Interest rates affect your life regardless of whether you are borrowing or not. Not only are they the cost of acquiring or using money, but they are also used as a powerful tool in controlling the pace of the economy and other major indicators within it.
The repo rate is controlled by the Reserve Bank and is the benchmark rate that commercial banks pay when borrowing from the central bank. It is 3.5 percentage points lower than, and directly affects, the prime rate, which is the benchmark annual rate that commercial banks charge consumers and businesses.
Interest rates affect us directly as soon as we need to borrow money or spend on credit because they are the expense we pay for using money we don’t have.
But they are also the expense we pay for using money we do have. If you decide to buy a R100 000 car for cash, you have sacrificed the opportunity to put that R100 000 in an interest-earning account or investment, a decision that could cost you up to R900 a year in potential earnings. Therefore, the higher the interest rate, the less likely you are to borrow or spend money.
There is another indirect dynamic affecting our lives. Ideally, the government and Reserve Bank want to promote high levels of spending and economic growth. However, if spending and demand exceed the ability of suppliers to increase their production at the same pace, it will result in too much money chasing too few goods and prices across the economy will rise.
To combat this, the central bank traditionally uses interest rates to bring inflation (the rising of prices) under control. It increases the repo rate, causing commercial banks to increase their rates and the demand for borrowing to decrease. Consumers and businesses spend less and the average level of demand for goods in the economy drops. This means that every person involved in selling a product or service is likely to see a dip in their profit.
Inflation targeting therefore limits short-term growth in the economy and this is the reason labour unions such as Cosatu are strong opponents of the policy.
In recent times, the Reserve Bank has sought other methods of keeping inflation under control without choking the economy with high interest rates.
One way of doing this is to allow the rand to strengthen against the currencies of South Africa’s main import sources. A large proportion of local consumption is made up of imported components – for example, oil – and when the rand is stronger, these goods are relatively cheaper.
The price of imports has a strong influence on the cost of production and the level of prices locally and, while a stronger rand causes demand for local goods to decrease, it also slows inflation and allows the central bank to stall any necessary increases in the interest rate.
This, essentially, is the conundrum that faces our economic management. Growth would be easy with low interest rates and a weak rand, but both of these things would lead to escalating inflation.
Prolonged inflation increases the cost of living, disintegrates wealth and reduces the competitiveness of local products, all of which negate the benefits of growth in the first place. The only way to truly empower the economy towards meaningful growth is to increase the amount of real value added by its industries and this will require capacity, skills and time.
Pierre Heistein is the course convener of the part-time UCT Applied Economics for Smart Decision Making short course, presented online throughout South Africa by GetSmarter, www.getsmarter.co.za.