Reasons why the SARB is likely to be conservative with rate cuts
CPI inflation for July 2024 surprised to the downside, slowing from 5.1% y/y in June to 4.6% y/y in July versus expectations of 4.8% y/y. Importantly, the downside surprise was largely due to lower administrative price inflation which, excluding fuel, fell from 8.5% y/y to 8.0% y/y. Slower administrative price increases will feed through to lower 12-month ahead inflation forecasts, and expectations of interest rate cuts have already been revised lower post the print. Interest rate derivatives are now more than fully priced for a 25 basis point (bp) cut in September and expect 133bp of cuts over the cycle, to July 2025.
We think that expectations of 100bp to 125bp worth of cuts are realistic and that calls for cuts of 175bp may be too aggressive. In large part, this is because of the South African Reserve Bank’s (SARB’s) longer-term goal, to shift structural inflation closer to the bottom of the current 3% to 6% target range. There is resistance to a lower target from government and National Treasury, but we hope that recognition of its net positive impact on GDP and fiscal sustainability will help to garner support as the debate continues. Our rationale for this is set out below.
Inflation promotes poverty
Inflation in South Africa increases the number of people living in poverty. The 23.6 million South Africans defined as poor (bottom 3 deciles of the country’s income distribution), experience higher and more volatile inflation than other households (Figure 1). “By measuring real income with the inflation rate experienced by the poor, rather than total inflation, the poverty head count rate goes up by 4.5 percentage points over the period 2005 to 2010” (Finn, Leibbrandt, and Oosthuizen, 2014).
Compounding the burden on the poor and reducing the potentially positive impact of inflation on inequality and GDP, poor South Africans (as defined above) have near negative unity price elasticities for all food items This means that in response to a 1 percentage point increase in the price of food, these income groups will consume 1 percentage point less food. Because these income groups are often unemployed and have no buffer against inflation, high food inflation can easily translate into malnutrition. This implies that the choice of inflation target matters directly for their well-being.
Why inflation doesn’t generate GDP growth in South Africa
Conventional economic theory dictates that, from a cyclical perspective, rising inflation should encourage consumption, by incentivising consumers to buy now, rather than later when prices are higher; and production, if there are unemployed resources in an economy, such that increased demand for labour doesn’t induce higher wages. Businesses increase employment and finally increase investment. This positive effect of inflation on growth tends to only hold in the short term until nominal and then real wages rise, interest rates are hiked, and the downward phase of the business cycle ensues. But SARB research shows that, for South Africa, higher inflation does not promote growth, even in the short run (Occasional Bulletin of Economic Notes 20/01 The impact of inflation on the poor, June 2020)
Currently 28.3 million South Africans are social grant beneficiaries such that their income is not subject to the higher inflation indexation faced by lower income deciles (Figure 1). Faced with higher inflation and no employment prospects they are worse off. People who are employed and represented by unions have very strong bargaining power and higher inflation translates far more quickly into higher wage inflation. “Dadam and Viegi (2015) find that wage inflation dynamics are not affected by the level of unemployment, and respond strongly to the level of inflation expectations (held by unions). This means that real wages adjust quickly to inflation increases and are not responsive to changes in unemployment. Those that have new jobs are better off, but most unemployed people do not get jobs. Under these conditions, higher inflation is not effective in stimulating economic activity and generating employment gains even in the short-run”
Further constraining the positive effect of inflation on growth is South Africa’s infrastructure constraints. GDP growth tends to be capped by electricity, rail, service delivery etc., while inflation is not capped. In other words that the output gap closes quickly, despite the high level of unemployment.
Figure 1: Inflation rates per expenditure decile
Source: Stats SA, Matrix
The SARB’s paper conducts empirical analysis for South Africa’s 23.6 million people in the bottom three deciles of the income distribution. It estimates that a 1% increase in inflation results in an R112 increase in the cost of living, while the increase in consumption is between R30 and R75. This results in a net loss with respect to expenditure and economic activity. It also finds that even if a 1% increase in inflation in South Africa were able to generate a real GDP growth rate of 5%, it would not be able to offset the negative income effects for the poor.
From a fiscal perspective, National Treasury has expressed reservations about the effect of lower inflation on tax revenue. However, our back-of-the-envelope calculation implies that a 1.5 percentage point (ppt) reduction in the GDP deflator over the medium term expenditure framework (MTEF) (2024/25 to 2026/27) would reduce tax revenue by R150bn.
On the other hand, the reduction in non-interest expenditure amounts to R130bn, with the wage bill lower by R70bn, and social grants by R60bn. And our rough estimate with respect to Inflation-linked bonds is that debt service costs could reduce by R20bn per year. Consequently, we estimate that a lower inflation rate of 3% is likely to be at least budget neutral from a deficit perspective and should have an additional positive impact on borrowing costs.
The above does not account for the upside to the currency, which will benefit if inflation falls in line with the country’s trading partners.
Although barriers to achieving lower inflation are stark, the overwhelmingly positive impact of lower inflation makes declaring it as a target the first step in the right direction.
