Reserve Bank governor Lesetja Kganyago’s bold call for a lowering of the inflation target to 3% comes at a vulnerable stage in SA’s recovery, just as inflation is picking up and at the anticipated start of an interest-rate-hiking cycle.
In a recent public lecture at Stellenbosch University, Kganyago conceded that though the timing is "delicate", he believes that "if SA wants to keep interest rates low, the most important thing we can do is to lower the inflation target".
The governor has for months been expressing a desire to correct the "major policy mistake" he feels the Bank and National Treasury made by failing to lower SA’s original 3%-6% inflation target, set 21 years ago, to 3%-5% in 2004, and then take it further down to 2%–4% along a clear glide path.
This plan was derailed in 2001 when the rand collapsed during the Argentine crisis because of the fear that this would have serious inflationary consequences. Though the rand recovered, the impetus to reduce the inflation target was lost.
Over time, the target range of 3%-6% came to be interpreted as a target point of 5.99%, which entrenched higher inflation and higher inflation expectations. This resulted in nominal interest rates being several percentage points higher than they might otherwise have been.
Every other emerging market that started targeting inflation around the same time as SA did has revised its target lower at least once. The average inflation rate across other middle-income countries over the past five years has been just over 3%. SA ranks last, with an average of 4.7%
About four years ago, the Bank decided to explicitly target inflation of 4.5%. Since then, it has succeeded spectacularly in anchoring inflation expectations at this point and driving SA’s inflation rate structurally lower.
The Bank initially thought it would have to lift the repo rate to 8% or higher to get inflation down to 4.5%, which would have shaved 1%-1.5% off GDP. Thanks to global disinflationary forces and slowing domestic demand, it achieved this without hiking rates.
"But 4.5% is not an optimal target," said Kganyago, "it’s just a logical and balanced interpretation of a target we should have reformed two decades ago."
With inflation, excluding the administered prices set by the government, having averaged a mere 3.5% this year, Kganyago understandably wants to bank these gains. His ambition is to narrow the inflation gap between SA and its peers for the welfare and competitiveness benefits this would bring.
However, any change in the inflation target must be agreed to by the finance minister. It is not yet clear where the new minister, Enoch Godongwana, stands on the matter, though he is a staunch supporter of the Bank and its independence.
The setting of an inflation target is an inherently political decision, notes Absa senior economist Peter Worthington, and one which he fears is likely to attract "fierce blowback" from the Left.
As such, he questions whether it’s worth waging a political battle for a reform that is probably not at the top of the government’s to-do list.
"[It’s] better that the government should spend its scarce political capital on getting some of the key structural reforms, such as mining charter 3, and continuing fiscal discipline, over the line," he argues.
RMB Morgan Stanley senior economist Andrea Masia agrees that political capital could be better spent by focusing on fiscal policy and debt management.
"After all, if policymakers are successful at lowering the risk premium through better fiscal policy, the effect would be a likely reduction in the neutral interest rate, which directly supports the Bank’s intention of removing monetary policy accommodation," he says.
Even so, he is in favour of a 3% target, arguing that "at 4.5% we’re miles away from our emerging-market peers, so something needs to be done".
But, having studied the international literature on the subject, Masia says it is unclear what the optimal inflation target for SA should be. Since the mid-1990s, about 60 academic studies have shown that the optimal level for inflation, globally, is 0%.
A great number have also found it to be less than 0%.
There certainly isn’t strong support for the 2% target that most of the large central banks have anchored around, and there is no consensus that 2% inflation is better than 3% or 4%, he finds. However, in the absence of a robust estimate for SA, he believes the best thing to do is to move much closer to the international norm of 2%-3%.
If SA can get inflation to stabilise at lower levels the rand stands to gain hugely, the growth rate in the cost of living would slow down, and income would hold its value, says Masia.
But what about the sacrifice ratio? How much growth would need to be sacrificed to achieve permanently lower inflation?
Across all the literature for all countries, estimates of sacrifice ratios average about 2%. However, it is a difficult thing to model. Though there is no shortage of estimates, they are strongly influenced by the modelling technique used and the inclusion of different control variables.
Various academic studies put the output or GDP sacrifice required to lower SA’s steady state inflation by one percentage point at anything from 1.8% to 7.7% — a range that is not only unhelpfully wide, but also changes with time.
This suggests that the Bank cannot be very certain as to how much output would have to be forgone to achieve an inflation target of 3%.
Kganyago seems relatively unconcerned, however, stating in his lecture that South Africans "should not be especially worried" about the disinflation costs of lowering the target.
"I am well aware that this is a delicate moment for SA’s economic recovery, and also that global inflation has picked up," he conceded.
"That said, I am even more painfully aware of an SA disease: we are scared of reform; we make every excuse to avoid it; we emphasise any short-term pain and discount any long-term benefits; and then we sit around wondering why our economy is stagnating, why our young people can’t find jobs, and why we are getting steadily poorer relative to the rest of the world."
According to RMB Morgan Stanley, the market narrative is that a target of 3% would result in additional tightening of about 40 basis points. But Masia is far more sanguine, pointing out that this ignores the role of central-bank credibility and forward-looking inflation expectations.
As the Bank has a reputation for being highly orthodox and hawkish, market participants would expect monetary policy to tighten, he says. Price-setters would adjust their behaviour accordingly and market interest rates would rise, cooling demand and driving inflation towards the new target.
[SA is] scared of reform; we make every excuse to avoid it; we emphasise any short-term pain and discount any long-term benefits; then we wonder why our economy is stagnating
— Lesetja Kganyago
"In that event, official interest rates might not need to rise on a vastly different path than would otherwise have been the case," says Masia.
Even so, Citibank economist Gina Schoeman thinks it would be "incredibly difficult" to get inflation to stabilise below 4%, and impossible to stabilise it below 3% painlessly, unless administered prices were brought under control.
This would be a big ask: it would mean slashing the annual price hikes that entities such as Eskom, Transnet and the water boards have become accustomed to. It would also require municipalities to restrain their annual rates, services and tariff charges, which they pad out to cover unsustainable salary bills.
Given the adjustment required, it seems likely the Bank will phase in any shift to a lower target over several years, possibly starting only in late 2022 or early 2023. This would give it time to undertake extensive research and inform the macroeconomic review which the National Treasury is currently undertaking, allowing both to consult widely before adopting a formal stance.
Masia is not in favour of a phased approach, arguing that SA will gain very little benefit from moving the target from, say, 4.5% to 4%. But Schoeman would be very surprised if the Bank didn’t adopt a phased approach, given its aversion to big, bold moves.
"The Bank knows a change of target would be a huge event for the markets and won’t want to shock them with something like three hikes in a row," she says. "The Bank will go slowly; it has its credibility to lean back on."
Schoeman doesn’t expect an announcement of a new target for at least another year, arguing that there are just too many uncertainties to deal with at present. These include the fact that Stats SA will be partially reweighting the consumer price index basket in February 2022, and that the Bank’s normalisation cycle is expected to kick off in November this year.
Then there’s the ANC conference in 2022, at which the party could vote to introduce a basic income grant — something that would probably be inflationary from a fiscal and spending perspective. Populists in the party could also use dissatisfaction at a proposal to lower the inflation target to open a new assault on the Bank’s independence.
Whatever happens, the policy trade-offs will be tricky. The burden of communicating all this calmly to the public will require that the Bank act with maturity and finesse. It will no doubt rise to the challenge, but the public — and the ANC — are unlikely to respond in like terms.
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