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To hike or not to hike interest rates?

Photo by SARB
Figure 1: GDP vs Inflation (indexed to 2006 Q1)

17th July 2014

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The South African Reserve Bank (SARB) has a difficult decision to make ahead of its Monetary Policy Committee (MPC) meeting on Wednesday 17 July 2014. It needs to decide whether or not to hike interest rates, and if so, by how much. This is against the backdrop of a grim macro-economic environment.

Earlier this year, the Reserve Bank Governor, Ms Gill Marcus, announced a rate hike for the first time in more than five years, raising the repo rate by 0.5%. The rationale for this increase stemmed from the decision by the US Federal Reserve to taper its quantitative easing policy, which saw emerging market (EM) economies, including South Africa, come under exchange rate pressure. The ‘easy money’ that had previously flooded into EM economies began to recede. When the tapering began, the resulting rand weakness ultimately forced the hand of the Reserve Bank.

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Now the SARB is faced with a new set of parameters within which to make its next decision. In no particular order: GDP is contracting, unemployment is growing, inflation is becoming unwieldy, the exchange rate is under renewed pressure and rating agencies have recently downgraded our credit rating. From a macroeconomics perspective, what more could possibly go wrong?

The figure below shows the key conundrum facing the SARB: the relationship between the growth rates of South Africa’s Headline CPI (year-on-year rates) and real Gross Domestic Product (GDP) at 2005 prices. In order to enable this comparison, these rates were converted to a common index, so that for both data series, the first quarter of 2006 is the base year and equal to 100. From the diagram it can be seen that relative to 2006Q1, inflation increased and peaked in 2008Q3 at the height of the 2008 global financial crisis. Meanwhile, growth in real GDP decreased from 2006Q1 to its lowest level in 2009Q1. As inflation decreased from 2008 to 2011, national output also recovered.

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From 2011 however, a disturbing trend has emerged, wherein the inflation rate has slowly crept upward whilst national output has consistently trended downward, giving rise to an increasingly prolonged divergence between the two. In principle, the flexible inflation-targeting framework adopted by the SARB in 2000 proposes the use of interest rates to ensure that inflation does not exceed the upper bound of the SARB’s target range of 3-6%. Currently, the inflation rate stands at 6.6%, clearly outside of this target. At the same time GDP growth has fallen into negative territory at minus 0.6%. Hiking interest rates may calm inflation, but may further dampen GDP growth.

Figure 1: GDP vs Inflation (indexed to 2006 Q1)


Source: Data from SARB (2014) and StatsSA (2014) collated by the authors

What then is the best course of action for the SARB under these circumstances? If the SARB were to pursue its inflation-targeting mandate, then another hike is in order. On the hand, if the SARB is concerned about short-term GDP prospects, then it might prefer to leave the interest rate unchanged. Such an approach would be GDP-accommodative in the short-term but may challenge the credibility of the SARBs inflation-targeting mandate, and could lead to a more uncertain macro-economic environment in the longer term.

In considering this difficult decision the SARB would be wise to heed the experience of their counterparts in Turkey. In January this year, when we increased rates by 0.5%, the Turkish central bank hiked them by roughly 5% at an extraordinary policy meeting to protect the value of their currency; a situation we would want to avoid. A little medicine now might be better than surgery later.

Unfortunately, the evidence suggests that there is increasingly little scope to reduce interest rates in order to accommodate economic growth. The resulting increase in prices would undermine any potential gain in disposable income and would penalise the poor. Ultimately, interest rate policy cannot be held accountable for the country’s long-term development. Rather, deeper and structural change is needed to lift South Africa onto a higher growth path. This may include, but is not limited to, maintaining and bolstering a policy-certain environment; more efficient use of domestic public resources, speedier resolutions to labour disputes and optimal investment in infrastructure and human capital from the public and private sector.

Written by Alex Constantinou and Stephen Chisadza, DNA Economics

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