Higher prices discourage demand and encourage supply. That prices generally tend to rise with increased demand or reduced supply, and vice versa, seems obvious enough. But the supply and demand for all goods and services are not determined independently of each other.
The supply of all goods and services produced in an economy over a year is equivalent to all the incomes earned producing the goods and services that year. The value added by all producers (GDP) is equal to all the incomes earned supplying the inputs that produce output.
Incomes are received as wages, rents, interest, dividends, taxes on production and what is left over — the profits or losses for the owners after all input costs have been accounted for.
Produce more, earn more and you are likely to spend more. The economic problem — not enough of everything and too little income — is surely not the result of any reluctance to spend on the necessities or luxuries of life. The problem is we do not produce enough, and earn enough income to spend more.
Extra demand can be funded with debt. Yet for every borrower spending more than their income there must be a lender saving as much. Matching financial deficits with financial surpluses is the essential task of financial markets and financial institutions, and may not happen automatically or seamlessly. There may be times when the demand for credit and the spending associated with it runs faster or slower than the supply of savings.
If so, incomes and output may increase temporarily above or below long-term trends. We call that the business cycle. Interest rates (yet another price) may be temporarily too low or too high to perfectly much the supply of and demand for savings. But such imbalances must sooner or later run up against the supply side realities and lack of income.
There is a further complication. The supply of goods and services is augmented by imports. And demand includes demand for exports. In SA both imports and exports are equivalent to about 30% of the economy, making a large difference to supply and demand. But the prices of these imports and exports are not set in SA. They are generally set in dollars and translated into rand at unpredictable and generally weak exchange rates.
The prices paid for imports and exports affect average prices and mostly push the averages higher. In SA the weak exchange rate has been equivalent to a supply side shock, with prices following.
The rand is still expected to depreciate against the dollar by more than the difference between SA and US inflation. The bond market expects it to weaken by about 7.3% per annum over the next decade, this being the spread between RSA bond yields (12%) and the US yield (4.7%). The difference between expected annual inflation in SA (7.2%) and the US (3.2%) over the next decade is far less — only 4.8% according to the break-even gap between vanilla bond and inflation protected bond yields.
Lenders to the SA government remain suspicious of SA’s ability to grow fast enough to raise the tax revenue that could sustain fiscally responsible policies. They expect the government will not be able to avoid resorting to funding expenditure with money supplied by the central and private banks. This is a sure source of extra demand without extra supply, leading to ever higher prices, as it does persistently in most African countries.
There is little monetary policy and short-term interest rates can do to strengthen the rand and bring inflation down further against this backdrop — without resulting in too little demand and even less supply than would be feasible, in turn bringing still slower growth, more fiscal strain, higher borrowing costs and a still weaker rand. And higher prices.
The call is not to inhibit already depressed demand but for economic policy reforms that would stimulate growth in SA output and incomes enough to change the outlook for fiscal policy, the exchange rate and inflation.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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