Interest rates are an exercise in relativity

Given its influence on monetary policy, economic indicators, financial markets, the banking sector and overall financial stability, interest rates (using the repo rate as the benchmark) attract significant attention and discussion from policymakers, economists, investors, analysts and the media.

The repo, or repurchase, rate is the interest rate at which the SA Reserve Bank is willing to extend credit to banks. It is not to be confused with the prime rate, which is the lowest rate at which a clearing bank will lend money to its clients on overdraft; that is the rate with which the average consumer is most familiar.

Technically, banks are free to set the prime rate at their discretion. In practice, however, competition forces the various banks in SA to set the same prime rate, which tends to be adjusted whenever the repo rate changes.

As such, the repo rate tends to be closely analysed by most market participants for several important reasons:

1. Monetary policy: The repo rate is a crucial tool central banks use to implement monetary policy. Central banks adjust the repo rate to influence borrowing costs in the economy; that affects spending, investment, and inflation. Changes in the repo rate can signal shifts in the country’s monetary policy stance, such as tightening or loosening.
2. Economic indicators: The repo rate is closely watched as an economic indicator. It reflects the cost at which banks can borrow funds from the central bank or other financial institutions, which affects the overall interest rate environment. Changes in the repo rate can provide insights into the central bank’s assessment of economic conditions, inflation expectations, and the overall health of the country’s financial system.
3. Financial markets: Since the repo rate influences short-term interest rates, including interbank lending rates, money market rates, and short-term government bond yields, traders, investors, and institutions monitor changes in the rate to assess the attractiveness of different investments, manage their portfolios, and make informed trading decisions.
4. The banking sector: The repo rate affects banks’ cost of funds and profitability. A higher repo rate increases borrowing costs for banks, which can affect lending rates for businesses and individuals. Banks also use repo agreements (repos) to manage their liquidity and obtain short-term funding. As a result, fluctuations in the repo rate can affect banks’ liquidity conditions and ability to access funds in the market.
5. Financial stability: The repo rate is essential for maintaining financial stability. By adjusting the repo rate central banks can influence market liquidity, manage systemic risks, and stabilise financial markets during times of stress. Moreover, monitoring and discussing the repo rate help policymakers and market participants across the board gauge these measures’ effectiveness and assess the financial system’s overall stability.

When a country’s central bank, such as the Reserve Bank in SA, meets to decide whether to hike (increase) or cut (decrease) the repo rate, the debate is primarily centred on whether said repo rate is deemed accommodative or restrictive. An accommodative repo rate is a relatively low interest rate set by a central bank to stimulate economic activity.

When the central bank wants to encourage borrowing, investment, and spending in the economy, it lowers the repo rate. Lower borrowing costs incentivise businesses and individuals to take loans, leading to increased investment, consumption, and overall economic growth. An accommodative repo rate is typically employed during an economic slowdown or a recession to support recovery.

Deterrent or stimulant

Conversely, a restrictive repo rate refers to a relatively high interest rate set by a central bank to curb excessive borrowing and spending. When the central bank wants to rein in inflationary pressures, slow economic growth, or address concerns about asset price bubbles, it raises the repo rate.

Higher borrowing costs act as a deterrent, reducing borrowing and spending, which can help control inflation and prevent overheating of the economy. Restrictive repo rates are often used during periods of high inflation or when there are concerns about financial imbalances. Therefore, the choice between accommodative and restrictive repo rates depends on the prevailing economic conditions and the central bank’s policy objectives.

Central banks closely monitor various indicators, such as inflation rates, employment levels, GDP growth, and financial market conditions, to determine the appropriate stance for the repo rate. The terminology may vary by country and central and central bank. Some central banks may use terms such as “expansionary” or “loose” instead of “accommodative” and “contractionary” or “tight” instead of “restrictive” to describe their monetary policy stance. For our purposes, the Reserve Bank uses the “restrictive” and “accommodative”.

Within its current framework, the Bank targets a neutral real interest rate — the level at which the real interest rate will settle once the output gap is closed, and inflation is stable. For 2023, the Bank has deemed the neutral real rate to be 2.4%. Therefore, in its mind if the real repo rate is less than 2.4%, then rates are deemed accommodative. Conversely, if the real repo rate exceeds 2.4%, then rates are considered restrictive.

Currently, the Reserve Bank has stressed that it will only look at ending the current rate-hiking cycle once it deems the repo rate to be restrictive. Therefore, if one is interested in forecasting the direction of interest rates within the near term, calculating the real repo rate in this context is useful. There are three fundamental methods which most market participants follow when calculating the real repo rate:

• Method A: nominal repo rate — one quarter ahead of expected inflation (annualised).
• Method B: nominal repo rate — expected inflation in the fourth quarter of 2023 (annualised).
• Method C: nominal repo rate — average expected inflation for 2023.

The Bank’s inflation forecast for 2023 as a whole is 6%, calculated from quarterly forecasts of 6.9% for the first quarter, 6.4% for the second, 5.5% for the third, and 5.3% for the fourth. As of March 19 the repo rate was 7.75%.

Following the above methodologies we get the following results: 

• Method A: 7.75%-5.5% = real repo rate of 2.25%: still accommodative;
• Method B: 7.5%-5.3% = real repo rate of 2.45%: slightly restrictive; and 
• Method C: 7.75%-6% = real repo rate of 1.75%, accommodative.

The Bank currently calculates the real repo rate using method A. Hence, according to its methodologies and the above calculation, rates are deemed slightly accommodative with a real repo rate of 2.25%. Therefore, there is still room for further rate hikes.

The market is pricing in a further percentage point of interest rate hikes (with a 50 basis-point increase expected to be announced on Thursday and the remainder at subsequent meetings) at a time when SA’s economic growth is zero or possibly even slightly negative. Unfortunately, SA is one of the very few countries whose economy is smaller than before the Covid pandemic; as a result, the Bank is walking a tightrope between raising interest rates too much and allowing inflation to rise.

Regrettably, in the current environment of heightened geopolitical tensions, economic malaise and a concerningly weak currency, circumstances suggest that the Bank will have no choice but to hike rates once again. Accordingly, our baseline view is that interest rates will be hiked by 50 basis points on Thursday.

Delport is fixed income investment analyst, and Poswa fixed income analyst, at Anchor Capital.