The view that South Africa’s inflation target could be lowered to 3% in the first half of next year, relatively painlessly on the back of rapidly falling inflation, has been dealt a blow by Donald Trump’s US presidential victory.
Bullish expectations that the target could be lowered as early as the February 2025 budget were dashed last month, when finance minister Enoch Godongwana said more technical work was required to estimate the potentially negative impact on households.
Reserve Bank governor Lesetja Kganyago has, however, long been convinced of the merits of lowering the target, given that the Bank succeeded after 2017 in moving the country from a de facto 5.9% target to a 4.5% target with very little pain.
Kganyago has become increasingly strident in arguing for a lower target since first raising the issue in 2021. South Africa’s inflation target at 4.5% remains high relative to many emerging markets, which mostly have point targets of about 3%. This imposes various costs on the economy and makes it less competitive.
Kganyago’s urgency is probably because the timing would appear to be ideal over the next few quarters as headline inflation and inflation expectations are tumbling in tandem.
When the Bank moved from a 3%-6% target range to explicitly targeting the 4.5% midpoint, the economy was on a structural disinflationary path aided by the pandemic. As a result, the Bank managed to achieve the new target and anchor inflation expectations at a lower level without sacrificing any growth in the process.
However, from a low of 2.9% in February 2021, CPI spiked to 7.8% in July 2022, driven by the Ukraine crisis. And because inflation was sticky on the way back down, inflation expectations became unmoored.
They have been trending downwards this year but remain backward-looking and have yet to re-anchor around the 4.5% target (see graph). In the third quarter, inflation expectations were for CPI to average 5.1% this year, before subsiding to 4.8% in both 2025 and 2026.
By contrast, the Bank’s forecast is for CPI to average only 4.6% this year, 4% in 2025 and 4.4% in 2026. Moreover, the Bank expects CPI (at 3.8% in September) to average just 3.6% in the final quarter of this year, and 3.7% and 3.8% in the first two quarters of 2025.
“This gives inflation expectations more chance to anchor around 4.5% and provides an opportunity to lower the target,” says Citi economist Gina Schoeman.
“With a 25 basis point [bp] rate cut in September, and further 25bp cuts likely in November, January and possibly March, the Bank could lower the target while still removing its restrictive monetary policy stance.”
In other words, it could shift to a 3% target while still cutting rates. This is significant as many have wrongly assumed that a shift to a lower target would necessarily imply hiking rates.
However, with Trump taking the White House, the risks to the inflation outlook have risen as his policies are likely to put downward pressure on the rand — as is already manifest.
This means there is no guarantee that the Bank’s benign inflation forecasts will transpire. Even without Trump, potential double-digit domestic electricity tariff increases from July 2025 pose an upside risk to the inflation outlook.
Monthly CPI readings are expected to start lifting back above 4.5% from midyear, which would make lowering the target more difficult if the process is delayed until then.
“What matters,” says Schoeman, “is whether inflation expectations have anchored at least at the midpoint by then. It’s difficult to see a world where an inflation target can be lowered without a [growth sacrifice] if inflation expectations remain above the current target.”
Last month, in a hard-hitting guest lecture at Stellenbosch University, Kganyago dismantled many of the arguments that may be preventing Godongwana from giving him the green light.
The first myth is the belief that because the country suffers from relatively high inflation it needs a relatively high inflation target. However, this ignores the influence of the target itself in shaping trend inflation, says Kganyago.
He cites, for example, the fact that in 2000, both Chile and South Africa adopted inflation targets. Chile went for 3%; we went for a range of 3%-6%.
Since then, our average inflation rate, at close to 6%, has been almost two percentage points (pp) higher than Chilean inflation, which has been a bit under 4%. The upshot is that Chile’s prices are now 2.8 times what they were in 2000, while ours are 4.5 times higher.
“It was not that we faced a higher world oil price or a higher wheat price. And both countries had professional, independent central banks,” explains Kganyago. “The difference was that we had a higher inflation target.”
The second misconception, and a standard objection to lowering the target, is that because South Africa has persistently high administered price inflation — those prices set by the government for services such as water and electricity — if it lowers the inflation target it will have to hurt the rest of the economy.
Since administered prices, which make up 16% of the inflation basket, have long been stuck about 2.4pp above headline inflation, this means that with a 4.5% inflation target, other prices in the economy can rise by about 4%. However, with a 3% inflation target, other prices would be allowed to rise by only about 2.5%.
This may seem an impossible ask, but Kganyago doesn’t see it that way. The bigger point he makes is that even with high administered prices the Bank would not have to push the rest of the economy into deflation (price cuts), it would just need everyone else to implement smaller price increases.
“Of course, it is highly desirable to have lower administered prices. And it is easier to have lower inflation, and lower rates, where these categories are helping, and not hurting, the disinflation effort,” he concedes.
“But let us not pretend we must live with a relatively high inflation target just because of our administered price problem. It did not stop us from getting from 6% inflation to 4.5%.”
The third concern about lowering the target is that the short-term costs would be high — that the Bank would have to raise rates, squeezing the economy and worsening unemployment in order for inflation to slow.
“This trade-off between growth and inflation strikes some people as unacceptable, even when they understand that lower long-term inflation would be desirable,” says Kganyago.
However, citing two research papers by local economists, he notes that there was little or no growth sacrifice in getting inflation to 4.5%. Both papers suggest that this was because the Bank’s hawkish commitment to 4.5% was fully believed. Or, as Kganyago puts it, “inflation was not forced down by a recession; it was managed lower by clear and credible communication”.
What Kganyago is describing is the self-fulfilling power of expectations — the Maradona theory of interest rates.
This term was coined by former Bank of England governor Mervyn King. He used the two goals Argentine football great Diego Maradona scored against England in the 1986 World Cup to explain how central bank credibility, and forward-looking inflation expectations, can deliver lower inflation outcomes without necessitating steep hikes in policy rates.
In a speech in 2005, King said Maradona’s first goal in that game, which became known as the “hand of God goal” because he touched it illegally with his hand, “was an exercise of the old mystery-and-mystique approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates.”
For his second goal Maradona ran from inside his own half, beating five players, before scoring, and all by running virtually in a straight line. Because the English defenders reacted to what they expected Maradona to do — move left or right — he was able to go straight on.
Monetary policy works in a similar way.
So if, for instance, the Bank announced firmly that it was lowering the target to 3%, market participants would expect monetary policy to tighten given that the Bank is highly credible and always does what it says it will do.
Price setters would then adjust their behaviour accordingly and market rates would likely rise in anticipation, cooling demand and driving inflation lower. In that event, official interest rates might not need to rise on a vastly different path than would otherwise have been the case.
In our current circumstances, rates might not need to rise at all, though the Bank may well cut less, especially if the Fed cuts less because of Trumpian inflation. This explains Godongwana’s concern about the impact on struggling consumers.
But Kganyago thinks the basic misconceptions around lowering the target have resulted in a discussion that is “too pessimistic and insufficiently ambitious”. As he sees it, South Africa has an opportunity to achieve permanently lower inflation and therefore permanently lower interest rates at very little cost and should seize it.
Godongwana is understandably cautious, but it would be a real pity if we allow Trump to delay our chances of seeing how adept Kganyago is at dribbling the ball.