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Interest rates are a powerful tool for controlling economic behaviour. In South Africa, the Reserve Bank sets the repo rate, which is the rate at which commercial banks borrow money from the central bank.

The prime lending rate is the rate at which commercial banks lend to the public and it tracks movements in the repo rate almost perfectly. About six times a year, the bank’s monetary policy committee (MPC) decides whether to adjust the repo rate.

Some speculators suggest that at the next meeting in March, the MPC may lower the repo rate if the rand remains strong, while others see rates rising later this year to keep a lid on inflation.

Since 2000, South Africa has embarked on a formal inflation-targeting strategy to try to keep consumer inflation between 3 percent and 6 percent. Controlling interest rates is a key method in achieving this target. Inflation occurs due to two effects: demand-pull and cost-push inflation.

Cost-push inflation occurs when the input costs of production rise and this is passed on to the price of the final good. Interest rates have no influence over this. Demand-pull inflation is caused when the level of demand in the economy exceeds the level of supply and prices increase as a result of too many people chasing too few goods. It is here that interest rates can have considerable influence.

Interest rates are the price of money. To spend, you must either use your own money or you must borrow. If you use your own, you will incur the opportunity cost of the interest you could have earned had you left your money in the bank, whereas if you borrow, then the amount you borrow comes at the direct cost of the interest rate you pay on your loan or credit card. In both cases, a high interest rate will cause less borrowing and less spending, curbing demand, where a low interest rate will encourage borrowing and boost spending.

When the central bank feels that inflation is rising too high, it is likely that it will swell interest rates to increase the cost of money and thereby shrink spending, slow demand and cut inflation. Spending is the backbone of any economy. When it does not come at the cost of achieving its inflation target, the bank will support spending and economic growth as much as possible.

It is therefore likely that as soon as inflation shows signs of falling comfortably within the target, the bank will decrease interest rates to encourage spending and growth. Interest rates are the crude reins used by the bank to keep gross domestic product (GDP) growing at the desired pace.

The increasing strength of the rand has reduced export demand for local goods and increased South Africans’ appetite for foreign goods. The resultant lessening of demand for South African goods will loosen the demand-pull effect on inflation. It would be expected, therefore, that inflation will decrease and the Reserve Bank will respond by decreasing interest rates.

Inflation takes many months to respond to the policies and rate changes of the bank, and more often than not, the bank will adjust the interest rate based on expected future inflation.

Factors other than a strong exchange rate, which may indicate an imminent fall in interest rates, are slower-than-expected economic growth, lower-than-expected key input and living costs (as was the case last September with the lower-than-expected electricity tariff rises), and lower-than-expected current inflation results.

Pierre Heistein is the course convener of the University of Cape Town’s Applied Economics for Smart Decision Making course, which starts on March 14. Visit www.getsmarter.co.za.