By Russell Lamberti, Head of Research and Strategy
The large Reserve Bank (SARB) rate hike on Thursday was probably necessary to avoid yet further economic distortions arising from lockdowns and their exceptionally low interest rates of 2020 and 2021. It will diminish harm to depositors and lenders who have had their savings eroded by inflation, but it will put some financial pressure on the heavily indebted. Real estate markets, heavily debt-reliant, are going to experience a further drop in buyer affordability, and asking prices by home sellers may well be forced lower in the months ahead. We should not, however, blame rising interest rates for the country’s economic woes, which stem from years of poor policy and resource waste. Finally, although a SARB rate hike now seems, on balance, prudent, the fact is that centrally determining interest rates – a function that should be done in decentralised markets – is far from optimal and always leaves scope for considerable error. Interest rates can only reflect underlying reality if they are set in free financial markets with competing currencies.
Largest Rate Hike in 20 years
The Reserve Bank (SARB) raised the repo rate by a hefty 75bp on Thursday, as it reacted to inflation concerns and interest rate increases by major foreign central banks. This was the largest single interest rate hike since the 1 percentage point (100bp) hike in September 2002, some 20 years ago.
The move takes the repo rate to 5.5% and the prime rate to 9.0%. Both rates are up 2 percentage points since just November 2021, where they had remained for just over a year after being slashed during the lockdown-caused economic crisis of 2020.
Most financial markets professionals expected only a 50bp rate hike, so the increase of 75bp came as quite a surprise to many.
Why might the SARB have decided to hike so much in one meeting?
Price inflation is one reason. The Consumer Price Index (CPI), as officially measured, has risen from 5% to 7.4% since October 2021. The price of a basket of essential goods and services we track in the official inflation statistics from Stats SA has risen by almost 10% y/y. Meanwhile, since February 2020 (just before the lockdown), the overall supply of money in the economy has been increased by about 32% while overall economic output shrank sharply for much of that time and has now failed to grow since 2018.
The rate of inflation has not exceeded the prime interest rate since 1988. Since the SARB adopted inflation targeting in the early 2000s, the smallest gap between the prime rate and inflation was around 2 percentage points. Since 2008, when global monetary policy changed dramatically in the direction of extremely low interest rates and unbridled money printing, the gap has averaged around 4 percentage points. By June 2022, that gap was down to under 1 percentage point. It could be said that the SARB hike is an attempt to protect the real rate of interest (interest minus the rate of inflation) so that lenders can make a sufficient real return on their loans to stay in the lending business.
As the chart above indicates, if the officially measured inflation rate does not fall quickly, the SARB may feel compelled to raise interest rates even further to restore the sort of real prime lending rate that has historically been considered desirable.
Another reason for the large rate hike is that foreign central banks are raising interest rates quite sharply. The SARB may have been worried that returns on rand deposits (once adjusted for various risks associated with holding rands) had started to look relatively less attractive than foreign exchange deposit returns, and hiked rates to stem the tide of rand selling in forex markets. On a broad basis against global currencies, the rand has lost about 11% of its value since April 2022. Deeper losses for the rand could threaten to cause local petrol prices to rise even further, another threat to already pressured household and business budgets and arguably raising the risk of acute social unrest.
The immediate impact of the 75bp rate hike will be, on the one hand, to restore some confidence to cash depositors that their deposits are not getting too heavily eroded by inflation. There is about R3.5 trillion held in relatively short-term bank deposits, and then multiple trillions held in short-term bonds and money market funds, all of which provide an interest return to savers for the risk and opportunity cost of lending their money for projects and other forms of financing. These depositors and lenders will immediately feel the marginal income benefit of the rate hike.
On the other hand, individuals and businesses with debt linked to floating market interest rates will see their required repayment amounts immediately rise. There is nearly R4 trillion of bank credit to households and businesses, excluding household and business debts from non-bank lenders. Then, the government itself has nearly R1 trillion rand in short-term debts (due in under three years), which in one way or another will be impacted by the rate hike.
The rate increase therefore represents increased income flows from debtors to creditors. Heavily indebted households and businesses will experience further financial pressure from rising interest expenses. Households and businesses with accumulated savings in cash and interest-bearing instruments will move into stronger income positions.
In modern economies, housing markets are heavily impacted by sharp interest rate increases. Many people who borrowed for home purchases in 2020 and 2021 will have by now experienced an almost 25% increase in their monthly mortgage repayments since this time last year. With petrol, electricity and food costs up considerably compared to last year, this adds to the pressure on household finances. Heavily indebted businesses are hit similarly, but with the additional pressure that demand for their products and services will come under some strain. Those businesses just managing to service debts before the rate hike will be forced to cut costs elsewhere, including by laying off some staff or delaying hiring.
The 200bp of rate hikes so far will have dented home affordability quite substantially. Someone who could only just afford a R2 million mortgage in 2021 can probably only afford a R1.6 million one now. This means that to afford the same house price, she will have to put down a much larger deposit (down-payment), or otherwise try to negotiate a much lower price, or be forced to look for a cheaper house.
We should not forget, however, that the level of interest rates seen in 2020 and 2021 was exceptionally low by historical comparison. It would have been very reckless to borrow excessively during a period of such low rates. In the last 10 years, most people bought houses at interest rates at or above the current level, so recent rate hikes should not be troubling those who have managed to protect their livelihoods through the harsh lockdown period.
For those for whom deep rate cuts in 2020 and 2021 provided financial relief, hopefully, many were able to use this relief to pay down their debts. Those that were unable to do so, or who have experienced job and income losses, will be feeling these rate hikes most harshly.
Interest rates are a vital price signal in the economic system. They mediate the amount and duration of savings and lending on the one side and debt and borrowing on the other. If lenders don’t believe they can get a sufficient real (i.e., inflation-adjusted) reward for giving up the use of money now and taking credit risk, they will be reluctant to lend. When inflation is high and central bank-controlled rates too low, it seems quite attractive to borrow but not so attractive to save and lend. This can lead to very harmful distortions in the economy, which cause unsustainable booms and harsh corrections known as recessions.
Strong and sustainable periods of economic growth tend to result from positive real short-term interest rates. In plain language, it is economically healthy when there is a real reward for lending money for even relatively short periods of time (say, less than a year or two). This encourages savings. Savings is the ultimate basis of economic growth because savings fund investments into growth-generating projects, new business start-ups, and so on. This also discourages excessive indebtedness or reckless borrowing, either for goods and services that will be quickly consumed or to fund excessively risky, speculative, low-potential business ideas – helping avert a lot of entrepreneurial error.
With officially measured inflation having risen substantially, raising interest rates as the SARB has done since November 2021 is, on balance, a means of limiting distortion in lending markets and putting the economy on a surer footing. It may also, on balance, serve to diminish speculative attacks on the rand, further buffering locals from inflation on imports through currency depreciation.
Those who blame recent SARB rate hikes for economic troubles are misguided. With inflation officially running at 7.4%, and at nearly 10% for basic necessities, and quite possibly higher in reality for many people with their own particular needs and spending habits, a prime lending rate of 9% is hardly abnormally high. Nominally it is still lower than it has been for almost all of the last 50 years, and in real terms (i.e., inflation-adjusted), it is around its lowest levels in over 30 years.
If anything, it seems more likely that interest rates are still having a harmful effect on the economy because they are too low, not too high. Moreover, interest rates distract us from the real culprits of stagnation and record levels of unemployment. These include foolish and economically devastating lockdowns of 2020-2022, multiple years of harmful overregulation and centralisation of economic and policy control in the hands of state bureaucracies, Eskom’s failures to secure enough energy, policies like Black Economic Empowerment and cadre deployment that obliterate merit and excellence and politicise capital allocation, municipal failure due to rank corruption and mismanagement, escalating crime, and much else that is well-documented.
Not an ideal system
Of course, there will always be arguments about the appropriate level at which the central bank should set interest rates. This arises because the central bank is a central planning committee setting interest rates for a currency held in place as a state monopoly using legal tender laws. It must make educated guesses on where the ‘right’ level of interest rates might be. And naturally, many people have opinions about this.
Ideally, a market for borrowing and lending money would determine interest rates. The handful of central bankers deciding rates have extremely limited knowledge of the complexity of the economic system, whereas rates set in a market naturally reflect the net effect of information from millions of transactions and negotiations. A central committee cannot be reasonably expected to determine what should arise from millions of private decisions in real-world transactions.
This is the unfortunate result of having nationalised currency governed by legal tender monopoly laws, exchange controls, and complex banking regulations instead of open and transparent competition in money and currency. As long as this situation persists, there will always be frantic debates about what the central planners should do, and key signals in the economy are going to be relatively unresponsive to real, dynamic conditions and foster harmful and persistent economic distortions.