July’s South African Reserve Bank (SARB) Monetary Policy Committee (MPC) statement, delivered more than a welcome rate cut. The MPC not only reduced the policy rate by 25 basis points to 7%, in a unanimous decision, but also doubled down on the ongoing discussion of its intent to shift focus to the lower end of the inflation target (3-6%), which has been in place since the early “noughts”.
In May, SARB Governor Lesetja Kganyago’s statement included the following: “The MPC is of the view that the 3% scenario is more attractive than the 4.50% baseline, and we would like to see inflation expectations move lower, towards the bottom end of our target range. We will also consider scenarios with a 3% objective at future meetings.” And consider they did, writing: “With actual inflation close to 3%, we wanted to highlight the opportunity to achieve permanently lower inflation at minimal cost.”
Best laid plans
It’s not every day–or every decade–that we see such structural changes in monetary policy. As mentioned, inflation targeting was first introduced back in 2000, with a target band of 3-6%. At that time, the stated intention was to narrow that band, first to 3-5% in 2001 and eventually to 2-4% by 2004. The “dot com bubble” bursting in 2001, however, scuppered those plans, leading to a broad-based financial crisis and elevated inflation in South Africa.
Fast-forward 25 years and South Africa’s inflation target is an outlier compared to peer countries. The SARB would align with said peers, and luckily, the current inflation environment post-COVID has provided them with an opportunity to revisit the inflation target.
This is a pivotal moment for monetary policy in South Africa, and implementation could have far-reaching consequences for the structure of our economy. What would this mean for the future?
“Future-casting” at 3%
As history has shown us, another external shock could delay any transition to lower inflation, but barring that, how might this shape our expectations?
The below table shows the expectation, across different measures, in the short to long term.
Next, one needs to ask how this will feed into your financial risks, FX, liquidity, and equity structuring… and how you manage them on the way to, and from within, this new paradigm.
When Governor Lesetja spoke at the sidelines of the European Central Bank’s forum last month – hinting that the inflation target review was close to completion – the market reacted immediately, with the ZAR strengthening and swap rates coming back significantly. It was, one could argue, a glimpse of the new-target future.
Setting your own smart course
The effect of what is proposed is that rates may remain higher for longer, eventually tracking to a new neutral level after implementation, and once inflation expectations are firmly anchored at the new target level. How long will that take? The SARB’s model suggests that inflation would be expected to decrease by 0.7 percentage points per year, assuming a starting point of 4.50%, the middle of the current inflation target range. Over time and once inflation expectations are anchored, this has the potential to drive South Africa’s policy rate (repo rate) to a long-term neutral rate of 5.00%. According to the SARB, this may take about two years to achieve.
But, with all the current risks in the global economy, here are a few potential opportunities to consider:
- For importers, it could be wise to lock in the current stronger ZAR levels in the short term such as the 17.50 handle we have tested twice in the past 6 months. Conversely, exporters should look to take advantage of sudden bursts of ZAR weakness – like the R18.35 handle we saw last week Friday.
- When the market gets ahead of itself and starts pricing in deeper interest rate cuts, that may not materialise, those paying interest can leverage these expectations by employing two- or three-year hedging strategies.
- Lastly, in the short term, it’s possible that we see equity prices somewhat suppressed. This suggests an opportunity to hedge long-term incentive schemes through equity structuring.
As always, however, “buyer beware”. There are potential pitfalls and potholes (aren’t there always?) that we can’t ignore. First, the Finance Minister doesn’t appear to be too pleased with the SARB’s unilateral decision to shift the target to the lower end of the band, citing that the authority to make that call lies with him alone. Without outright fiscal support, it may take much longer (if ever) for South Africa to achieve low inflation, and in turn, low interest rates.
Secondly, administered prices like Eskom’s tariff increases have tended to outstrip inflation, and could continue to impose upward pressure on costs. Lastly, wage increases above the inflation target and externalities such as oil price shocks may also influence the direction, or at least the speed at which the new inflation target is reached.
These would complicate the overall picture, and it’s crucial to be attuned to such variables when strategising. Staying informed and responsive will be key, as too centring your specific needs and risk profiles. What factors will you be watching for as it all unfolds?