Repo rate hike will do little to curb inflation

As of today, you’re paying R1 469 more each month on a 20-year home loan of R1 million than you were back in January 2014, when the SA Reserve Bank began its rate hiking cycle. Beyond making your debt more expensive, it’s not clear whether interest rate hikes are very effective at doing what they ought to be: keeping inflation under control.

According to John Loos, household and property sector strategist at FNB Home Loans, the Sarb has raised the repo rate by a cumulative 1.75 percentage points since January 2014.

On Thursday, a 50 basis point hike took the repo rate to 6.75%, which is a full percentage point ahead of where it was less than 12 months ago and accounts for a R331 climb in the monthly mortgage payment example.

Commercial banks promptly raised their prime lending rate – the benchmark rate at which they lend to the public – to 10.25%.

Why did the Reserve Bank hike the repo rate? Chiefly, it’s concerned about spiralling inflation, which it forecasts will average 6.8% in 2016 and 7% in 2017 – uncomfortably higher than its 3-6% target range and indicative of higher drought-induced food prices and a weak rand.

The latter effectively imports inflation by making any imported goods, including materials used to produce basic goods and services, more expensive.

Whether or not hiking interest rates can do anything about food prices driven by a drought – or a weak currency, wage inflation and higher electricity prices – is debatable.

Responding to inflation that is demand driven is a “rare luxury nowadays”, as most inflation comes from the supply side, admitted Rashad Cassim, head of the Sarb’s research department. Cassim said that monetary policy, specifically inflation targeting, is most effective in moderating the consumption of discretionary products.

In other words, if inflation is rising because consumer demand for goods and services is pushing prices up, it’s quite easy to moderate that demand by increasing interest rates so that goods cost more.

Responding to supply-side inflation, however, is much more difficult because it is very often driven by external factors.

“It’s a bit like pushing on a piece of string,” commented chief strategist at Citadel Wealth Management, Dr Adrian Saville. “The sources of inflation are overwhelmingly supply-side,” Saville said, pointing to currency weakness, drought-effected food prices, energy inflation and wage inflation.

“Raising interest rates will do nothing to any of those. It may only have a secondary effect on the strength of the currency, which will alleviate imported inflation,” he added.

The Sarb expects food inflation to peak at 11% in the fourth quarter of this year, as the country battles its worst drought since 1904. Risks of electricity tariff increases are seen as being on the upside and wage growth continues to outpace inflation.

While inflation targeting is more effective in dealing with demand-side shocks, which is the “crux of the dilemma”, according to Cassim, it remains the only tool that the Reserve Bank has, he said.

“We are not responding crudely to an increase in prices from drought, for instance. What we are really trying to do is assess what implications these exogenous supply shocks will have on inflation and inflation expectations. A critical function [of interest rate hikes] is to ensure that these supply shocks don’t feed into what we call second round effects,” Cassim said.

Attempts to defend the rand?

Cassim said that the upward trend in core inflation – which excludes food, fuel and electricity – provides an indication of a possible emergence of second-round effects.

Second-round effects refer to a variety of flow-through impacts that rising inflation has on an economy. An example could be workers demanding higher wages due to the rising cost of living.

Saville is unconvinced that repo rate hikes will stem even the so-called second-round effects of inflation and suggested that the hikes could be an attempt to defend the rand. “The fair value of the currency is much stronger than current levels,” he said.

Under Reserve Bank Governor Christian Stals (1989 – 1999) interest rates eventually “brought sanity to the pricing of the rand”, Saville said.

The bank is, however, quite careful to distance itself from intimations that it may be targeting the exchange rate. Reserve Bank Governor, Lesetja Kganyago on Thursday said there was a time when the Sarb interfered in the foreign exchange market and that it “came out second best”.

The Reserve Bank adopted inflation targeting as a monetary policy framework in 2000, he said.

Perhaps unsurprisingly then, Kganyago stressed that “the growth constraints facing the economy are primarily of a structural nature and cannot be solved solely by monetary policy”.

If at all, governor, if at all.