The SA Reserve Bank has been making the case for a lower inflation target since 2021, and it now looks like the proposal is gaining traction. But what is driving the push? Are there benefits and what are the potential risks?
Inflation targeting was formally adopted by the Bank in February 2000, with a target range set at 3%-6%. At the time, average annual inflation for the preceding five years had been 6.4%, and the target was consistent with global practices and those of SA’s emerging market (EM) peers, many of which were grappling with persistently high inflation.
Twenty-five years later though, much has changed. Emerging market central banks have narrowed and lowered their inflation targets, with several converging at about 3%. Despite having a strong and credible central bank, SA remains an outlier, with a higher target. In 2017 the Reserve Bank began to argue for a lower inflation target, and the monetary policy committee (MPC) began to explicitly target 4.5%, the midpoint of the 3%-6% range.
The conversation has progressed, and a growing body of Bank research makes the case for shifting the official inflation target to 3% over the medium term. The Bank’s motivation for lowering the target is clear: lower inflation would reduce the economy’s average interest rate over time, reducing the cost of borrowing and resulting in billions of savings of debt service costs for the fiscus over the next decade.
If successful, the combination of stronger real growth and lower borrowing costs could lower the cost of capital across the economy, potentially driving investment and lifting valuations across multiple asset classes.
However, the transition to a lower inflation target is not without risks. To lower inflation the MPC typically increases interest rates (via the repo rate). SA is already grappling with weak GDP growth, supply-side bottlenecks and fragile consumer demand. High interest rates are likely to stifle already fragile growth even further in the short run. In addition, if inflation expectations are not successfully lowered to the 3% level the result would be more volatile inflation and a loss of credibility.
The experience in Brazil provides a cautionary tale: the country lowered its inflation targets too, but fiscal dominance and political pressure have at times undermined the central bank’s credibility and inflation expectations remain above the 3% target. Brazil’s experience illustrates the challenges of anchoring expectations, and highlights that loose fiscal policy can undermine monetary policy credibility.
The Reserve Bank working paper argues that now is the ideal time to implement a shift in the inflation target. Domestic headline inflation has been consistently printing close to the lower end of the 3%-6% target range, hovering at 2.7%-3% in recent months. This disinflationary trend has been supported by lower fuel prices, a stronger rand and a benign global inflation environment.
Inflation expectations in SA are adaptive — they tend to follow recent outcomes. Price setters and wage negotiators base their forward-looking assumptions on recent inflation prints. This provides the Bank with an opening to guide inflation expectations towards the 3% level while inflation is already low.
A change in the inflation target can only be implemented through close alignment and agreement between the Reserve Bank and National Treasury. The latter recently indicated that its technical work on the potential adjustment to the inflation target was at an advanced stage. After this communication, government bond yields rallied, reflecting growing market confidence that a policy shift might come sooner rather than later, with some market participants anticipating a formal announcement of the change as early as October during the medium-term budget policy statement.
A lower inflation target implies that the Bank will be more hawkish and less tolerant of inflation surprises as they pursue anchoring inflation expectations lower over the implementation period of two to three years. As seen in June, the global macroeconomic environment is volatile and susceptible to sudden shocks — the geopolitical tension in the Middle East between the US, Iran and Israel pushed oil prices from $66 to $80 per barrel, albeit briefly. In a 3% inflation targeting regime such external shocks from a fragile global environment could elicit a stronger monetary response by the Bank. This means potentially keeping the repo rate higher in the short run to defend the credibility of the lower inflation anchor.
If the Reserve Bank succeeds in guiding inflation expectations lower, it will raise real yields offered by SA bonds, which will make them more attractive to foreign investors. Elevated real yields with a credible lower inflation regime could provide strong support for rand-denominated assets. The rand could also benefit from the enhanced credibility, resulting in longer-term increased currency stability.
As inflation expectations begin to trend lower, the yield curve is likely to respond accordingly. A more stable inflation environment is supportive of a compression in inflation risk premiums, particularly at the long end of the yield curve. This, with improved policy credibility, could result in a flattening of the yield curve over time.
The shift to a lower inflation target would mark a structural change in the SA macro framework. For investors this introduces opportunity and risk: the transition will not be linear, and it will depend on the Bank’s ability to maintain its credibility and guide inflation expectations lower without stifling an already struggling economy.
In the interim, investors should position for a world where lower inflation and tighter policy coexist, and where portfolio strategy must adapt to a more anchored, but possibly more demanding, macro regime.
• Makondo is fund manager at PSG Asset Management.
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