South Africa’s inflation target conundrum

A few months ago, the South African Reserve Bank (SARB) announced its preference for headline consumer inflation to anchor at the bottom of the inflation target range of 3% to 6% (i.e. at 3%). This year we have seen inflation steady at around 3%, driven by a range of factors including a stronger rand-dollar exchange rate and lower Brent crude prices.

Exchange rates and fuel prices play a key role in prevailing inflation outcomes in South Africa, particularly as they relate to imported inflation. Administered price inflation similarly poses a challenge to the goal of anchoring inflation at 3%. That said, lower inflation outcomes should be good for society, particularly lower income households, which have tended to feel the inflation burden more materially than higher income households.

Chart 1: Inflation dynamics in South Africa

The SARB has been successful in containing inflation in the last 15 years. Chart 2 below shows how inflation trended higher to peak levels in 2023, the highest levels since around the global financial crisis. If we divide consumers into 10 groups (deciles) ranked by how much they spend, we see that the lowest expenditure deciles had higher levels of experienced inflation relative to lower expenditure deciles.

This chart alone illustrates how important monetary policy is in containing inflation while achieving the best inflationary outcomes for the most vulnerable in society. Lower income households spend a larger proportion of income on the most volatile elements of inflation, which includes food and petrol prices (i.e. transport costs).

According to Stats SA, decile 1 (poorest) households spend 50% of income on food, starkly different to decile 10 which spends around 11% on food and non-alcoholic beverages. However, given South Africa’s vulnerability to external dynamics, we should ask: how effective is monetary policy in controlling those variables, given that domestic monetary policy settings have no influence on international food and petrol prices?

Chart 2: Inflation outcomes by income segment (by expenditure)

Since 2021 inflation has been disproportionately more burdensome on society’s most vulnerable (the lowest earning 10% of society, or decile 1) relative to both the highest earners (the top 10% of earners, or decile 10) and median earners (decile 5).

Inflation similarly normalised more rapidly for higher earners than low earners. That said, inflation has since normalised across income segments, illustrating the relative success of the SARB in achieving its mandate of price stability.

Another measure of monetary policy effectiveness is the Bureau for Economic Research’s (BER) inflation expectations index. Inflation expectations are now at their lowest levels since the tail end of 2020 / beginning of 2021. Inflation expectations play an important role in household planning and wage setting behaviour. Lower inflation expectations typically have the effect of lower wage inflation.

While this would likely have a positive impact on the government wage bill and improve fiscal stability, there is some risk that lower wage consumer inflation will have a negative impact on nominal GDP growth, which in turn may have a negative impact on South Africa’s debt-to-GDP trajectory.

Chart 3: BER inflation expectations

The market, proxied by consensus expectations, also believes inflation is under control, though it is not convinced that inflation will settle at 3% within the next two years. Inflation is expected to average 3.4% this year, increasing to 4.1% next year and 4.2% the year after.

Inflation expectations based on consensus forecasts and the BER’s numbers, would be problematic for the SARB, posing some risk that interest rates may remain higher for longer.

Chart 4: Consensus inflation expectations

Chart 5 captures the level of monetary policy restrictiveness. Real interest rates are currently sitting at close to their highest levels over the last 20 years or so. With a preference for inflation of 3% and still elevated inflation expectations relative to that target, it is likely that the SARB will continue to keep real rates high.

South Africa is however fighting another battle of stagnant economic activity. Despite a relatively good second quarter GDP print of 0.8%, South Africa requires yearly growth of 2% or more on average to make meaningful progress in the fight against poverty, unemployment and inequality.

Restrictive monetary policy will thus likely remain a handbrake on economic activity and among the key questions asked by National Treasury will be how restrictive rates in pursuit of a 3% target will impact economic growth and fiscal projections/outcomes.

Chart 5: Monetary policy restrictiveness

In summary, there are many important considerations when setting a new inflation target, including, but not limited to:

1. How a lower level of inflation is of benefit to society’s most vulnerable.
2. How lower inflation influences wage setting behaviour.
3. How lower inflation impacts fiscal outcomes, notably:
   • Debt-to-GDP ratio given that this is primarily driven by nominal GDP growth.
   • How it impacts the government wage bill. Around a third of government spending is on wages.
   • How restrictive monetary policy impacts economic growth.

National Treasury is expected to imminently release its findings on the fiscal implications of a new, lower inflation target. The Minister of Finance, Enoch Godongwana, has also indicated that monetary policy, as far as setting the inflation target level is concerned, is not only within the purview and control of the SARB. The report should give us greater clarity on where the National Treasury stands.