The South African Reserve Bank (SARB) is emphatic that monetary policy is not the solution to South Africa’s economic growth challenges.
By Lullu Krugel, PwC Strategy& chief economist for Africa, and Christie Viljoen, PwC Strategy& economist
Reiterating this after the May 2019 meeting of the central bank’s Monetary Policy Committee (MPC), SARB Governor Lesetja Kganyago commented that “current challenges facing the economy are primarily structural in nature and cannot be resolved by monetary policy alone.
It is now even more urgent to have a combination of prudent macroeconomic policies and structural reforms that raise potential growth and lower the cost structure of the economy”.
The governor is correct: monetary policy is not a solution to long-term economic growth challenges. However, it can provide short-term relief for strained South African businesses and consumers. A substantial reduction in interest rates would reduce debt repayment costs and ease pressure on household and business budgets.
At the same time, there is likely to be very little impact on inflation rates which, at present, are primarily driven by supply-side factors. PwC’s Strategy& Economics believes that the SARB mandate is correctly formulated and administered by the central bank, but that the MPC could make a big contribution to business and consumer confidence by substantially reducing interest rates this week by more than 25bps.
The Taylor Rule (named after Stanford economist John Taylor) has often been used in rate adjustment debates to determine what the ‘right’ level for the interest rate should be. Taylor formulated his equation in the 1990s to forecast interest rates and suggest how central banks should change rates to account for both inflation and economic growth.
Based on Taylor’s formula and required assumptions, PwC’s Strategy& Economics estimates that the repo rate is currently around one percentage point too high. This is premised on inflation averaging 4.5% this year, real economic growth coming in at 0.7%, and – based on academic research – the country’s potential economic growth being around 2%.
Of course, the ‘one percentage point too high’ calculation will vary from one economist to the next, depending on these assumptions. If, for example, the upper end of the 3%-6% SARB target is used as the inflation target, the repo rate would be calculated as being 1,7 percentage points too high. (The SARB MPC has over the past year aimed for the 4,5% mid-point of the inflation target range – making this the more appropriate level for Taylor Rule calculations.) The bottom line is that this kind of calculation highlights the criticism that the SARB has received in the past about being too conservative on interest rates, that is: erring on the side of caution – and rather keeping rates higher than too low.
The MPC started its three-day meeting on interest rates on July 16, with a statement on its deliberations scheduled for 15:00 on July 18. Policymakers decided at all three of their meetings this year so far to keep interest rates on hold, following a 25 basis points (bps) increase in November 2018.
Considering recent economic developments and their impact on the inflation outlook, PwC’s Strategy& Economics believes the MPC will reduce the repo rate by 25 bps this week to 6.50%. However, we also believe that the SARB should be bold and rather make a 50bps cut in order to stimulate the local economy. This would reduce interest rates to the lowest level in almost four years.
A resilient rand seen in recent weeks, supported by the US Federal Reserve and European Central Bank (ECB) hinting at rate cuts, provides the SARB with sufficient room to ease monetary policy. In addition, the SARB mentioned in recent comments that its inflation outlook has improved, forecasting inflation to remain within the 3%-6% inflation target towards 2021.
At the previous MPC meeting held during May, two of the five MPC members already preferred a rate cut of 25 basis points, with the post-meeting statement suggesting that a rate cut is possible by the end of the first quarter of 2020. As such, a 25bps rate cut is expected to happen soon – most economists anticipate a cut this week, and September by the latest.
South Africa’s weak economic situation remains a point of much concern. The central bank had forecast in May that South Africa’s growth would reach 1.0% in 2019.
This estimate will certainly be revised downwards this week due to the 3.2% quarter-on-quarter (q-o-q) contraction in GDP during the first quarter of 2019. The contraction was the biggest decline in 10 years, signalling very weak underlying demand in the economy. Further deterioration in domestic demand is likely to impact the growth outlook over the forecast period and keep business confidence in net negative territory.
A 50bps change in the SARB repo rate was often seen in the 2000s, but last observed in early 2014. Since then, the MPC has moved monetary policy in 25bps increments. As such, it is possible that the MPC members that voted for a rate cut in May might have opted to voice their support for a 50bps reduction if such an option was on the table. It likely was not.
The monthly repayment on a R1-million home bond would decline by about R165 with a 25bps rate cut, and a more substantial R330 with a 50bps cut. The R330 per month saved would result in the bond repayment declining to a level not seen since late-2015, when the repo rate was last at 6,25%. Cutting interest rates this week to a four-year low will definitely offer a short-term boost to the South African economy.
Admittedly, the impacts of a monetary policy shock are short-lived, and could dissipate within 12-18 months. A 2013 working paper[1] published by the SARB considered the impact of a 100bps increase in the repo rate on the economy. By modelling the monetary policy transmission mechanism, the authors found that a shock in the repo rate quickly impacts market interest rates, leading to a decline in gross domestic product (GDP), consumption expenditure and investment.
While the working paper modelled an increase in lending rates, the modelling process would be the same for a reduction in the repo rate, and the impact on GDP, spending and investment would move in the opposite (supportive) direction.
A final point to consider: in July 2017, the MPC reduced the repo rate by 25bps based on an improved inflation outlook and a deteriorated growth outlook. The SARB commented that underlying demand in the economy was “extremely weak” and that a decline in the growth outlook was broad-based. This sounds familiar to South Africa in July 2019. While emphasising that monetary policy easing was not a solution to structural growth constraints in the economy, the central bank acknowledged that lower interest rates “will however provide some relief at the margin”.
It is this positive impact that PwC’s Strategy& Economics is hoping for in recommending a 50bps reduction in the repo rate this week. The relief to strained households and businesses could be marginal, but it would be better than the status quo.