Kim Silberman, Macro Economist and Fixed Income Strategist at Matrix Fund Managers

In September’s monthly note we used an interest rate gap framework to estimate the cyclical trough in the US real policy rate. This month we apply the gap framework to South Africa’s monetary policy cycle.

A central bank’s monetary policy stance cannot be assessed using the absolute level of the real policy rate. Policy rates need to be viewed on a relative basis – similar to assessing a country’s debt relative to its GDP. The gap model measures the real policy rate relative to the prevailing neutral real rate, where the neutral rate achieves price stability. If the real rate is above the neutral rate, then monetary policy is considered restrictive; if it is below neutral, it is accommodative. Because the neutral rate varies over time, changing in response to economic shocks and sovereign risk, it controls for structural changes in the domestic and global macroeconomy, specifically with respect to potential growth and inflation, and hence provides a relative measure for the prevailing policy rate.

In the decade prior to the GFC (Global Financial Crisis), SA inflation averaged 5.7% and the repo rate averaged 9.7%, resulting in an average real repo rate of 4.0% (Figure 1) (we use the Bureau for Economic Research’s (BER’s) survey of inflation two years ahead, as utilised by the SARB’s Monetary Policy Review).

In the decade post the GFC (2008 – 2018), SA was allowed to run a real repo rate of only 0.4%, significantly below the pre-GFC average, even while our sovereign risk rose to historical highs (Figure 3).

This was possible because global real rates were significantly negative, resulting in SA’s neutral rate falling from 2.9% to 1.4%.

During Covid (2020-2023), although the real repo rate was marginally higher (0.6%), monetary policy was loosened, averaging 200 basis points (bp) below neutral, significantly wider than the ‑90bp average post the GFC. Currently, assuming the repo rate is reduced to 7.75% at the MPC meeting in November 2024, the real repo rate should measure 3.1%, which relative to GDP of less than 1.0% feels extremely tight; however, it is only 40bp above neutral.

Figure 1: SA Inflation and monetary policy dynamics though macroeconomic cycles

SA’s cutting cycle

Looking ahead, we expect that the policy rate will end the cutting cycle in accommodative territory, although how accommodative is uncertain, given the almost unprecedented assumption that there will be a soft landing in the US. We note that in SA the only pre-GFC cyclical trough for which we have all the required data was -81bp below neutral (Figure 2). However, this required a global crisis.

Figure 2: SA’s real interest rate gap is positive for the first time since 2008

SA’s current 2-year ahead inflation expectation according to BER is 4.7% and the neutral rate is 2.7%. The interest rate gap is +62bp. Below we look at various scenarios for a trough in SA’s policy rate, assuming in all that monetary policy enters accommodative territory:

• Policy rate at 7.0%: In a US “soft landing” scenario, with SA inflation at 4.5% and the neutral rate remaining at 2.7%, the real rate (2.5%) would fall to a moderate -22bp below neutral.
• Policy rate at 6.75%: A nominal rate of 75% would provide a still reasonable -50bp interest rate gap.
• Policy rate at 6.50%: This would require that inflation expectations fall to 4.0% in 4Q24, resulting in a marginally accommodative real rate of -20bp below neutral.
• Policy rate at 6.50%: Alternatively, if the US enters recession, with SA inflation expectations at 4.5% the gap would fall to -70bp.

SA’s neutral rate has declined despite rising sovereign risk

SA’s r-star (the neutral real policy rate) fell to a low of 1.0% in 2011 despite rising sovereign risks (Figure 3), which ultimately culminated in a downgrade to non-investment grade in 2020. Although the neutral rate has risen since 2011, and is currently at 2.7%, it is still below the pre-GFC average of 2.9%, which was at a time when SA was investment grade.

This apparent inconsistency is resolved when SA’s r-star is viewed as a spread over the US r-star (Figure 4). This spread has widened consistently and post SA’s ratings downgrade it shifted higher, from 60bp to 200bp. This relationship explains SA’s current r-star, i.e. the US neutral rate of 0.75% plus a spread of 200bp.

Figure 3: SARB’s measure of SA neutral real rate

Figure 4: SA neutral real spread over US neutral real rate

EM vs DM neutral rates

There are several ways to calculate the neutral rate. In the US, until the introduction of quantitative easing (QE), the neutral rate approximated trend GDP. Post the GFC, neutral averaged 75bp below potential GDP. Currently, it is at an historic low of 165bp below trend GDP. Research by the Federal Reserve Bank of New York (NY Fed) suggests that this has to do with the fall in labour productivity requiring more accommodative monetary policy to produce the same rate of potential GDP growth.

While the US can run ultra-accommodative monetary policy in response to deteriorating economic fundamentals, the opposite is true for emerging markets which are forced to run higher rates in response to deteriorating economic conditions to compensate investors for associated increases in sovereign risk.

ENDS