Speech by Rashad Cassim,
Deputy Governor of the South African Reserve Bank,
at the Central Banking Conference,
Mount Nelson Hotel, Cape Town,
14 March 2023
The state of the South African economy and the role of monetary policy
These are some of the most remarkable years in the history of the South African
economy. Unfortunately, they are remarkable for the wrong reasons. Domestically, we
are experiencing the lowest growth episode in modern South African history, marked
most recently by the widespread failure of basic infrastructure, especially electricity.
Externally, we have been buffeted by a series of extraordinary shocks: the COVID-19
pandemic, the war in Ukraine, and a global inflation surge. These circumstances have
profoundly affected the lives of all South Africans. They have also confronted
policymakers with difficult choices. Today, I want to outline how monetary policy has
responded, and share with you the main uncertainties and debates we are grappling
with today.
I will start with the changing external environment. In 2020, the COVID-19 shock
prompted an unprecedented drop in economic activity worldwide. We saw a broad
decline in inflation which led to a huge wave of stimulus from fiscal and monetary
authorities. In South Africa, this included lowering the repurchase (repo) rate to 3.5%
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its lowest level ever.
Fortunately, global pandemics are rare events, but this meant no one had much
experience on which to base forecasts. While policymakers emphasised this
uncertainty clearly, we can still say actual outcomes surprised most of us. For
example, in 2020 it did not seem like the major advanced economies would soon be
confronting the highest inflation rates in a generation.1 Part of the challenge was that
the pandemic produced an unusual mix of supply and demand effects, which included
supply chain disruptions and abrupt shifts in the composition of demand. On top of this
came the Ukraine war, a further shock in none of our forecasts, which pushed up food
and energy costs around the globe.
The result for macroeconomic policymakers was that we had to pivot fast. In South
Africa's case, as inflation rebounded, economic output recovered to pre-COVID levels,
and global rates soared. At a minimum we needed to have interest rates near their
normal or longer-run levels, not at long-term lows. In this context, the South African
Reserve Bank's (SARB) Monetary Policy Committee (MPC) implemented a series of
75 basis point hikes, larger than those used in the previous hiking cycle, to get back
to safety.2
Given that the full impact of monetary policy on inflation is not immediate but has a lag
effect, we could not immediately bring inflation back to target in 2022. Instead, what
we aimed to do was set policy so that inflation would normalise after the initial, deep
shock had played out.
As at the latest data, headline inflation is at 6.9%, with core or underlying inflation at
4.9%. The peak appears to have been in July last year when headline inflation hit
7.8%. To put that in context, we have been outside of our 3-6% target range since
May 2022. The last time we were close to the midpoint of that range, which is where
we aim to stabilise inflation, was about a year before that.3
On current forecasts, we anticipate inflation will be back at the midpoint of our target
International Monetary Fund's
range towards the end of this year. Similarly, the (IMF)
forecasts, from the most recent World Economic Outlook, have end-of-period inflation
for 2023 at 4.5%,4 which is the midpoint of our target range. To put that in perspective,
the IMF does not see major advanced economies hitting their 2% targets over this
horizon, with year-end projections at 2.3% for the United States (US), which is quite
close to target, but 5.4% for Germany and 6.3% for the United Kingdom.
These projections are encouraging. After all, the key test of policy is not whether
shocks happen, but whether inflation comes back to target after the initial effects of
the shocks wear off. After that, the next test of policy is how difficult the adjustment
process is for getting inflation back to target.
One problem is that we could get more shocks. Food inflation has been coming in
higher than expected, and it surprised us once again in the latest consumer price index
(CPI) release from Statistics South Africa. There is a global dynamic to elevated food
price inflation, but now we are also worrying about load-shedding driving up food
prices, as electricity shortages start to disrupt the production and storage of food.
The exchange rate outlook has also deteriorated recently. At the start of this year,
markets were optimistic that US inflation was coming down, that the US dollar had
peaked in late 2022, and that the US Federal Reserve (Fed) would be able to pause
rate hikes soon and even think about cutting rates. Recent data have undermined this
benign view.
The US economy still appears to be running hot, and markets have rapidly priced in
an extra half a percentage point of Fed hikes, relative to where we were earlier in
2022. This has helped weaken the rand from around R17 per dollar in January 2023
to over R18 to the dollar recently. Domestic factors also have not helped. The local
news flow has been mostly rand negative, for instance around load-shedding. Local
interest rates are also well below those in some peer economies, adding to a weaker
For example, Brazil's policy rate is at 13.75%, Mexico's is at 11% and
currency.
Hungary's is 13%.
In a world where the dollar is weakening, the rand is likely to benefit along with other
currencies. But February was not kind to the market consensus on a weaker dollar,
and the rand outlook has correspondingly become more worrying, once again.
A second problem is that South Africans might start seeing a higher level of inflation
as normal.
For a start, inflation expectations have risen. The fourth quarter survey of inflation
expectations, published by the Bureau for Economic Research (BER), registered
expectations of 6.1% inflation for 2023, up from 5.9%, and 5.6% for 2024, up from
5.3%. Over five years, expectations are at 5.5%, up from 5.4% previously.
Of course, respondents are rational to see higher inflation at the moment, given
elevated food and fuel prices. A bigger concern is that expectations for longer-term
expectations are well above our 4.5% target, which may indicate that the initial supply-
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side shocks are feeding through into longer-run price and wage-setting behaviour a
phenomenon referred to as 'second-round effects'. We are therefore monitoring
expectations closely, to see if people recover their faith in our target or if we need to
do more to stabilise longer-term expectations close to 4.5%.
For a sense of underlying inflation pressure, another important area we look to is core
inflation. This is a measure of inflation which excludes food and energy prices, which
are often volatile. Core inflation has been lagging headline inflation, only moving above
the midpoint of our target range during the second half of last year. We anticipate that
the peak for core is still ahead of us, with the January MPC forecast projecting core
inflation of 5.4% in the second quarter of this year.
So far, most of the pressure in core inflation has been coming from imported goods,
which are being repriced to reflect the weaker rand and higher global goods prices.
Our forecast takes the view that core goods inflation peaked at the end of last year.
A weaker rand could keep core goods inflation higher for longer. But the bigger
concern may be that inflation pressure is shifting over to services. This category is
around two-thirds of the core basket, and it contains many prices which are not
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adjusted frequently for items such as housing rental or insurance contracts. This is
the area where second-round effects, through wages5 and inflation expectations, are
most likely to manifest.
A year ago, services inflation was near the bottom of our target range, at 3.1%. The
latest CPI release puts it at 4.3%.6 In our forecast, the peak is just over 5%. The
disinflation trends we see in headline inflation is therefore not the narrative for
services.
That said, we have had a couple of better-than-expected outcomes for services
inflation recently, and these allowed us to revise down our core forecast at the January
2023 MPC, even as we revised up headline inflation. Perhaps we can hope our core
forecasts will be too high. Of course, if we do not see services coming down later this
year, then we will have a problem. We are not going to be able to achieve our target
over time if services inflation gets stuck in the top half of our target range.
After all this inflation analysis, you may well be thinking: but what about growth? Here
the outlook is not good at all.
We are expecting growth rates of 0.3%, 0.7% and 1.0% over the next three years.
These are disastrously low. Given population growth rates of around 1.2% annually,
the implication is that living standards will continue to fall, as they have done on
average since 2014. Our growth rate also compares very badly to the historical record.
Since the 1960s,7 South Africa has, on average, managed to grow by about 2.8% a
year. This is around four times the average growth rate both for our forecast and for
the past 10 years. This feeble growth outlook is also related to other social ills,
including our 33% unemployment rate.8
What does South Africa's growth challenges mean for monetary policy?
When we at the SARB think about growth, we would of course like to have the highest
growth rate possible. But there are many things that drive growth that central banks
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do not control and do not have mandates to tackle including technological
innovation, education, natural resources, and yes, reliable electricity supply. In this
sense, delivering growth is much more of a team sport than controlling inflation.
Central banks can do much of the work of managing inflation by themselves, although
as with any solo sport, such as golf or tennis, support teams make important
contributions. Growth policy, however, is more like soccer or cricket, where individual
heroes cannot do much if their team members are weak or absent.
When a central bank is playing for the growth team, what it can affect is demand, which
can be applied to reduce the volatility of output. More technically, as long as prices are
fairly stable, changing a nominal variable such as interest rates can temporarily affect
real variables, including quantities of goods and services. This is useful when demand
is too weak, during downswing phases of business cycles. Where a central bank aims
for a growth rate which requires more output than an economy can produce, however,
the results are troublesome. For a small open economy such as South Africa, this
typically means that we experience unsustainable imports, currency depreciation and
rising inflation.
In modern central banking practice, we formalise these intuitions using a concept
called 'potential growth', which is an estimate of the amount an economy can produce
at full capacity. To the extent an economy is not at potential, we say it has an output
gap. If output is below potential, then the output gap is negative; if it is above potential,
the gap is positive.
South Africa's
For every MPC meeting, the forecast team prepares estimates of
potential growth and the output gap. They are unobservable concepts and must be
estimates using imperfect techniques, which makes them uncertain. So, when I look
at these figures, and how they shape the forecast and the policy advice, I do not
quibble about the exact numbers, but I think about what kind of problem these numbers
describe, how this information squares with the other information available, and how
policy should then respond.
As of the January 2023 MPC forecast round, those numbers told an extraordinary
story. I have already mentioned that our growth projections are very low, but our
potential growth estimates are even lower. The team estimates potential growth at 0%
this year, then 0.6% in 2024 and 1% in 2025. Because the economy performed better
than expected last year, and because expected growth is above potential, the forecast
now sees a small positive output gap developing this year. In other words, in the
interpretation of our Quarterly Projection Model (QPM), we have an economy
above
operating modestly its potential. And this, in turn, supports policy advice to raise
rates not only because inflation is above target, but also because growth is too high.
In assessing this forecast story, I am struck by two plausible but competing
interpretations.
The first interpretation is that potential growth must be 0%, or worse, given the scale
After all, isn't it hard enough for people just
of supply-side dysfunction in the economy.
to achieve the output they delivered last year, let alone produce more? We know
electricity shortages have intensified; we expect to have 250 days of load-shedding
this year, from 157 days last year and 48 days in 2021. On top of that, the freight rail
system has, for the most part, not been functioning optimally, removing another pillar
of the economy's
productive potential. There are many other constraints in the
economy that also suppress potential growth.
squarely, and it's better to
For our forecast team, these are facts that must be faced
accept them up front than gradually mark down the projections as disappointing data
come in. Of course, it is reasonable to expect that South Africans will find ways to cope
with these challenges, and that there will be policy steps to address them with time.
For this reason, potential growth rises over the forecast period, reaching 1% in 2025.
But the narrative for this year is that the economy does not have the supply-side
capacity to produce more than it did last year.
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At the same time and this is the second interpretation is it possible for the economy
to be at full potential when unemployment is over 30%? The Quarterly Employment
Survey recorded 10.57 million formal jobs at the end of 2019, against 9.98 million
now.9 Were all those workers unproductive, so that recovering those roughly half-a-
million jobs would add nothing to output? Are all sectors in the economy at full
capacity? Can potential realistically be at zero?
These competing views are not wholly incompatible. They both capture important
truths. The main point of the comparison is to illustrate how the economy is short of
some inputs, like electricity, but there is slack in other areas, such as employment. In
these conditions, what the MPC is trying to gauge is the space to satisfy additional
demand and follow through on what that means for monetary policy. The difficult part,
for the MPC, is judging how much we can do to help on the demand side when the
supply side of the economy is in such a perilous state.
In common with many other central banks, we are flexible inflation targeters. We aim
to achieve our inflation targets while also considering growth; if inflation is above target
but there is a negative output gap, then we can tolerate a somewhat slower disinflation
path for the sake of supporting demand. No one really targets inflation exclusively,
ignoring growth and employment, as great policy thinkers like Stanley Fischer have
pointed out.10 There is always a balancing act.
As you know, a balance rests on a fulcrum, which is the central point around which
balance can be achieved. In monetary policy, this fulcrum is another one of those
unobserved concepts, like potential growth; it is called the neutral rate. The neutral
rate is the interest rate that neither speeds up nor slows down the economy; it is the
level at which the policy rate will settle when inflation is at target and output is at
potential. This is a concept many of our close watchers have questions about.
In South Africa, we estimate this neutral rate to be 7% over time,11 of which 4.5% is
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compensation for inflation and 2.5% is the so-called neutral real interest rate the rate
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excluding inflation which economists abbreviate as r-star. In turn, that 2.5% is made
up of half a percentage point which reflects the global real rate, which we derive from
the longer-run real policy rate of the US, the euro area and Japan, plus 2 percentage
points for the South African risk premium.
As with potential growth, we cannot be sure that the neutral rate is exactly 7%. It is an
unobservable concept and our tools for measuring it are imperfect. Nonetheless, a
rate of around 7% is a reasonable place to start conversations about the policy stance.
It suggests that current rates, at 7.25%, are in the region of the neutral rate, and it also
illustrates how loose policy was back when we were at 3.5%.
Of course, if the inflation-adjusted rate needs to be around 2.5%, then for policy to be
4.5%. We aren't there
neutral we need inflation to be around yet; as I noted earlier,
inflation is still close to 7%. For this reason, the extent to which the policy rate will
change from the current 7.25% will depend on whether we feel confident that
disinflation is proceeding and we will get to 4.5% this year.
play out as expected, then we won't get
If the disinflation story does not real rates
where we need them. I have discussed the risks that could produce that outcome.
Because we cannot stabilise prices with persistently low or negative real rates, in this
scenario there will be more work to do with rate changes, and the trade-offs between
output and inflation will be more difficult. There are clear risks of adverse
developments, which could require further monetary policy action to contain inflation.
And so, to conclude, while we hope for the soft landing, we are also prepared for worse
outcomes.
Thank you.