The Reserve Bank’s decision at the July monetary policy committee (MPC) meeting to explicitly target the lower bound of its inflation range (3%), and to communicate this clearly in its announcements and forecasts, represents a welcome reduction in policy uncertainty.
The market appears to agree. Movements in asset prices around the MPC meeting suggest that the monetary policy announcements had the intended effect. Since the Bank had signalled its preference in advance, little of the announcement came as a surprise. Nevertheless, the formal statement reinforced expectations and contributed to a downward shift in the long-term policy rate (see graph).
Furthermore, after an initial reaction, both the exchange rate and the country risk premium have been trending downward. This is confirmed by a more detailed analysis of the effect of the policy on asset prices, where we consider 17 different assets and study their reaction to the policy decision. The main reaction is a decisive downward adjustment of long-term premia, which are linked to a significant reduction of long-term expected inflation.
Thus, up to now, the market seems to move in line with the assessment of the Bank that stabilising inflation at the lower possible level, within the current inflation targeting framework, will help to reduce long-term interest rates.
The discussion following the Bank’s communication seems to focus on procedural aspects, but the substantive aspects merit closer inspection. The decision rests on three key considerations.
First, the 3%-6% target range reflected an inefficient regime design. It tolerated excessive inflation and generated significant uncertainty, leading to elevated long-term interest rates and sovereign bond risk premia. Importantly, the difference between 3% and 6% effectively corresponded to two distinct inflation regimes. At 6%, inflation substantially eroded purchasing power — particularly harmful in a country where a large share of the population depends on state transfers and weakly protected wages.
Moreover, the higher tolerance increased the risk that external shocks could push inflation to levels that would be costly to contain. The inefficiency of this framework has been well documented in numerous studies, including the review of SA monetary policy by Patrick Honohan and Athanasios Orphanides, commissioned by the National Treasury.
Second, higher inflation uncertainty and hence higher long-term rates impose large and unnecessary costs on the economy. After years of stagnation, the Bank can contribute to long-term economic growth by steering long-term interest rates to a lower level. In a small open economy reliant on international capital flows, this requires a reduction of both the long-term inflation rate and the associated country risk.
The notion that the Bank could sustainably boost growth by cutting unconditionally the policy rate is fantasy economics, as demonstrated recently by Turkey’s experience. This approach is not viable even in economies like the US, regardless of the political desires of President Donald Trump.
Finally, the Bank is recognising that there is now a very narrow opportunity to anchor inflation towards the bottom of the band without any significant negative transitory real consequences. The opportunity arises from how emerging markets, and SA among them, have managed post-Covid inflationary pressures.
While the US Federal Reserve and the Bank of England, among other central banks, responded cautiously to the inflation surge after the pandemic, with considerable economic and political costs, emerging countries responded rapidly and efficiently, producing better inflation outcomes and gaining credibility in the process. It is now time to reap the benefits of a sound and balanced policy: leveraging the downward trend in inflation and the credible commitment to price stability to anchor both inflation and expectations at the lower bound of the target range, while continuing to reduce the policy rate towards its long-term equilibrium level of 6%.
Looking ahead, once inflation is firmly anchored at 3%, the Bank should consider moving towards a symmetric target around this level. Such a framework would fully capitalise on reduced risk and eliminate the current asymmetric upward inflation bias that is priced by the markets.
A persistent argument against reducing the target is about the price pressures coming from administrative prices. The argument confuses relative price changes, driven by sectoral reallocation and by the inefficiencies of the public sector, with the long-term level of inflation, which is under the control of the monetary authorities, and it is uniquely determined by its policies. The setting of administrative prices places a significant burden on the private sector and contributes to the high cost base of the SA economy. This represents a persistent obstacle to investment and growth, one that is unaffected by the level of inflation. The only way the Bank could accommodate such a burden would be through reducing real wages via unexpected inflation — a strategy that is neither desirable nor sustainable in the long run.
The Bank’s new inflation target is an important step towards reducing inflation risks in an increasingly uncertain world. Monetary policy is a balancing act between the need to respond flexibly to external shocks and the necessity of providing a long-term anchor for prices and expectations.
The more credibly policy is committed to long-term stability, the greater the space it has to counteract short-term shocks and to look through the first-round effects of external supply disturbances (whether international, such as oil prices, or domestic, such as energy costs). When the Fed adopted an average inflation targeting framework, it made the regime less clear and complicated its response to the inflation surge. This episode showed, once again, that in an uncertain world, the provision of certainty is itself a benefit.
Not doing so would be inconsistent with the Bank’s constitutional mandate “to protect the value of the currency in the interest of balanced and sustainable economic growth in the republic”.
• Viegie is head of the economics department at the University of Pretoria, Ricco professor of economics at the Ecole Polytechnique and University of Warwick, and Pirozhkova an assistant professor in finance at EM Normandie.
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