‘With inflation falling and growth collapsing it is time to cut interest rates’

by Clyde Rossouw & Nazmeera Moola, Investec Asset Management 0

The SA economy is in recession – two quarters of consecutive declines in the real distributable pie. The only bright spots are agriculture, which is largely rainfall-dependent, and mining, which is largely commodity price-dependent. These two sectors cannot be directly helped by monetary policy, insofar as interest rates are concerned.

All three rating agencies have made it clear that they would view a weaker growth outlook very negatively.  If South Africa is serious about avoiding further downgrades, the key areas that need to be addressed are the growth outlook and the growing concerns about “institutional quality”. The Reserve Bank can also do little about long-term growth.  That is the job of the rest of government.  Currently the commitment of the broader cabinet to boosting South Africa’s structural growth rate is unclear.  For example, the revised Mining Charter released last Friday will stunt growth in the mining sector for years to come as the industry battles the government in court.

While confidence is lacking at present, the Reserve Bank does have an ability to influence growth in the shorter term, even if it is only cyclically and at the margin.  Given the weakness of growth, this is an important consideration to escape the negative spiral.

The SARB’s mandate is to target inflation.  This mandate has proven to be far more successful and transparent than any rule the SARB has followed historically.  Since 2001, the data shows that the Bank has targeted 5.75% – just below their 6% ceiling.   With inflation falling sharply, there is growing scope to cut interest rates as the year progresses.

The SARB appears averse to such action.  The Bank is concerned about the outlook for the rand.  The May MPC statement noted that “the risks to the inflation outlook, will be highly sensitive to unfolding domestic political uncertainty.”  As a result, the Bank is opting to remain hawkish.

Why would easier monetary policy, which is focused on getting the policy settings right in an economy be seen as negative? The combination of a strong currency and high real interest rates is clearly negatively impacting on growth.

The May MPC statement went on to say that they believe “the current level of the repo rate is appropriate for now…..A reduction in rates would be possible should inflation continue to surprise on the downside.”

The data for both growth and prices show that policy settings are too tight.   The result is hot money inflows chasing high interest rate differentials, a stronger rand and ultimately poor economic growth. Disinflation in the economy is undermining profits, hurting wage growth and curbing investments.

Lower interest rates will reduce the incentive for hot money to flow into the local markets. Is the Reserve Bank worrying too much on flows reversing? If SA gets downgraded by both Moody’s and S&P, we expect ZAR120bn to flow out as South Africa is ejected from the WIGBI.  However, will it?  Barclays sold Absa shares worth R36bn at the beginning of June, and the currency didn’t flinch. Setting interest rates on a forecast of the rand(om) is questionable.

An economy that sees cash in the bank producing the best investment returns compared to other investments is indicative of an economy which has overly discouraged both investment and risk-taking entrepreneurial activity. Households have further been squeezed by too high interest rates at a time when tax rates are also rising, further reducing consumption expenditure.

Many economies in the developed world are stagnant. They have no levers to pull to influence economic outcomes with interest rates at or below inflation. SA is not in this position.

We see this as a time for the SARB to take the lead and make a bold, but correct step looking forward. Changes in policy impact the economy 18 months in the future. If inflation is at 4% by year end, why would short-term rates at 6% be incorrect? That is 100bp lower than today. 2% in real terms is still a lot tighter than most peers.  Given the current political uncertainty, 100bps is potentially wishful.  However, rate cuts of 25-50bps before December look very plausible.

It is important we highlight here that we are proposing rate cuts within the current mandate of the SA Reserve Bank.  We see no need to change the mandate or Section 224 of the Constitution, which governs the objectives of the Bank.  Rather the opportunity to cut interest rates is greatly premised on the strength of the Reserve Bank’s credibility.  The vehicle charting the trajectory to lower interest rates should not be hijacked by politics.

The SARB is internationally viewed as amongst the strongest institutions in South Africa, with the quality of financial sector regulation regarded as being viewed as world class.  The Public Protector’s proposed change would remove the need for the SARB to protect “the value of the currency in the interest of balanced and sustainable growth in the Republic.”  In addition, the Bank would be required to liaise with parliament to “achieve meaningful socio-economic transformation.”

The wording in the Constitution was carefully chosen.  It limits the SARB’s ability to monetise government debt by printing money.  Thus it protects the value of the currency in the Republic, protecting the purchasing power of the rand for the average wage earner.  It protects South Africa from a return to the inflation rates of the late 1980s.  Or from the many currency crises that Zimbabwe, Argentina and Italy (pre-euro) have faced.

With seemingly innocuous changes, Busisiwe Mkhwebane has raised concerns about the inviolability of the independence of the SARB.  Her ability to achieve the proposed changes is highly questionable – Does the Public Protector have the authority to direct parliament to make constitutional changes?  However, her actions may make MPC members more cautious about supporting rate cuts.  We think this would be a mistake.

Despite the unnecessary discussions the public protector has sparked, the palpable threat to the independence of the SARB is limited.  Therefore we would hope that the MPC is able to look beyond these machinations – and focus on their mandate.  Inflation is falling, growth is collapsing.  It is time to cut interest rates.

While the SARB may be tempted to be overly cautious at this time, we think that would be a mistake.  Rate cuts at this point will provide some much needed relief to the SA economy.  Keeping the SA economy out of stall speed is vital to prevent the threat of further populism down the line.