Conjecture about lowering SA’s inflation target from its current 4.5% has gained momentum since the publication in February of the National Treasury’s macroeconomic policy review.
It is argued in the review that the goals of inflation targeting have “broadly been achieved … but some adjustments to the framework may be desirable given inflation differentials compared to our peers and trading partners”.
Given that the target is 4.5%, SA’s inflation rate remains above the global average (4%) and its main trading partners: Germany (2%), the US (2%), China (2.5%) and the UK (2.6%), bar India (7%). In accordance with the principle of purchasing power parity (PPP), this persistent differential requires the steady depreciation of the rand’s value, creating a feedback loop as a weaker currency puts pressure on inflation.
Since the February 2000 introduction of inflation targeting by the Reserve Bank, inflation has averaged lower with reduced volatility. Exogenous shocks (for example, a higher oil price) have also been contained more effectively and inflation has reverted to target faster at lower interest rates. This is because inflation expectations have been better anchored.
By protecting the value of the currency, inflation targeting has significant fiscal advantages. Theoretically, sovereign bonds need to compensate investors for a sovereign’s default risk over and above the global risk-free rate. Local currency bonds must provide additional yield for currency risk (figure 1).
It is argued in the review that SA’s fiscal policy has become structurally unsustainable at current GDP growth rates, increasing the credit/default risk priced into its bonds. Since credit risk is unlikely to compress in the medium term, it is up to monetary policy to do the heavy lifting to counter macroeconomic risks.
Lower, less volatile and more predictable inflation compresses the currency risk premium embedded in local currency sovereign bond yields. It should also reduce the term risk premium by reducing interest rate uncertainty. A lower inflation target can therefore lead to lower long-term borrowing costs and reduce the cost of servicing inflation-linked bonds. Treasury’s inflation-linked expenditure would also benefit: we estimate that inflation of 3% versus 4.5% would reduce the wage bill by R60bn over the current medium-term expenditure framework.
Surprisingly, no economic research has determined a country’s optimal inflation rate, or more specifically the optimal trade-off between inflation and growth. Over the longer term, inflation is a function of population growth, utilisation of labour and capital, and productivity, or total factor productivity, which broadly refers to technology and efficiency.
Greater total factor productivity allows a country to grow faster without generating higher inflation. For example, the introduction of the internet permitted increased growth without having to increase employment and generate wage inflation. SA’s productive capacity has been in decline, such that faster growth necessitates higher inflation. This makes the Bank’s job difficult. The Treasury has looked to use trading partner inflation as a guide, implying SA’s target should be lowered to 3%-3.5%.
Is it practical for SA to lower its inflation target when the headline consumer price index (CPI) has been above 4.5% for almost 80% of the time (excluding 2020) since it was explicitly targeted in 2017?
Over the past five years, headline CPI has averaged 5% and administrative price inflation has averaged 7.2%. If we exclude administrative price inflation, CPI has averaged 4.5% — exactly on target. It is likely SA could achieve a lower target excluding administrative prices, which are not responsive to monetary policy and require political buy-in. From a theoretical perspective, political buy-in would allow SA to increase its total factor productivity.
Lower inflation requires the policy rate to remain higher for longer. Lowering the target to 3% is expected to take more than two-and-a-half years and, while it would still allow the Bank to cut rates, it would be at a slower pace. The gain associated with this initial pain is that the terminal rate would be lower; SA rates can be cut to 7% if inflation is at its 4.5% target. If inflation were to slow to 3%, rates could be cut to 5.5%.
Figure 2 provides a stylised model. The policy rate remains above its 4.5% inflation target profile until mid-2027, after which it falls rapidly as inflation is assumed to respond, with a 12- to 24-month lag, to higher rates for longer, and moves towards a 3% target.
The Bank is working on its next five-year strategy plan, which is likely to include a lower inflation target. The announcement is the responsibility of the finance minister and will likely be at the presentation of the medium-term budget policy statement or the February 2025 budget.
Interestingly, when the US Federal Reserve implemented an inflation-targeting framework, it did not make the target public as then Fed chair Alan Greenspan did not want his discretion constrained: “If you make 2% public, and you’re running at 2.5%, then the question is, ‘why aren’t you creating unemployment to get to 2%?’ That’s not a position anyone really wanted to be in.”
The decision to lower the target is reached by consensus between the Bank and National Treasury. We expect this to be a robust debate and another opportunity for the Bank to display its independence.
• Silberman is economist and macro strategist at Matrix Fund Managers.
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