Today’s blog post is an ungated version of a Financial Mail article which discusses the disagreement between market pricing, market analysts and the SARB’s projections.
What does the data imply SARB should do?
The SARB Monetary Policy Committee (MPC) will decide whether to hike the policy rate on 23 September. The market thinks hikes are a done deal. Market analysts are still split about whether it will happen in September, but agree tightening is on the horizon. But SARB’s projections still assume it can cut rates in November. The Governor likes to say that MPC decisions are data driven. But what data should SARB look at and why does the market disagree with SARB?
A good starting point to judge whether the data imply that SARB should hike or not, is to use the SARB’s own model. SARB’s model not only uses observable economic data like inflation, but also draws on unobservable estimates of things like potential growth, expected inflation or risk premia. Because the Reserve Bank has not published the exact inner workings of the model it currently uses, a full-scale simulation of its model is not possible. Instead, we can use the Bank’s own formula for determining how it reacts to economic developments, alongside its latest projections for inflation and growth, to see where rates should be heading.
SARB’s model implies that interest rates should be set consistent with the Bank’s estimates of how much economic slack there is (the ‘output gap’), how far it expects inflation to deviate from target (which depends partly on inflation expectations), its estimate of the ‘goldilocks’ level of interest rates where they neither speed up or slow down the economy (known as the ‘neutral’ rate), and how much growth is expected to deviate from potential growth. If we use SARB’s assumptions: that the economy is below potential, that inflation will come down to the target and surveyed inflation expectations fall over time, and the policy rate is above the neutral level, then the current policy stance is justifiable.
But if we instead base the outlook for inflation on our estimates of market-implied inflation expectations and use our estimate of the neutral interest rate based on market pricing, the SARB needs to tighten policy ensure that it will achieve a 3% target over the medium term. If one were to also assume that potential growth is lower than SARB’s estimate, it would further increase how much the policy rate would need to rise.
How much the SARB will need to tighten depends mainly on how long one expects inflation to remain above target, whether you believe surveys or market-based measures of expectations best capture price and wage setting behaviour in South Africa and whether you think market risk premia will fall to the level SARB assumes.
For SARB to be able to cut as it continues to project, on the other hand, inflation will need to come down a lot compared to what most market analysts currently expect, and inflation expectations must be better anchored than has historically been the case.
The data and the Reserve Bank’s own formula show that interest rates will need to stay high for longer than official forecasts suggest. Unless we get a sequence of good news — as SARB assumes in its baseline projections — borrowing costs are not coming down anytime soon. Lower food inflation and domestic petrol prices certainly were recently welcome pieces of good news. But the bad news is that South Africa’s structural fundamentals do not give the SARB a lot of room to manoeuvre.
Government continues to make a 3% inflation target hard to achieve, with public sector-related inflation running well over double the target level. Our market-based estimates of inflation expectations and inflation risk imply that sustainably reducing inflation to the new target will require monetary policy to remain tighter for longer to re-anchor inflation expectations to a permanently lower level. Infrastructure bottlenecks and increasing compliance burdens on business are eroding our growth potential and raise costs throughout the economy. The possibility of a ‘super El Niño’ and continuation of the conflict between the US and Iran create further upside risk to the inflation outlook.
Everyone wants to feel optimistic about South Africa’s future, and the Reserve Bank has led the charge, tending to overestimate economic growth over the past decade. But plugging more realistic assumptions into the Bank’s own interest rate formula delivers an important reality check: South Africans will not see lasting interest rate relief without deep economic and political reforms.
Dr Steenkamp is CEO at Codera Analytics and a research fellow with the Economics Department at Stellenbosch University. Sinead Morrow is a researcher with Codera. This article is based on their paper Evaluating monetary policy rate settings under data uncertainty in South Africa.
