​Press Room

Inflation and the effect of real interest rates


Jeremy Diviani
Mar 29, 2016
The inflationary numbers illustrated by the CPI numbers have come out above the target range.

February 2016’s Consumer Price Index (CPI) figures have shown a material acceleration from 6.2% in January of this year to 7.0%, which represents a 1% breach of the SARB’s inflation target of between 3% and 6%. This is the highest inflation has been since May 2009 where the rate was 8%.

Interestingly, within sectoral inflation figures:

  • Food and non-alcoholic beverage sector which have been affected by the worst drought in more than a century, coupled with rand weakness, has led to 8.6% year-on-year price increases – vegetables alone increased 21.7%.
  • Alcoholic beverages and tobacco increased 7.6%, pre-empting the announced increase in sin taxes effective April 2016.
  • Transport prices increased 8.7%, primarily led by a 20.7% increase in the price of petrol over the period February 2015 to February 2016.  

This is of importance as it comes shortly after the Reserve Bank and its Governor Lesetja Kganyago increased the Repo rate by 0.25% to 7% which in turn led to a hike in the prime lending rate to 10.5%. This move by the Reserve Bank illustrated its policy continuity in sticking to its mandate of keeping inflation between 3% and 6%.

The latest move follows a hike of 0.5% in January and forms part of a cumulative increase of 2% since December 2013, where the repo rate was at its’ lowest. What this has achieved is to give the Reserve Bank further credibility with foreign investors, in that they will stick to their mandate of inflation targeting, which forms part of the ratings agencies decision when assessing the downgrade of South Africa bonds to junk status.

So what does high inflation and an increasing interest mean?

Well let’s first look at inflationary pressure as sadly this is often the cost of life that sneaks up on the consumer. Inflation is the gradual erosion of one’s spending ability on a day to day basis and an economic indicator that often does not get directly noticed. Therefore a more rapid increase in inflation year on year has a destructive compound effect on the consumer’s discretionary income they have to spend. This in turn leads to poor sales in various retail and manufacturing linked sectors as consumers switch or stop spending and this leads to lower profitability and growth in the economy.

If you then couple a high inflationary environment with an economy that is not growing more than 1%, there becomes a disconnect, which is a stumbling economy that has below inflationary increase in salaries or no increases at all. This in turn can put pressure on the struggling consumer strangling funds from flowing into the economy further.

The SARB increases interest rates for many reasons, but the basic outcome is to reduce the money supply in the economy. Effectively by making ones debt cost more, individuals will spend less as they have there is increased pressure on their budget. There will also hopefully make more people willing to deposit money in fixed savings as the return should be more favourable. In a faster growing economy, or one with a high Gross Domestic Product (GDP) growth, this is not typically a concern, but with one such as ours, with slow GDP growth, its puts pressure on the economy and pushes it towards a recessionary environment. This is typically measured by two consecutive quarters of negative GDP growth.

Moving back to interest rates. What is interesting to note is that, alongside the recent 0.25% interest rate hike in the repo rate, this now means that the real repo rate is 0%, which is the real repo rate minus inflation. The graph below depicts this relationship.

The importance of a positive real repo rate is that, as the repo rate can be used as a proxy for cash, this means that while interest rates are increasing, the real value of depositor’s money is in fact flat. Historically investors have enjoyed a positive carry for investing in cash.

It also gives us an interesting insight into possibly where rates may move given long term averages. Comparing this with the long term average of 3.3%, this means that without any further increases in inflation we would need to see rate hikes of up to 3.3% to normalise this historic relationship. If inflation were to increase to the 2016 peak predicted by the SARB of 7.8% in Q4 of this year, this would result in hikes of 4.1% needed for normalisation. If this were to happen, this would mean a prime lending rate of 14.6%. This is purely for illustrative purposes as we do not expect such an aggressive restrictive monetary policy alongside weakening economic growth figures. It is, however, important to note the five year moving average of approximately 0% which means at this point we are in line with the short-term real repo rate average.

This illustration is no way meant to predict the level to which rates may climb, but rather to illustrate that we should expect to see further increases in interest rates which will put further pressure on the economy and the man in the street.