Aggressive interest rate hikes may have more to do with the currency than local inflation.

The decision in September to increase interest rates by 75 basis points was an aggressive decision by the Monetary Policy Committee (MPC) considering the weak economy and major power outages.

The repo rate now sits at 6.25% and the prime lending rate is 9.75%. Since the start of the interest rate cycle in November 2021, we have seen the cost of borrowing increase by 2.75 percentage points. On a mortgage of R1 million, the monthly repayment would have increased by R1 730.

The MPC and Reserve Bank argue that this increase is necessary to keep inflation under control. Inflation figures of over 7% are above the official inflation target of between 3% and 6%, and the Reserve Bank has unofficially been targeting an inflation rate of 4.5%.

However, unlike other countries facing high inflation figures, South Africa’s economy is hardly “overcooking” and the drivers of local inflation are not increased demand by consumers but rather external factors of higher fuel and food prices.

“While inflation in South Africa is well above the Reserve Bank’s target range, it is mostly due to fuel and food prices that are set in global markets, and that the Reserve Bank can do nothing about. Inflation rates of items that are sensitive to domestic demand and interest rates, such as housing, remain muted,” says Old Mutual Wealth Investment Strategist Izak Odendaal.

Has the Reserve Bank done the right thing in continuing with aggressive interest rate hikes when our economy is on its knees? Businesses, still recovering from the pandemic lockdown, are now facing prolonged loadshedding, and the latest employment figures show that we have lost another 119 000 jobs in the last quarter.

“It is difficult to explain inflicting pain when the economy is already in pain and more pain coming with stage 6,” says Stanlib economist Kevin Lings, who adds that we do not know what the effect of these interest rate hikes will be on the economy.

Interest rate hikes to temper inflation expectations

Lings says one reason for hiking rates is to temper inflation expectations. Over the last few years, the Reserve Bank has managed to reduce inflation expectations to around 4.5%. The risk, if they do nothing, is that expectations go back to 6% and we see higher wage demands which then fuel the inflation cycle requiring even higher interest rates.

Old Mutual Chief economist, Johann Els agrees. “It is the Reserve Bank’s job to fight inflation and to manage inflation expectations and wage increases. It has done a great job in fighting it and as a result we are close to end of cycle.”

Most economists agree that a rate hike was required, but was such a large (75bps) hike necessary?

Mamello Matikinca-Ngwenya, FNB Chief Economist says they expected the Reserve Bank to “front-load” the rate hikes, in other words hike more aggressively to reach the peak of the interest rate cycle earlier.

“Before the MPC meeting the inflation data was improving. That meant they could have raised rates by only 50bps, but it appears they did not take that into account,” says Lings, who believes the driving factor of the more aggressive rate hike was to keep in line with other central banks which are aggressively hiking rates. The US increased interest rates by 75 basis points in September with expectations that there will be a further 100 basis point increase to come.

Globally, inflation is a major concern, and developed economies in the US and Europe are experiencing inflation rates higher than what we in South Africa are experiencing.

“Although domestic inflation is not as high as in many other major economies, the Reserve Bank doesn’t operate in a vacuum. As other central banks hike, the Reserve Bank will not want to be left too far behind,” explains Odendaal.

Attracting foreign currency

The bottom line is that South Africa needs foreign currency. As a country that relies on imports, we need to fund these foreign purchases with foreign currency and therefore we rely heavily on investment inflows into our bond market.

Having fallen below investment grade, with our financial institutions being threatened with grey-listing, and the continuing Eskom crisis decimating any hope of an economic recovery, there is little else to encourage investors other than our relatively high interest rates.

A good analogy would be a second-tier or newer bank (such as African Bank or Tyme Bank) offering higher deposit rates than first-tier established banks in order to encourage depositors. Depositors or investors need to feel that the higher rate offsets the risk they are taking in investing in a higher-risk institution.

Foreign currency inflows also create demand for our currency and therefore protect the rand against further weakening, which in turn does impact inflation.

“While the Reserve Bank is not directly protecting the currency, a weaker currency might pass through into higher import prices and therefore increase inflation,” explains Els.

“My view is that the currency is the issue, but the Reserve Bank needs to explain that and get people to understand why these interest rate hikes are necessary,” says Lings who explains that it is not just about attracting inflows but about retaining the money that is already invested.

“It would be naïve to think that higher interest rates would see money pouring in, but you don’t want to see money exiting. It is a competitive world for foreign capital flows.”

Lings does see light at the end of the tunnel with the expectation that interest rates will stabilise early next year.

“The Reserve Bank will want to see positive real interest rates where the repo rate is above inflation. Then it will possibly pause the interest rate hikes,” says Lings.

He predicts a further 50bps increase in November and another increase of 50bps next year. This will bring the repo rate to 7.25% and the prime lending rate to 10.75%.

Els is more optimistic and believes that the latest aggressive rate hike will give the Reserve Bank room to stop increasing rates after a 50bps increase in November.

“It has helped to be more aggressive now which allows the Reserve Bank to end the cycle earlier.”

Els also points out that currently, interest rates are back where they were in February 2020 before the emergency rate cuts during Covid.

Matikinca-Ngwenya says their house view is that rates will increase by 50bps in November, however there is still upside risk to inflation if the US dollar continues to strengthen.

“This could derail the slowdown in inflation and risk another rate hike early next year or even a higher rate increase in November.”

The message is clear: while the worst may be over, prepare your budgets for further interest rate hikes.

This article first appeared in City Press.