plan (NDP), SA’s economic growth blueprint.
How does this influence the outlook for interest rates?
Slowing GDP growth triggers a loss in investor confidence and a weakening rand, in turn, raising the risk of imported inflation. Higher inflation then prompts the SARB to implement stricter monetary policy. Recent domestic political uncertainty has contributed to rand volatility, reflecting domestic and global investor jitters and undermining SA’s objectives of stimulating fixed investment. The rate of fixed capital formation has shrunk throughout 2016, declining by 3.9 percent compared to the previous year. With private enterprises contributing close to two thirds of fixed capital formation, stimulating investor confidence will be essential for laying the tracks for greater economic growth in coming years.
Read also: No surprises in rates announcement
Soon after the downgrades of SA’s sovereign debt rating by S&P Global Ratings and Fitch Ratings, the rand exchange rate recovered and has since stabilised around R13.50/$. The rand has been bolstered by a weaker dollar, improved Chinese trade data and global demand for emerging market assets. Due to a comparatively strong local currency, the SARB may keep interest rates stable at this month’s MPC meeting, due to a lower risk of imported inflation.
Lower interest rates can fix SA's growth challenges
Not in the long run.
Various economic schools of thought differ on the degree of responsibility monetary policy can take for facilitating higher growth rates. The SARB adopts the view that it is through creating a stable financial environment that monetary policy fulfils an important precondition for fostering economic development. Furthermore, it is in the interests of balanced and sustainable growth in SA that the SARB protects the value of the rand and keeps inflation in check.
SA’s growth challenges are structural: high unemployment, the skills gap, and geographic inequities are deeply entrenched in the structure of the economy. Sound fiscal policy, especially through fixed investment spending, in tandem with improved political and policy certainty can make a dent in SA’s triple challenge of high unemployment, poverty and inequality. Conversely, it is unlikely that lower interest rates on their own can overcome these challenges. What is more likely is that unwarranted reductions in interest rates would imply higher inflation, a weaker rand currency, and therefore higher costs of living that disproportionately impact the poor.
“Looser monetary policies will not get our people Bachelor of Science degrees or move their residences close to where the job opportunities are. Nor will lower interest rates reform our labour markets.” SARB Governor Lesetja Kganyago, April 2017
In spite of the limitations of monetary policy in contributing directly to economic growth and employment creation, Governor Kganyago regularly confirms the MPC is conscious of the possible negative implications of stricter monetary policy, especially for consumer demand, and therefore carefully weighs the risks associated with every interest rate decision.
Outlook for this month’s interest rate decision
The MPC is meeting between 23 and 25 May to determine whether a change in its monetary policy stance is required following recent political and economic uncertainty. At the last MPC meeting, the central bank left interest rates unchanged, keeping the repo rate and prime interest rate at 7 percent and 10.5 percent respectively. SARB Deputy Governor Daniel Mminele indicated early in April that it was too soon to draw firm conclusions on how the cabinet reshuffle and consequent sovereign credit rating downgrades would influence the SARB’s inflation forecasts.
Current inflationary outcomes suggest the MPC may have room to keep interest rates on hold in May. Consumer inflation in March decreased to 6.1 percent y-o-y, from 6.3 percent y-o-y in February, confirming inflation has moderated since peaking at 6.8 percent y-o-y in December last year. This slowdown is largely facilitated by more benign food price inflation, which recorded 8.7 percent y-o-y in March compared to 10 percent y-o-y in February. Food price inflation has thus decelerated from close to 12 percent y-o-y in the preceding four months.
All eyes are on Moody’s Investors Service and S&P to see if the rating agencies will follow in Fitch’s footsteps by downgrading the country’s local currency rating to sub-investment grade. For a country like SA, the local currency debt credit rating is essential as the bulk of SA’s debt is issued domestically in rand. Any significant outflow of foreign investment funds due to SA losing its local currency investment rating would be a blow to recent currency strength and could force higher interest rates in coming months.
Maura Feddersen is an Economist in Financial Risk Management for KPMG in South Africa.
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