BER flags economic implications of changing inflation target in South Africa

The Bureau for Economic Research (BER) has revealed that the South African Reserve Bank (Sarb) may no longer be pursuing an inflation target of below 4.5%, which could have substantial implications for the nation's economy.

In a recent analysis, BER indicated a growing consensus among economists that the Sarb's focus has shifted away from the previous benchmark, suggesting a potential move towards a lower target of around 3% over time.

This development follows a year in which South Africa encountered three national budgets, signalling a period of significant economic recalibration.

While the Sarb's inflation target technically remains unchanged, BER remarked that it was evident the central bank was not committed to the 4.5% aim any longer.

“The inflation target shift has big implications for the economy. Our (mid-July) baseline assumes monetary and fiscal policy will remain tight for the foreseeable future. It expects that a shift to a 3% inflation target will occur over time, meaning that real interest rates will stay restrictive with cuts only when inflation expectations settle near this lower target,” said BER.

BER's analysis suggests that while an optimistic scenario would see the National Treasury adopt this new 3% target promptly, aligning its fiscal policies accordingly could foster stronger backing for the Sarb's disinflation efforts.

“This cooperation strengthens the bank's disinflation efforts, so inflation converges to 3% sooner, allowing interest rates to be cut earlier. Lower borrowing costs support household spending and investment. The rand strengthens, reducing imported inflation and restoring confidence.”

Such cooperation could lead to earlier interest rate cuts, supporting household spending, boosting investment, and strengthening the rand.

The BER said that in its optimistic case, which broadly aligns with the Sarb's baseline forecast, Treasury embraces the 3% target soon and aligns its fiscal framework accordingly by revising down spending growth and reinforcing fiscal anchors.

Conversely, in a pessimistic scenario where Treasury neglects the 3% target and retains expectations around 4.5%, significant downtrends could surface. This misalignment could harm the bank’s credibility, resulting in persistent higher inflation and a need for prolonged elevated interest rates.

“This disconnect undermines the bank’s credibility, inflation expectations stay higher, and inflation remains sticky at around 4.5%,” it said.

“To get inflation down, the bank keeps rates higher for longer but despite higher rates, the rand weakens, increasing the cost of imports and external debt. Capital inflows slow, causing financial volatility. Growth stagnates closer to 1%, unemployment rises, and fiscal metrics worsen.”

Amidst this backdrop, North-West University Business School's economist Professor Raymond Parsons remarked that achieving a 3% inflation target would necessitate short-term sacrifice in economic growth.

Parsons pointed out that the Sarb acknowledges that keeping interest rates high for a longer duration will ultimately create advantages for borrowing rates once a stable lower inflation environment is established.

“The Finance Minister has emphasised that there is no official decision pending to change the target. The Sarb Governor has subsequently said that the present 4.5% midpoint inflation target remains operative for now,” he said.

“It is desirable that this apparent conflict between the Sarb and National Treasury about the future inflation target should be resolved as soon as possible to eliminate uncertainty.”

Unisa economist Dr Eliphas Ndou said that the lowering of the inflation target will remain a contentious policy issue, but the adoption of the proposed target point should be based on the cost-benefit analysis.

“I would rather suggest a 2% to 4% target band, as research indicates that monetary policy is more effective at this band compared to outside this range,” Ndou said.

“Thus the change in repo rate is passed much more through to lending rates at lower inflation levels. In this regard, the lowering of the target band would be more beneficial to the borrowers.”

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