Has South Africa’s Inflation Target Shifted?

Lesetja Kganyago has finally walked the walk. After years of hawkish talk, the South African Reserve Bank (SARB) finally took an actual hawkish decision at the November Monetary Policy Committee (MPC) meeting when it decided to raise rates despite the stronger Rand and improved inflation outlook. The 25 basis point rate hike reverses the 25bp rate cut made earlier this year in March.

SA Repo Rate

There was a reasonable case to be made for both hiking rates and remaining on hold. Prior to the meeting this was reflected in the forecasts on Bloomberg where 9 out of 18 economists expected rates to remain on hold, while the other 9 forecasted a hike. The MPC was split as well with 3 members favouring a hike and 3 preferring to keep rates on hold. Lesetja Kganyago as governor has the final decision, so his preference for hiking was decisive.

The case for and against the hike

The case for holding rates steady centred around an improved inflation outlook. The SARB’s inflation forecasts for 2019 was reduced from 5,7% to 5,5%. The majority of economists expect it to be even lower. Since the last MPC meeting in August the Rand had strengthened 5% against the USD. The oil price has also fallen by 25% in Rand terms, leaving a potential R2,40 petrol price cut on the cards.
The case for hiking focused on the need to move inflation expectations closer to the midpoint of the 3-6% target band. The other key factor was the global environment where liquidity conditions have tightened, and rates have been moving higher. Over the last year we have seen 4 rate hikes in the US. This has put pressure on a number of emerging markets and most of them have already started hiking cycles. The following chart shows the gap between US and SA rates.

SA Repo vs Fed Funds

With the FED hiking rates and the SARB cutting, the gap between the official rates had narrowed to its lowest level over the last decade. With the Fed expected to hike 25bp in December, and further in 2019, the SARB viewed it as inevitable that rates would have to move higher. Delaying hiking now could mean a greater number of hikes in the future and that is why they chose to react.

Has inflation target been adjusted?

The 3-6% target band has been in place since inception of February 2000. Throughout this period, it has been accepted by the SARB and the market that the goal was to keep inflation below the upper end of the 6% target. Rates were generally hiked when inflation was forecast to be above target, and there was room to cut when inflation was forecast to be below 6%. The lower bound of 3% and the midpoint of 4,5% were mostly irrelevant.

In speeches and investor meetings over the last two years there has been a change in the rhetoric. MPC members have consistently communicated the desire to shift inflation expectations from the 6% upper end of the target band towards the 4,5% midpoint. Lesetja Kganyago style and tone has been far more aggressive than under the previous governor Gill Marcus. But despite all the hawkish talk, the SARB cut rates in July 2017 and March 2018 in order to help a struggling economy. While inflation was supportive at the time, it was definitely a dovish action in an environment of rising global rates.

After all the talk, this November rate hike is the first action which indicates that the SARB is looking to manage inflation down towards 4,5%. They have indicated that it will take around 5 years to get there, so there is no intention to be very aggressive at the expense of the economy. This is an MPC that has been uncomfortable for some time with expectations being anchored towards the upper end of the range. They are willing to acknowledge that they have some responsibility for elevated inflation expectations in SA given that historically they have only reacted when the upper band was breached. Governer Kganyago has been talking about this for some time, so he is definitely on board with the new strategy. However, the 3-3 split for the last hike shows that not everyone is convinced with the new hawkish tilt.

This was a good opportunity for the SARB to hike rates as part of a normalization process and they took it. On balance it is positive for bonds, but I don’t think that one hawkish action, on a split decision, is enough to demonstrate a fundamental change in approach and I wouldn’t be adjusting my valuation models quite yet.

Is this the start of a hiking cycle?

The SARB’s quantitative Quarterly Projection Model (QPM) indicates a further 3 hikes, but they won’t materialise if inflation remains contained and the economy is weak. The SARB is slightly more hawkish and more focussed on the midpoint, but this is a long-term aim and they are unlikely to inflict pain on the economy in the process. The key driver will be the US where the market expects a further hike in December, and one more in 2019. The FED itself expects a hike in December and a further 3 in 2019. If those do materialise then the SARB will have to follow suit and we can expect the SARB to continue hiking rates next year.

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