David Crosoer | Chief Investment Officer | PPS Investments | mail me |
The South African Reserve Bank (SARB) recently signalled its intention to target the lower band of the 3% to 6% inflation range.
Previously, the Bank adopted the mid-point of 4.5% as its formal objective in 2019. This shift shows a deliberate effort to anchor investor expectations closer to 3%. It may also reshape long-term assumptions about South African inflation as SARB focuses on targeting the lower inflation band.
With current inflation hovering near the bottom of the band, SARB’s messaging implies a commitment to keeping it there. Achieving this will require higher short-term interest rates for longer periods. Moreover, given the many inefficiencies in the South African economy, this approach raises important questions.
Can targeting a lower inflation rate, without proper structural reforms, make economic growth more difficult and further constrain the ability to service growing debt?
Investor response and market effects
The dilemma for SARB and for long-term domestic holders of government debt is clear. Both real economic growth and the debt-to-GDP ratio continue to worsen. A hawkish monetary policy aimed at suppressing inflation may not support either indicator. In fact, it could intensify fiscal pressures if growth remains weak, even while targeting the lower inflation band.
In the short term, foreign investors have responded positively. The prospect of lower inflation has increased their willingness to fund government debt. Expectations of capital gains have contributed to a decline in long-term yields on South African nominal bonds.
However, the implications for debt sustainability remain complex. Lower inflation will reduce the cost of inflation-linked debt, which adjusts with the consumer price index. For nominal debt, the benefit is less straightforward. If SARB keeps real interest rates elevated to maintain low inflation, the cost of servicing nominal debt may not fall meaningfully. It could even rise in real terms, despite targeting the lower inflation band.
Global context and historical trends
Globally, most emerging market central banks target the mid-point of their inflation bands. Developed market central banks typically aim for a symmetrical point target, usually around 2%, which they may overshoot or undershoot but seek to average over time. SARB’s new approach aims for an average inflation rate as close to 3% as possible, though likely not by allowing inflation to fall below that level.
Historically, since adopting inflation targeting in 2002, South Africa has rarely recorded inflation below 3%. The policy emerged after two decades of double-digit inflation. Yet before the 1970s, very low or even negative inflation periods were not unusual.
One ambiguity in SARB’s strategy is whether it will treat deviations below 3% with the same urgency as those above 6%. If not, the policy could invite political pressure when inflation undershoots. In such cases, monetary policy may appear too restrictive, placing unwanted pressure on SARB and potentially compromising its independence.
Balancing structural realities and policy goals
The Bank’s motivation is understandable. Since adopting inflation targeting, South Africa’s average inflation rate has not diverged much from its long-term historical trend. Inflation has stayed within the 3% to 6% band for most of this period. By targeting the lower inflation band, the Bank hopes to reduce the inflation risk premium embedded in government debt yields.
Our internal models currently assume a long-term inflation rate of 5.5%. If we, along with other investors, adjust this assumption downward in response to SARB’s new stance, funding government debt at lower yields becomes more likely. This outcome is precisely what SARB intends. Greater certainty around inflation should reduce the premium that investors, both local and foreign, demand to hold South African debt.
That said, South Africa’s structural inefficiencies in labour, energy and logistics have historically required a higher inflation rate to absorb rigidities and maintain nominal growth.
Unexpected inflation can also help ease pressure on ballooning government debt. Aligning inflation closer to that of more efficient trading partners may unintentionally constrain the economy. It could make structural adjustment and growth more difficult, even while targeting the lower inflation band. In this context, a lower inflation target may be desirable in theory, but not necessarily optimal in practice.
