Will higher interest rates do more harm than good?

Rising interest rates appear to have had little impact on inflation, but higher interest rates are placing South Africans under significant financial pressure.

The current interest rate cycle has been more aggressive than predicted, with interest rates rising 425 basis points since November 2021.

Despite the prime lending rate increasing from 7% to 11.25% in less than two years, it appears to have had little impact on inflation, which remains well above the target of 4.5%. At the same time, households and small businesses are being placed under significant financial pressure.

Has the interest rate cycle reached a point where higher rates would do more harm than good?

In a traditional economic framework, inflation is a result of high demand: too much money chasing too few goods. This would be a good description of inflation in many developed economies which experienced years of exceedingly low interest rates. Yet that is not what is driving inflation in South Africa. There is virtually no demand in South Africa as our economy faces recession.

As Stanlib economist Kevin Lings explains, the start of the inflation cycle was driven by external factors including global inflation, higher oil prices and then the war in Ukraine.

The South African Reserve Bank’s quick reaction to hike rates was to curb “second-round inflation”. This is where price and wage increases are based on expectations of higher prices. This expectation becomes an internal driver of inflation and suddenly you have rampant, out-of-control, inflation rates which become hard to contain.

Inflation hurts the poor the most

As political analyst JP Landman points out, inflation hurts the poor the most. While homeowners and consumers with car finance will struggle with rising interest rates, rapidly increasing food and transport costs have a far greater impact on the poor.

The problem with rising prices, unlike interest rates, is that they never come down again. While rates can ‒ and will ‒ be cut, the price of bread never comes back down. The best we can hope for is that the price increases more slowly. That is why the Reserve Bank is prepared to use a short-term measure like interest rates to curb the long-term ill of higher prices.

Yet the extent to which interest rates have worked in the South African economy is limited. Despite the aggressive interest rate hikes, we are now experiencing inflation in the broader economy driven by different factors, all of them unrelated to interest rates.

Loadshedding is driving food prices ever higher. The amount of money food producers and retailers are having to spend on alternative power is being passed on to consumers.

Then there is imported inflation. “If you look at something like stationery, prices have increased by 10%. This is not being driven by demand, but by global inflation and a weaker currency,” explains Lings. As the rand weakened and global prices rose, so the cost of stationery increased. “A store owner has a choice either to increase the price by 10% or stop selling it,” says Lings.

There is also opportunistic pricing of those goods that consumers are prepared to pay more for. “Inflation on school education is now over 6% and we are seeing double-digit figures at private schools who know they can pass on the price increases as parents are prepared to pay to educate their children.”

So, if all of these price increases have nothing to do with demand, then why are we continuing to use the destructive instrument of higher interest rates?

The question is what would the inflation rate be if we did not have interest rate increases. It could be a lot worse. If demand-driven inflation was added to cost-push inflation, Lings says we could be experiencing double the rate of inflation.

Geoff Blount, chief investment officer at private equity firm Invequity, says that when inflation is cost-push driven, you could take interest rates to 30%, but it will not pull inflation down. So why do we bother?

Higher interest rates attract foreign investment

One of the things interest rates do in South Africa is attract investments. Foreign investors looking for higher returns will watch the interest differential between countries. “If we lag our trading partners and other emerging economies when they are increasing interest rates, the rand weakens and we have imported inflation. So, interest rate hikes work, but for different reasons,” says Blount.

Lings points out that in March when the Reserve Bank increased interest rates by 50bps which was higher than expected, the rand strengthened. “The Reserve Bank would not want to be out of step with the rest of the world when it comes to interest rates,” says Lings.

Higher interest rates also signal that the Reserve Bank is serious about containing inflation and it keeps wage increase expectations under control. While everyone would love a large salary increase, higher salaries become a higher input cost for a company which in turn drives up the cost of production – and therefore raises overall inflation levels.

But as we enter a period where it appears central banks around the world are pulling the foot off the interest rate pedal, is this an opportunity for the Reserve Bank to pause and let the current interest rate hikes take effect? In this environment, would higher interest rates cause more harm than good?

Lings says with the highest interest rate in 14 years there is a real risk that further rate hikes could make matters worse. “If you push up rates further, you do more damage to households and business. If  businesses close and there are further job losses, that results in less economic activity and less tax revenue. Now you have a weakening economy resulting in lower tax collection,“ says Lings.

That then becomes a problem about fiscal stability, worsening sovereign credit ratings and foreign investors becoming weary. If consumers start defaulting on debt then there is a concern about the stability of the banking system.

“At that point high interest rates are doing more harm than good. You are inflicting so much damage that you make the government’s fiscal situation unattractive for investment and it is not helping with inflation,” says Lings.

The good news is that economists are hoping for a respite from interest rate hikes, however South African consumers will need to become used to higher overall interest rates.

Mamello Matikinca-Ngwenya, FNB Chief Economist is expecting the SARB Monetary Policy Committee to keep rates unchanged at its next meeting on 25 May, unless there is a rise in inflation. The bank then expects the SARB to start cutting interest rates towards the end of 2024.

However the repo rate is expected to settle around 7% with prime at 10.5%. “This is consistent with the global “higher for longer” theme, given medium-term inflation that remains higher than pre-pandemic averages, as well as the SARB’s view of a suitable level for nominal interest rates over the longer-term.”

A blunt instrument

Ultimately interest rates are a very blunt instrument, made even more blunt in South Africa’s context.

Simplistically, interest rates are seen as a lever to moderate the temperature of an economy – yet in South Africa we have so many structural issues that interest rates have very little real impact.

Lower interest rates will not suddenly bring economic growth to a country with no electricity supply and broken infrastructure. It will not solve a chronic unemployment problem caused by lack of growth and a very broken education system.

The SARB cannot solve our economic challenges – it is just playing at the margins and trying to prevent us from reaching a point from which we cannot return.

This article first appeared in City Press.