Arthur Kamp: Chief Economist at Sanlam Investments
Following the Rand’s sharp fall this month, a firm interest rate hike of 50bp is widely anticipated following this week’s Reserve Bank Monetary Policy Committee (MPC) meeting. The possibility of further interest rate hikes thereafter has also been raised. The MPC decision is, however, far from straightforward and the outcome of the meeting is not cast in stone.
It should be noted at the onset that the Bank is unlikely to actively “defend” the currency with interest rate hikes. Rather, the key consideration is the expected impact of the depreciation of the Rand on the Bank’s inflation forecast. Episodes of sudden, sharp Rand depreciation not only impact some components of the consumer price basket directly, for example fuel prices, but also increase production costs and risk lifting inflation expectations and wage demands. This could lead to so-called second round impacts on the overall level of inflation.
In its March 2023 MPC Statement, the Bank indicated the implied starting point for its currency forecast in 2Q23 is R18,06 to the US$. Although the Bank will be mindful that the currency is now materially undervalued, it seems likely a weaker exchange rate will be assumed for its forecast, which is likely to result in an upward revision to the Bank’s medium-term inflation forecast, all else equal.
Against this, escalated loadshedding levels, higher household debt service costs and lower export commodity prices could cause an outright contraction in real GDP this year. The accompanying negative output gap should constrain inflation to an extent. Considering this, another interest rate hike is likely to prove unpopular.
However, South Africa’s growth problem is not of the Reserve Bank’s making. Rather, apart from cyclical influences such as changes in commodity prices, the problem is failing infrastructure, policy uncertainty, flat business confidence and an unsustainable fiscal policy as reflected in the continuous increase in the government debt ratio. As regards the latter, high levels of government spending and sovereign debt rating downgrades, which lifted domestic real interest rates, have crowded out private sector borrowing and investment. At the same time, the persistent deterioration in South Africa’s potential growth rate (and hence the potential return on investment) has discouraged foreign capital inflows. Typically, South Africa runs a current account deficit when it grows (as investment and consumption spending increase). However, if foreign capital inflows are too low to fund the deficit, the deficit must shrink. This requires tighter macroeconomic policy including higher interest rates.
The solution is to attract more foreign capital to supplement domestic savings to fund investment and employment. Hence, we need greater economic policy certainty and productivity enhancing economic reforms. Also, the lights must stay on. In the absence of these reforms, poorer potential returns on investment and a higher country risk premium are reflected in Rand depreciation and potentially higher inflation. This compels the Reserve Bank to act if its inflation-target is breached. Indeed, communication from the MPC has been consistently clear. It is first and foremost focused on its inflation target.
On balance, we expect inflation to slow through the remainder of 2023 and into 2024. Even so, inflation is still expected to average 5.0% in 3Q24. It seems an additional interest rate hike is needed to anchor inflation expectations and guide inflation towards the Reserve Bank’s stated target of close to 4.5% (the mid-point of the Bank’s inflation target range) over the medium term. Therefore, it seems likely the Bank will increase its repo rate once again this week, we think by up to 50bp. Looking further ahead, if inflation behaves as expected through the remainder of 2023 and into 2024, we think this week’s interest rate hike could be the last in the current cycle.