THE end of the cycle of rising short-term interest rates in SA that began in January 2014 is, thankfully, in sight. Given the continued weakness of demand for goods and services, it will take the assumption of a more or less stable rand, at about current exchange rates, to bring inflation and forecasts of inflation in 2017 well below the upper 6% band of the inflation targets.
The Reserve Bank model of inflation has reduced its estimate of inflation in December 2016 to 7.1% from its May forecast of 7.3%. The Bank, which was predicting a gradual decline in headline inflation in 2017, has reduced its central estimate of inflation in December 2017 at 5.5%.
The Reserve Bank has revised lower its already weak GDP growth forecasts. It is forecasting no growth in 2016 (previously 0.6% a year) and an anaemic 1.1% a year. GDP growth in 2017 compared to 1.3% a year estimated previously. Our own exercise in simulating the Reserve Bank forecasting model using current exchange rates has generated the following forecasts for headline inflation. The governor indicated that the Bank’s own forecasts were made with unchanged assumptions about the exchange rate-hence the slightly higher estimates of inflation.
A combination of slow growth with less inflation vitiates any possible argument for higher interest rates for now, and hopefully for an extended period to come.
Should inflation sustain a downward trend and growth in SA remain well below potential growth, the case for cutting rates to stimulate growth will become irresistible in due course. High food prices brought about by the drought have already stopped rising (according to the June consumer price index) and so will help materially to reduce the rate at which prices in general rise next year. The chances have improved for a very helpful inflation and interest rate surprise in the downward direction.
These developments in the currency and capital markets raise a question difficult to answer: given the impossibility of rewinding the economic clock, did the rates hikes imposed on a fragile economy do anything to hold back inflation?
Given the global forces that have driven the exchange value of the rand weaker, it is not at all obvious that higher interest rates have made the rand more attractive to hold or acquire. Nor will interest rate increases have done anything to offset the effect of President Jacob Zuma’s intervention in fiscal affairs that made the rand such an underperforming emerging currency and bond market until recently.
Indeed, by further slowing growth, higher interest rates may have discouraged investment in SA and weakened rather than strengthened the rand — while discouraging the credit rating agencies, and so investors in the local bond market, leading to higher long-term interest rates.
What must be conceded is that the Bank’s rhetoric about interest rates — explained as bound to rise, given more inflation than expected — was correct. Any reluctance to act on interest rates would have seen the Bank accused of being soft on inflation, so undermining its independent inflation-fighting credentials.
READ THIS: Government has a lot to start fixing to dodge downgrade
An essential distinction that needs to be made by the Bank is about the different forces that can drive prices higher. The difference between prices that rise because less is being supplied to the economy, and prices that rise in response to higher levels of demand that run ahead of potential supplies, calls for very different monetary policy reactions. It is a vital distinction about inflation the Bank has refused to acknowledge.
Inflation has accelerated mostly because of supply-side shocks — supplies of goods and services have reduced and higher prices have followed. Exchange rate shocks — such as the drought that reduced local supplies of essential foodstuffs — have caused prices to rise independently of the state of domestic demand. These inevitably higher prices have further discouraged demand. Adding higher interest rates to the mix just depresses demand even further.
What the South African economy deserved and didn’t get from the Bank was a very different narrative. One that explained why interest rates do not have to rise irrespective of the forces driving prices higher. Excess demand justifies higher interest rates — reduced supply does not.
Sacrificing growth for no less realised inflation is not good monetary policy.
• Kantor is chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.