Rand shedding and restrictive interest rates

On top of everything else, South Africa is now also in the grips of a serious interest rate squeeze. Interest rates have not only risen sharply since the start of the year in absolute terms, but also relative to what was expected.

There are many different interest rates in a sophisticated economy since there are many borrowers with unique credit profiles and loan horizons. A poorer quality borrower will generally pay more, and longer-term loans or bonds will have higher rates to compensate for the greater uncertainty into the far future.

The two most important rates are normally the central bank’s short-term policy interest rate, which acts as the base from which bank loans are priced and also the government long-bond yield (usually the 10-year yield), which is a benchmark for all bond market activity. In other words, the one key rate (or set of rates) is set deliberately by the central bank, while the other important rate is set by the market. The distinction is important, but the market will also always keep an eye on what the central bank does and vice versa.

Restrictive
Let’s start with the first, the central bank policy rate. Despite a bigger-than-expected decline in the April inflation rate to 6.8% year-on-year from 7.1%, the SA Reserve Bank’s Monetary Policy Committee raised the repo rate by 50 basis points to 8.25% in a unanimous decision. It was 7% at the start of the year and 3.5% at the bottom of the cycle. The sharp increase from the Covid lows is one of the fastest since the early 1980s, repeating a pattern that we’ve seen across the world. For the first time, the MPC statement acknowledges that policy is now in “restrictive” territory.

Unlike the rest of the world, or at least the developed countries, South Africa does not have a demand-led inflation problem. The economy is simply too weak for that. Most of the inflation shock has come from supply side pressures, namely food and fuel prices, and to the extent that firms pass on the cost of running generators, due to load shedding. Higher interest rates cannot address supply constraints. All it can do is prevent firms from passing on higher input costs by weakening what little demand remains left. This so-called second round impact of higher input costs is what the Reserve Bank is particularly concerned about.

The same goes for a weaker currency, which has emerged in the past few weeks as a major risk factor. The Reserve Bank can ignore a weaker currency if it thinks the effects will be temporary, but when there are concerns that businesses will push up prices because of the weaker rand, it acts. Over time, this passthrough from rand weakness to inflation has declined, partly due to falling global goods prices. However, when the rand’s depreciation becomes front-page news, businesses often believe they have an opportunity to raise prices, because they can blame the exchange rate and customers will accept it.

This is also a pattern that is drawing increased scrutiny globally. The more inflation is front-page news, the more companies have opportunities to raise prices and blame general inflationary conditions, the war in Ukraine or Covid-related disruptions. There is even a term for it, “greedflation”. But it is not just companies, central banks are also worried about wage growth in the context of low unemployment in rich countries, as higher incomes support spending growth, which puts sustained upward pressure on prices. Despite high unemployment in South Africa, the Reserve Bank specifically noted its concern with rising average salaries.

Having said all that, what is notable about the Reserve Bank’s decision is that its own inflation forecasts have not changed dramatically. Inflation is still likely to decline steadily in coming months as food inflation stabilises and the lower global oil price reflects in the numbers. This highlights the Reserve Bank’s fear of a further disorderly depreciation in the rand.

By hiking rates further, the Reserve Bank can squeeze out the ability of firms to raise prices by further dampening consumer demand, but it can also directly affect the exchange rate by increasing its carry, the interest foreign buyers can earn on rands. The Bank rarely if ever acknowledges that it is trying to prop up the rand. The language is all about inflation, second-round effects and expectations, but the currency is certainly part of the thinking as is evident from past rate decisions. Therefore, if the rand doesn’t stabilise – it fell further after the announcement – further rate hikes cannot be ruled out.

Unusually, South African policy rates have fallen behind the peer group as chart 1 shows. We were among the highest in 2019 but are only middle of the pack today. On a relative interest rate basis, it has been more attractive for foreigners to buy the Brazilian real or Mexican peso. The latest hike moves us closer to the front range of the pack.

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