By Dr Roelof Botha
During the past 12 months, households and businesses have been saddled with the highest lending rate in 14 years, and one of the highest in the world. Although the Monetary Policy Committee (MPC) of the SA Reserve Bank (SARB) has finally provided millions of indebted South Africans with marginal relief from very high debt service costs, capital markets are suggesting that the MPC is very far behind in reversing the restrictive monetary policy stance that kicked in at the end of 2021.
Three fundamental flaws underpin the strange decision by the MPC to lift the prime overdraft rate to a level of 11.75%, when it was 10% just prior to the Covid-19 pandemic, and also considered too high by the standards set by the MPC when Gill Marcus was governor of the Reserve Bank (the increase in the prime rate occurs instantaneously via the repo rate, which is pegged at 350 basis points lower than prime).
The first flaw is a lack of understanding over the causes of higher inflation immediately after the worst of the lockdowns imposed during the Covid pandemic. No country in the world escaped the twin effects of a 720% increase in global shipping freight charges (between the third quarter of 2019 and the third quarter of 2021) and the 430% increase in the price of Brent crude oil (between April 2020 and the beginning of 2022).
These price shocks impacted on cost-push inflation, and were the two key reasons for the sharp rise in consumer inflation, which peaked at above 10% in most of South Africa’s key trading partners. South Africa’s proud status as the most food secure country on the African continent (for availability), made it possible to have an inflation peak of only 7.6% (in the third quarter of 2022) and the consumer price index (CPI) has been declining ever since.
A third supply-side cause of higher prices was related to the lower levels of capacity utilisation in manufacturing that ensued after the Covid pandemic, and that have not yet recovered to pre-2020 levels. This had the effect of increasing fixed overhead costs per unit of production. It seems clear that excess demand had nothing to do with the temporary rise in the CPI. By raising interest rates to record-high levels, the MPC’s policy approach only served to reduce aggregate demand in the economy.
Inflation was bound to start declining again, once freight shipping costs had normalised and fuel prices declined to significantly lower levels.
A second flaw is the inconsistency of monetary policy ever since the retirement of Gill Marcus in 2014. Under her watch, the average real prime rate was just above 3% and real GDP growth averaged 2.5% over a five-year period. Within one year of her retirement, the new MPC raised the real prime rate by 57%, to a level of 4.9%, and four years later the real prime rate stood at 6% – an increase in the cost of capital and credit of 94%.
A third flaw is the undue importance given to inflation expectations. Apart from the fact that significant variations permanently occur between the results of quarterly surveys on anticipated future inflation and observed inflation, the samples for these surveys are minute and devoid of meaningful academic substance.
Extensive research by Reid (2012 and 2021) has revealed that a relatively large number of respondents either declare that they have no knowledge of the subject, or answer with ridiculously large numbers. This problem has also been identified in research by Rossouw et al, indicating the existence of confusion among respondents about the difference between price levels and price increases.
The crux of the problem with using inflation expectations as a basis for conducting monetary policy has been succinctly stated by Reid (2021), with the following conclusion: “…expectations matter, but they are observable.”
The costs of overly-restrictive monetary policy are huge. Due to the absence of any sign of demand inflation, interest rates have been unnecessarily high and have served to restrict South Africa’s economic recovery from the Covid pandemic. The most significant direct cost has been the erosion of household disposable incomes.
In the first quarter of 2022, just before the negative impact of the rate hiking cycle started to bite, the ratio of household debt servicing costs (mainly interest on loans and credit) to household disposable income stood at 6.7%. The relentless rate hiking experiment by the MPC was directly responsible for this ratio increasing to 9.2% in the first quarter of 2024, with the second quarter estimate standing at 9.4%.
In the event of the debt cost servicing ratio having remained at 6.7%, cumulative household disposable incomes would have been R176 billion higher. Due to the effective parity between disposable incomes and consumption expenditure, this would have translated into an equal increase in total demand. Based on the fairly stable relationship between aggregate demand and taxation revenues, National Treasury would have pocketed an additional R43.8n – enough money to build 378 000 low-cost houses and create 250 000 jobs in the construction sector supply chain.
The debilitating effects of record high interest rates on the economy are visible in virtually every economic indicator of note, including negative per capita GDP growth, the Afrimat Construction Index, and the Drive.co.za Motor index. The latter two indices are based on quantitative data expressed in real terms and both continue to languish at pre-Covid levels. South Africa’s residential property market has been exceptionally hard hit by the high interest rates, which have served as a disincentive for home buying. Since the rate hiking cycle began, the BetterBond Index of home loan applications is down by 28%.
Another point of concern is the scant regard shown by the MPC for the important role that household credit extension plays in facilitating higher demand and higher economic growth. The current level of total household credit is lower, in real terms, than 10 years ago, which has made it virtually impossible for the South African economy to grow at a meaningful rate.
South Africa’s real prime rate currently stands at 7.1%, which is 129% higher than the average real prime rate during the tenure of Gill Marcus. With the 10-year bond yield having dropped by more than 200 basis points since late April, it is abundantly clear that monetary policy is on the wrong track – a track that is busy destroying jobs and keeping the economy from expanding.
Dr Roelof Botha is the economic advisor to the Optimum Investment Group.
BUSINESS REPORT