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
No.
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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