Rate hikes to control rand, not inflation

Rate hikes to control rand, not inflation

Apr 20, 2016

In a highly debated article, Investec’s Brian Kantor went knocking on the South African Reserve Bank’s door, pleading with them to focus on the things they have control over. His main concern is that of stagflation.

And while high inflation is usually cornered by higher interest rates, that’s the case when it’s demand driven. And he argues in South Africa’s case, it’s due to factors beyond the Reserve Bank’s control.

The Bank wasn’t listening and raised rates, using high inflation as the reason.

In economic theory there are two types of inflation:

Cost Push Inflation: This is price increases caused by increased costs of production (increased labour costs, increased costs of raw materials (think higher oil prices due to unrest in middle east, or increased prices for agriculture products due to droughts that are limiting supplies).

Demand Pull Inflation: Demand pull inflation is experienced when there is an increase in demand for goods and services, or when the demand for goods and services outstrips supply of goods and services. Strong growing economies will have increased demand for goods and services as more people are employed. Leading to increased inflation.

SARB’s main tool to control inflation is interest rates. The problem with interest rates is that it is a very crude tool to control inflation. The theory goes that if inflation goes up, it implies that there is too much money available to spend in the economy, and retailers and wholesalers know this, and they start pushing up prices to earn higher margins on their products, causing inflation to rise (Demand Pull inflation).

While this might be true for a fast growing economy. This is hardly ever the case for an economy with sluggish growth, as South Africa is currently experiencing. Interest rates are not as effective in controlling inflation when it is caused by Cost Push factors.

Now that South Africa’s inflation rate has breached the 3% to 6% target of SARB, they need to act (and they have been acting over the last couple of months by increasing interest rates). Problem with increasing interest rates to control inflation, when inflation is caused by external factors and shocks (Cost Push inflation), and not by increased demand (Demand Pull inflation).

Overall demand in the economy will slow down as interest rates lowers the amount of money people have to spend on buying goods and services as more of their money goes towards paying their debt,

Yet there is nothing to suggest that inflation would slow down too as it is not caused by increased demand. In essence we can end up with continued high inflation and lower economic growth (since higher interest rates is slowing down spending in the economy). High inflation and low to no growth…That’s called Stagflation. And this is the situation South Africa is in.

SARB is walking a very tight rope and needs to be careful when deciding on interest rates, as they can end up doing more harm than good by blindly increasing interest rates as inflation goes up. We suspect that the last couple of interest rate increases has been more to protect the vulnerable Rand than controlling inflation.

Higher interest rates leads to more foreign currency flowing into SA to take advantage of higher interest rates, leading to increased demand for the Rand, and it strengthening. A stronger Rand will also ensure that we import less inflation. Import inflation occurs when prices of goods being imported becomes more expensive as the Rand weakens, leading to those goods costing more in Rand terms.

SARB will never admit or acknowledge that they might be increasing interest rates to protect the Rand, as that is not their mandate, but we suspect they are more worried about that Rand than they are about inflation at this point in time, as they know current inflation trends is not due to increased demand in the economy, but due to external factors outside their, or consumers control.

By John Maynard* for www.fin24.com
* This is a nom de plume