DAAN STEENKAMP: Not behind the curve, but rates may not fall as much as hoped

Prominent journalists and commentators are asking whether the SA Reserve Bank is “behind the curve”. But which curve, and by what measure could it have fallen behind?

Usually, the focus is on whether the policy rate is keeping pace with inflation. Since consumer price index (CPI) inflation has been slowing, the question is whether the Reserve Bank should be easing policy faster. Our view, based on four key considerations, is that the Bank has not fallen behind the curve, but rates may not have as far to fall as many people hope.

Over recent months, the gap between the policy rate and core inflation has been rising, suggesting that there may be scope to loosen policy. Measures of underlying inflation highlight the influence of volatile components on overall inflation. Now that headline inflation (4.4% in August) and core inflation (4.1%) are close together, it suggests pressures from unstable price categories such as fuel prices have dissipated. 

The share of detailed CPI components growing above the midpoint inflation target of 4.5% has also fallen below 50%. This marks a significant development in the inflation landscape, signalling that inflation pressures may be easing across a range of goods and services.

However, there are lots of different ways to measure underlying inflation, so there is always uncertainty around these judgments. Our core inflation measure, CPI-common, a model-based measure of common price changes across categories in the CPI basket, suggests that more broad-based inflation pressure remains than implied by the Stats SA core measure.

Some would argue that the Bank merely follows the US Federal Reserve. Every time the Fed changes its policy rate, there is speculation about whether the Bank will follow suit. Since 2000 the correlation between the three-month lagged federal funds rate and the repo rate is only about 0.5, suggesting the Bank has not tended to directly follow US monetary policy. The coincidence between US and SA monetary policy has varied a lot over time, with SA events such as Nenegate and the 2016 drought contributing to periodic divergences. 

Whether the Bank follows the Fed ultimately depends on how correlated SA’s economic cycle and capacity pressures are with those of the US and the extent to which relative interest rates and currency movements synchronise underlying inflation pressure. It is also worth noting that the Fed’s mandate includes supporting maximum employment, which makes US monetary policy more reactive to labour market developments. In the US, demand pressures have been softening, though nowcasts suggest a lot of built-up capacity pressures remain.

A second consideration is the output gap, or slack, in the economy. The Bank estimates that this remains slightly negative, suggesting a lack of capacity pressures. The Bank’s negative output gap projections also imply that it thinks there is space for policy cuts over the next couple of meetings. But since GDP data gets revised and one cannot observe economic slack directly, this is another area of uncertainty. Our statistical analysis, which in recent years has been more aligned with the IMF than the Bank’s estimates, suggests there is less slack at present. This would suggest that cutting rates too far could see inflation pressures re-emerge.

A useful concept for assessing the stance of monetary policy is the neutral interest rate. This is an estimate of the level of interest rates consistent with inflation at the target and output at its full potential. The Bank has revised its neutral estimate upwards over recent months and estimates a terminal neutral rate of about 7%. This implies that it thinks the policy rate is restrictive and gradual policy easing would be consistent with achievement of the inflation target. The Bank’s estimate suggests another 100 basis points of cuts would be consistent with shifting to a neutral policy stance over the medium term. Again, because we cannot observe the neutral rate, economists will argue over whether the Bank’s assessment is correct.

A third consideration is financial markets, which embed expectations of interest rates and inflation, so one can also use market pricing to assess the market’s assessment of whether the central bank’s policy is keeping up with changes in economic conditions or falling behind. One can assess whether policy decisions are in line with market expectations and use models to measure long-term interest rate expectations. We estimate that market pricing implies a slightly higher terminal neutral rate than the Bank’s estimate. 

A fourth consideration is whether inflation expectations of consumers and businesses are moving towards the inflation target. Expectations have remained stubbornly above the inflation target, though they have been falling over recent quarters. Again, inflation expectations may not be measured without bias, so economists tend to argue over whether monetary policy should do more to anchor inflation expectations at the inflation target. 

Any assessment of the appropriateness of the Bank’s stance requires evaluating the state of the economy, financial conditions, asset markets, and consumer and business expectations. Economists often make strong assertions about the future, but evaluations of economic conditions and the outlook involve a lot of uncertainty.

What really matters is applying a consistent framework to interpret how economic and financial developments will affect how the central bank will react. It is not enough to just look at what other central banks are doing, as SA’s economic cycle has not been strongly aligned with global dynamics.

Whether the Bank is behind the curve depends on the credibility of its assumptions and economic narrative about the future. In our assessment, the Bank is not currently behind the curve, but it might not have as much space to cut as it projects. 

• Steenkamp is CEO of Codera Analytics and a research fellow with the economics department at Stellenbosch University.