The South African Reserve Bank’s monetary policy committee (MPC) will decide the course of interest rates on September 23. Markets are pricing hikes in as a done deal. Analysts remain split on whether a hike will come, but agree tightening is on the horizon.
Yet the Bank’s projections still assume it can cut rates in November. Governor Lesetja Kganyago likes to say MPC decisions are data driven. But what data should the Bank look at, and why does the market disagree with it?
A good starting point for judging whether the data implies that policymakers should hike is the Bank’s own model. It uses not only observable economic data like inflation, but also unobservable estimates of potential growth, expected inflation and risk premiums. Because the Bank has not published the exact inner workings of the model it now uses, a full-scale simulation is not possible. Instead, we can use the Bank’s own formula for how it reacts to economic developments, alongside its latest projections for inflation and growth, to see where rates should be heading.
Under the Bank’s model, interest rates should be set according to four things: its own estimate of how much slack there is in the economy (the “output gap”); how far it expects inflation to deviate from the target (which depends partly on inflation expectations); the “Goldilocks” level of interest rates that neither speeds up nor slows down the economy (known as the “neutral” rate); and how far growth is expected to deviate from potential.
The Bank assumes the economy is below potential, inflation will come down to the target, surveyed inflation expectations will fall over time, and the policy rate is above the neutral level. On those assumptions, the current policy stance is justifiable.
But if we instead base the inflation outlook on our estimates of market-implied inflation expectations, and use our estimate of the neutral interest rate based on market pricing, the Bank needs to tighten policy to ensure it hits the 3% target over the medium term. Assume also that potential growth is lower than the Bank’s estimate and the policy rate would need to rise further.
How much the Bank will need to tighten depends mainly on three things: how long one expects inflation to remain above target; whether surveys or market-based measures of expectations best capture price- and wage-setting behaviour in South Africa; and whether market risk premiums will fall to the level the Bank assumes.
For the Bank to be able to cut as it projects, on the other hand, inflation will need to fall much further than most analysts now expect, and inflation expectations must be better anchored than they have been historically.
High interest rates
The data and the Bank’s own formula show that interest rates will need to stay high for longer than official forecasts suggest. Unless we get a sequence of good news, as the Bank assumes in its baseline projections that borrowing costs are not coming down any time soon. Lower food inflation and domestic petrol prices were welcome recent news. But South Africa’s structural fundamentals do not give the Bank much room to manoeuvre.
The government continues to make the 3% inflation target hard to achieve, with inflation in public sector-related prices running well over double the target. Our market-based estimates of inflation expectations and inflation risk imply that sustainably reducing inflation to the new target will require monetary policy to stay tighter for longer, to re-anchor expectations at a permanently lower level. Infrastructure bottlenecks and heavier compliance burdens on business are eroding our growth potential and raising costs throughout the economy. The possibility of a “super El Niño” and a continuation of the conflict between the US and Iran add further upside risk to the inflation outlook.
Everyone wants to feel optimistic about South Africa’s future, and the Bank has led the charge. It has tended to overestimate economic growth over the past decade. But plugging more realistic assumptions into the Bank’s own interest rate formula delivers a reality check: South Africans will not see lasting interest rate relief without deep economic and political reforms.
Steenkamp is CEO of Codera Analytics and a research fellow in the economics department at Stellenbosch University. Morrow is a researcher at Codera. This article is based on their paper “Evaluating Monetary Policy Rate Settings under Data Uncertainty in South Africa”
