SA’s inflation and interest rate path in an emerging market context

SA’s current inflation target of 3 percent to 6 percent was introduced in February 2000. At the time, the annual inflation rate was a very modest 2,3 percent, but it had averaged 7,3 percent over the preceding five years, spiking to over 10 percent at times.

This suggested that achieving the inflation target was not going to be easy, and would require a meaningful change in policy implementation.

Fortunately, since February 2000, SA’s inflation rate has averaged 5,6 percent. It has been at or inside the inflation target range for almost 75 percent of the time over the past 15 years.

This is a heartening and important economic success story, especially given SA’s general economic malaise since 2010.

Keeping the inflation rate persistently inside the target range is challenging for a variety of reasons.

These include the volatile and relatively weak rand exchange rate; above-inflation wage increases in key economic sectors, including the public sector; poor productivity growth in most industries; sustained large increases in key administered prices (such as the cost of water and electricity); and a rise in import intensity.

SA’s recent inflation success supports lower interest rates

In recent years, the South African Reserve Bank (Sarb) has been consistent in highlighting its desire to get SA’s inflation target anchored around the midpoint of the inflation target (4,5 percent), rather than the upper end of the 3 percent to 6 percent target range.

This change in policy emphasis is partly being driven by the fact that the inflation target is relatively high compared to other emerging economies.

In addition, achieving a sustained lower level of inflation (4,5 percent) should help to improve SA’s international competitiveness as well as support some improvement in the stability of the rand exchange rate.

Encouragingly, the inflation rate is expected to moderate further over the next six to 12 months to an average of around 4,5 percent, dropping below 4,5 percent in the first few months of 2025.

This view is supported by a very welcome easing of food inflation to just over 4 percent in May 2024 (despite earlier fears about the potential impact of an El Niño weather effect), a decline in fuel prices, and the recent outperformance of the rand exchange rate.

It is also encouraging that core inflation has been inside the target range for the past 37 months, remaining unchanged at 4,6 percent in May 2024. A core inflation rate of around 4,5 percent would argue strongly in favour of the Sarb starting the interest rate cutting cycle, especially since the repo rate is well above inflation at 8.25 percent.

This raises two important questions:

Can SA start cutting interest rates prior to the commencement of the interest rate cutting cycle in key developed markets — especially the US?

Can SA achieve a sustained lower average inflation rate, thereby justifying a meaningful reduction in the Sarb’s inflation target? This is something the government is in the process of investigating.

Emerging economies have started cutting interest rates

In the past 12 months, a total of 38 central banks have commenced their own interest rate cutting cycle. This is measured out of a total of 80 central banks that Stanlib monitors on a regular basis. At least 18 of them have cut rates on three or more occasions over the year, all of which are either emerging economies or developing countries.

These rate cuts were implemented prior to the start of the European Central Bank’s rate-cutting cycle and, in general, preceded all the recent rate cuts in developed markets — which now include Switzerland, Sweden, Denmark, Canada and the Euro area.

Successive interest rate cuts by five emerging economies are worth examining in more detail, namely Brazil, Chile, Peru, Hungary and the Czech Republic. All five countries started cutting rates between July 2023 and December 2023.

They have all cut rates on at least four or more occasions in the past year (Chile has reduced rates on nine separate occasions, while Hungary and Peru have reduced rates eight times over the past year), and they have all lowered interest rates by between 175 basis points (bps) and 575 bps.

It is also interesting that all five emerging economies started cutting interest rates before their inflation rates were fully under control.

For example, when Chile started cutting rates in July 2023, its consumer inflation rate was measured at 6,5 percent, which is well above the inflation target of 3 percent. Subsequently, inflation rates moderated further, but remain elevated at 4,1 percent. Under these circumstances, it is not surprising that the Chilean currency has weakened by a substantial 15,3 percent over the past year against the US dollar.

This compares with a 10-year annual average currency depreciation of 5 percent. The central bank of Chile remains confident that it will achieve its inflation target of 3 percent over the next two years and is likely to cut rates further in 2024.

The currency performance of the other four emerging economies over the past year has also been weaker than average, ranging from -5,1 percent for Peru to -13,1 percent for Brazil. Clearly, the risk of some currency weakness has not deterred these emerging economies from easing monetary policy in an effort to soften the negative impact of sustained high interest rates, especially when interest rates have risen well above the rate of inflation.

SA could have started cutting . . .

SA’s relatively high interest rates, weak economic performance, progress in bringing headline inflation back inside the target range of 3 percent to 6 percent in each of the past 12 months, as well as the fact that (as mentioned earlier) core inflation has been inside the target range for the past 37 months, suggest that the Sarb should already have embarked on its own interest rate cutting cycle. — Moneyweb