Some economists believe the governor of the Reserve Bank could even announce the 3% inflation target on Thursday, along with the repo rate.
The South African Reserve Bank has been making the case for a lower inflation target since 2021, and it now looks like the proposal is gaining traction. What does it mean for South African markets and, importantly, for South African debt?
The South African Reserve Bank (Sarb) formally adopted inflation targeting in February 2000 and set the target range between 3.0% to 6.0%. At the time, average annual inflation for the preceding 5 years was 6.4% and the target was consistent with global practices and those of South Africa’s emerging market peers that were also grappling with persistently high inflation.
Fast-forward 25 years, and much has changed. Central banks in emerging markets narrowed and lowered their inflation targets, with several converging around 3%. South Africa, despite having a strong and credible central bank, remains an outlier with a higher inflation target.
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Sarb started arguing for lower inflation target in 2017
In 2017, the Sarb began to argue for a lower inflation target, and the Monetary Policy Committee (MPC) began to explicitly target the midpoint of the 3.0% to 6.0% range at 4.5%.
The Sarb’s motivation for lowering the target is clear: lower inflation would reduce the economy’s average interest rate over time, bringing the cost of borrowing down and resulting in billions of savings of debt service costs for the fiscus over the next ten years.
If successful, the combination of stronger real growth and lower borrowing costs could lower the cost of capital across the economy, potentially driving investment and also lifting valuations across multiple asset classes.
However, Felicia Makondo, fund manager at PSG Asset Management, says the transition to a lower inflation target is not without risks. “To lower inflation, the MPC typically increases the repo rate. South Africa is already grappling with weak gross domestic product (GDP) growth, supply-side bottlenecks and fragile consumer demand.
“High interest rates are likely to stifle already fragile growth even further in the short term. In addition, if inflation expectations are not successfully lowered to the 3.0% level, the result would be more volatile inflation and a loss of credibility.”
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What happened in Brazil when it set its inflation target at 3%
She says the experience in Brazil provides a cautionary tale. “The country lowered its inflation targets too, but fiscal dominance and political pressure at times undermined the central bank’s credibility and inflation expectations remain above their 3% target.
“Brazil’s experience illustrates the challenges of anchoring expectations and highlights that loose fiscal policy can undermine monetary policy credibility.”
A lower inflation target implies that the Sarb will be more hawkish and less tolerant of inflation surprises as it pursues anchoring inflation expectations lower over the implementation period of two to three years.
Makondo says, as we saw in June, the global macroeconomic environment is volatile and susceptible to sudden shocks, such as the geopolitical tensions in the Middle East between the USA, Iran, and Israel, which pushed oil prices from US$66 per barrel to US$80 per barrel.
“In a 3.0% inflation targeting regime, such external shocks from a fragile global environment could elicit a stronger monetary response from the Sarb. This means potentially keeping the repo rate higher in the short term to defend the credibility of the lower inflation anchor.”
She points out that the shift to a lower inflation target would mark a structural change in the country’s macro framework. “For investors, this introduces both opportunity and risk: the transition will not be linear, and it will depend on the Sarb’s ability to maintain its credibility and guide inflation expectations lower without stifling an already struggling economy.
“In the interim, investors should position for a world where lower inflation and tighter policy coexist and where portfolio strategy must adapt to a more anchored, but possibly more demanding, macro regime.”
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Sarb says SA could see almost R1 trillion saving with lower inflation target
Nick Balkin, chief investment officer at Foord Asset Management, points out that the Sarb circulated estimates of almost R1 trillion in interest savings over a decade if the target is lowered.
“The thesis is that better price discipline will pull down borrowing rates, shrink Treasury’s debt service bill and release scarce funds for social priorities. The arithmetic appears neat but does not take into consideration one of the main reasons putting upward pressure on borrowing costs: the deteriorating credibility of government.
“I have spent two decades investing in South African debt and equity markets. During that time, the Sarb generally delivered on its mandate to keep prices stable within the target range. However, real economic growth barely averaged 1% a year since 2014.
“Stabilising prices did not unlock capital expenditure or boost economic growth. If anything, it was the weaker growth that helped keep inflation in check.”
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Lower inflation target not a silver bullet for lower borrowing costs
Balkin says lower inflation does not automatically mean lower borrowing costs for the South African government. “Firstly, South Africa’s bonds have much higher average maturities than for many other emerging markets.
“Even if yields fell meaningfully tomorrow, the interest line in the national budget would decline only gradually as outstanding bonds mature and are refinanced at lower borrowing rates over time.
“Secondly, lower inflation would result in lower nominal economic growth (nominal growth is equal to real economic growth plus inflation). As a result, South Africa’s troubling debt-to-GDP ratio – which is measured against nominal GDP – would continue to deteriorate, with the denominator lower than it would otherwise be.
“Without meaningful, structural state interventions to address the root causes of constrained economic growth, the debt burden may even worsen. Thirdly, South Africa’s risk premium – the yield above US Treasury yields demanded by bond investors – is another binding constraint.
“Strip inflation out of current bond yields, and investors still demand a real return of roughly 5% – double that of comparable emerging economies. The risk premium compensates investors for weak governance, unreliable energy supply and unresolved fiscal risks – not for an inflation target that is set too high.”
He says unless these underlying fundamentals improve, global capital will continue demanding a high spread over US Treasuries, regardless of the official inflation target.
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Treasury has other option to reduce borrowing costs
“National Treasury also has other options to reduce borrowing costs, including shifting debt issuance away from long-dated, fixed-rate bonds towards Treasury bills, floating-rate notes and inflation-linked securities – assets that already carry lower yields.
“The Sarb’s stewardship of price stability is one of democratic South Africa’s macroeconomic successes. Central banks earn credibility by meeting the targets they set. A lower target that proves hard to attain, for many reasons, would force the Sarb either to tighten policy sharply or tolerate repeated misses. Neither outcome would enhance the Sarb’s standing.”
Balkin points out that lowering the inflation target may promise a quick political win but warns that it offers only a faint hope of materially lower funding costs.
“South Africa’s fiscal arithmetic improves meaningfully only when two conditions hold: when the economy grows at a faster pace than outstanding debt and the country risk premium narrows. Achieving both depends on structural reform, fiscal consistency and reliable service delivery – not on fine-tuning the inflation target.”
