The SARB hike might just be justified

The recent interest rate decision by the South African Reserve Bank (SARB) was not all that surprising. The SARB, with its forward guidance policy, has signalled a bout of rate hikes when the repo rate increased by 50 basis points in January 2014. That hike was a bit surprising given low growth expectations among high rates of unemployment in various sectors. But, it was also surprising because some might argue that the rate hike happened too late - if the SARB forecasts inflation above 6% in period t+6 (quarters) then it ought to increase interest rates in period t. This is if we are to believe that it takes about six quarters for monetary policy to influence aggregate consumer prices.

The rate hikes would thus seem justified - the SARB is only following its guiding law of low and stable prices. Unfortunately this leaves us with a few unanswered questions: The SARB tells us that SA has a negative output gap (GDP < production capacity), should we not then expect minimum pressure on prices from a demand side? We know, however, that South Africa has been bombarded by a weaker currency and by persistent high oil prices. Thus there have definitely been some supply-side shocks. No doubt that the SARB will be worried about second round effects of inflation (perhaps that is why the interest rate hike took so long).

We need to balance weak demand with strong supply shocks regarding inflation. A hike in interest rates imply that the SARB believes that inflation will rise even further. The increase in interest rates will help (hopefully) anchor inflation expectations. In this case it will delay or even halt importers to pass the weaker rand onto final goods. This supports demand from decreasing even further. On the other hand the hike in interest rates will lead to a decline in demand through lower credit and higher debt payments that reduces overall consumption. Thus the demand benefit from increasing interest rates needs to be balanced by the demand loss from raising rates.

At this point you should have been wondering why the SARB raised rates by 25 basis points. It could be due to a numerical solution from some model, it could be due to possible fear that increasing interest rates by too much will hurt the economy, or it could be another reminder of further interest rate increases.

The problem with 25 basis points is that it does little to reduce inflation. Using a simple semi-structural model of inflation (this is just for illustrative purposes) shows that a 100 basis points hike reduces inflation at most by about 0.4 percentage points (as an example from 6% to 5.6% inflation). And this is based on an assumption that interest rates have a large weight in the New-Keynesian IS curve. Figure 1 shows what happens to the model economy when interest rates increase by 100 basis points.  Alpha is the weight on the interest rate in the IS curve. Output is the level of GDP. The shocks are deviations from baseline which is assumed to be the steady state. This means that the model does not take into account nonlinearities such as the response of output in an already depressed economy. The point about the figure is that 25 basis points hardly has any impact on inflation. Or perhaps it is exactly the right number that balances a very sensitive economy from collapsing while keeping inflation in check. This is pure speculation.

Anyhow, the interest rate is the least of South Africa's problems. Constant strikes (Toyota and Ford have shut down some operations), unproductive people (those that do nothing at one of the many district or local government municipalties), bad employment policies (yes I think the current format of BBBEE is doing harm to the economy) and corruption undermines all the good macro and micro economic policies in place. Economic policy makers can only juggle a sensitive economy for a short period of time before the fundamental problems unravel all that is good.