'The interest rate cycle during and after the COVID-19 pandemic'
Keynote address by Ms Fundi Tshazibana, Deputy Governor of the
South African Reserve Bank, at the Absa Annual Fixed Income Conference,
7 October 2019
1. Introduction
Ladies and gentlemen, thank you very much for allowing me the opportunity to
deliver the keynote address at your Fixed Income Conference. While, sadly, I do
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not have the pleasure of standing in front of you today the COVID-19 pandemic
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is not allowing it this year I am nonetheless confident that this conference will
stimulate pertinent and challenging discussions. The pandemic has changed many
aspects of our life in 2020, and interest rate setting is one of them. The rate
decisions taken by both the South African Reserve Bank (SARB) and its global
counterparts in the past nine months are set in broad macroeconomic trends that
have been in place for years, and which have made this speedy and sizable reaction
to the COVID-19 pandemic possible. Now, will these trends remain in place in the
coming years? Will the pandemic exacerbate them or, on the contrary, will it usher
in structural changes that call for a different calibration of monetary policy in the
future? These are some of the issues I will attempt to address today.
2. A long trend towards lower interest rates
The start of the long-term downtrend in global interest rates can be traced back to
Federal Reserve's
the early 1980s, in the wake of the United States (US) (Fed)
decision to tighten policy sufficiently to uproot what was, at the time, seen as
structurally high inflation. As US inflation started its long decline, so did interest
rates: from averaging 10.0% in the 1980s, the federal funds rate declined to
averages of 5.1% in the 1990s and 2.9% in the 2000s. As other countries, first in
the developed and then increasingly in the emerging world, followed the US
example and made price stabilisation a priority, a global trend towards lower interest
rates set in. The Reserve Bank of New Zealand was a pioneer in the field of inflation
targeting in 1990; 20 years later, the majority of advanced and large emerging
economies had a similar framework in place. This not only allowed for lower
average inflation around the world, but also for lower dispersion of inflation rates
across countries. Global drivers of inflation gradually gained in importance at the
expense of domestic factors, allowing for a broader international diffusion of major
economies' disinflationary trends.1
The shift towards lower trend, or equilibrium, interest rates continued in the wake of
the global financial crisis, although it could not be solely attributed to better control
of inflation and inflation expectations. In fact, in several advanced economies,
central banks for the first time struggled to raise average inflation towards targeted
levels, and undershooting became the norm. In this context, the use of
unconventional policy tools to circumvent the effective lower bound did succeed in
lowering longer-term interest rates, flattening yield curves and compressing risk
premiums; yet it failed to lift most countries out of their low-growth, below-target
inflation paradigm.
Several explanations have been sought for what economists increasingly referred
to as 'secular stagnation', including demographic trends; a growing propensity to
save, exacerbated by rising income inequalities; a structural break in investment-
to-gross domestic product (GDP) ratios in dynamic Asian economies; widening
productivity gaps between 'high-tech' firms and others; and a growing investor
preference for safe assets.2 What seems likely is that most of these factors
contributed to structurally lower interest rates, not just in advanced economies but
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also in the emerging world even though many emerging markets and developing
countries are still far from the 'technological frontier' and could be expected to grow
faster.
South Africa was no exception to these trends: in the past decade, our policy rate
averaged 6.1%, down from 15.4% in the 1990s and 9.9% in the 2000s. On the
positive side, greater compliance with the 3-6% inflation target range3 and lower
inflation volatility have allowed for lower average policy rates and lower volatility of
the monetary policy cycle. On a less favourable angle, the trend in real GDP growth
lost momentum throughout the past decade, a pattern which is only partly
attributable to global trends but mainly reflects domestic supply constraints such as
limits to the availability of electricity or critical skills.
3. The COVID-19 pandemic required lower interest rates
It is important to recall the macroeconomic and financial trends that pre-dated the
COVID-19 crisis, as they informed the ability of central banks to deliver a speedy
and large enough response to the crisis. When compared with the onset of the
global financial crisis about 12 years earlier, as of July 2008, the average inflation
rate in advanced economies had climbed as high as 4.6%, from 1.8% a year earlier;
the average for large emerging countries had followed a similar trend, albeit at
higher levels. Many central banks were still tightening policy even as the crisis was
setting in. The SARB was one of them: in July 2008 the Monetary Policy Committee
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(MPC) had raised the repurchase (repo) rate as high as 12.0% a total increase of
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500 basis points over 26 months to fight an inflation rate that had reached double-
digit levels on the back of rising food and fuel prices and strong credit growth.
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By contrast, a large number of countries South Africa included entered the
COVID-19 crisis with inflation rates that were not only stable but also below, or
within, target levels. Consequently, central banks in those countries did not have to
first unwind restrictive policy stances before pushing for monetary stimulus. They
were also able to quickly utilise tools, such as asset purchases programmes that
had been 'tried and tested' in the previous crisis. And indeed, a quick response was
warranted, especially as the combined health and economic shocks associated with
the pandemic and subsequent lockdowns threatened at first to be accompanied by
Bloomberg's measure of US
a disruptive financial shock. In late March 2020,
financial conditions stood about six standard deviations in restrictive territory; major
equity markets had shed between 25% and 35% in the space of five weeks; and
commodity prices had plunged, with Brent crude, in particular, falling as low as
US$17 per barrel, from an average of US$64 per barrel in January.
The strong global response of both fiscal and monetary authorities allowed a quick
normalisation of financial conditions. Equity market and commodity prices have
rebounded; corporate and sovereign spreads have narrowed; funding conditions in
offshore dollar markets have improved, helped by bilateral swap lines made
available by the Fed; and most emerging market currencies have stabilised, even
though they remain much weaker than pre-crisis levels. South Africa is no
exception: the South African rand is currently trading at about R17.00/US$, weaker
than the January 2020 average of R14.40/US$ but much improved from early April
lows of R19.00/US$. Shorter-dated government bond yields are now trading lower
than at the start of 2020, though yields on longer-dated bonds are higher, probably
reflecting higher credit risk and debt issuance.
4. Interest rates are likely to stay low over the next two years
The economic shock from COVID-19, however, will probably take longer to subside
than its financial counterpart, despite the combination of fiscal and monetary
support provided. Global activity has rebounded from the lows of April (when most
of the world faced a strict lockdown), as restrictions on economic activity and
people's mobility
have been lifted. But activity indicators are still significantly below
pre-crisis levels, and as activity gradually converges towards 'normal' levels, the
pace of convergence slows. Some commentators argue that the harder part of the
economic normalisation begins now. In most countries, private and official
institutions, on balance, do not project a return of real GDP to pre-COVID-19 levels
until late-2021 or even late-2022. Negative output gaps are expected to be the
norm. With respect to unemployment, the consensus view is that normalisation will
take even longer.
South Africa has been gradually lifting restrictions on economic activity since late
April; both fiscal and monetary policies were eased significantly to help facilitate the
On the monetary front, the SARB's
economic recovery. MPC lowered the repo rate
by a cumulative 275 basis points between March and July; the bulk of the reduction
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(250 basis points) occurred between the March and May meetings a fast response
by the standards of large emerging markets. To facilitate the flow of credit to cash-
constrained businesses and individuals, the SARB injected liquidity in money
markets through larger and more frequent repo operations. It also temporarily
relaxed some regulatory capital requirements for banks. Finally, the SARB
purchased government bonds in the secondary market to ensure liquidity and the
smooth functioning of the bond market.
Nonetheless, the plunge in second-quarter economic activity, when real GDP fell at
an annualised rate of 51%, could not be reversed. Base effects, admittedly, will
result in spectacular growth rates in both the third quarter of 2020 and 2021 as a
whole. But they can be misleading. In level terms, our model only expects real GDP
to gradually converge back towards pre-COVID-19 levels. At the time of the
September MPC meeting, the Quarterly Projection Model (QPM) pointed to a large
output gap that will only gradually narrow over the remainder of the forecasting
period and remain negative even in 2022.
The combination of ongoing economic slack, an undervalued real effective
exchange rate and a recent decline in medium-term inflation expectations suggest
that inflation should not be a problem for the next two years or so. The QPM projects
that both headline and core inflation rates will remain largely within the lower half of
the target until the end of 2022, with the exception of a short-lived spike in the
headline inflation rate in the second quarter of next year as a low base distorts
energy price inflation. Baring materialisation of upside risks, this benign inflation
outlook should allow the SARB to maintain an accommodative stance for most of
the coming two years, and only withdraw stimulus in a gradual fashion, as the output
gap slowly closes. Indeed, the latest QPM projections are consistent with a rise in
the policy rate to 4.0% by the end of 2021 and 5.0% in 2021, which would still be
100 basis points below the average of the past decade.
5. Can there be a new paradigm in the long run?
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In summary, there appears to be a growing consensus both among forecasters
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and policymakers that the interest rate cycle in the next couple of years, both
globally and in South Africa, is going to be one of gradual normalisation. But towards
which levels are interest rates going to normalise, and what is going to be their
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average over the longer term say, a horizon of five years or longer? Few
economists presently seem willing to make forecasts over such a horizon, at a time
when it is not yet clear how long the pandemic will be with us. Will the past few
decades' trends towards lower equilibrium interest rates persist
or, on the contrary,
will COVID-19 usher in structural changes that are consistent with higher interest
rates over time?
Economic theory tells us that equilibrium interest rates should reflect potential real
GDP growth, inflation expectations and a risk premium that varies with the term of
the loan and the creditworthiness of the borrower. The outlook for all three appears,
at present, to be marred with varying degrees of uncertainty. Many are concerned
with downside risks to global potential growth, which would be highly relevant for
the trend in the growth outlook in an open economy such as South Africa.
Uncertainty about the longer-term impact of the pandemic may in itself result in
lower global capital accumulation, especially at a time when corporate profit rates
are declining and global trade, which is historically a driver of investment, is still
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contracting.4 Indeed, supply concerns experienced at the height of the pandemic
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for example, in the procurement of medication or personal protective equipment
may entice authorities to reduce reliance on global value chains, or at least reduce
the length in the supply chains and reliance on single suppliers.
Some economists also highlight the possibility of durable labour market 'scarring',
which would risk the permanent loss of skills, and make it more difficult to match
labour supply and demand in the future.5 Admittedly, other shifts could be more
positive for potential growth. The sudden imposition of the lockdowns certainly
forced many firms to speed up their adaptation to different ways of work and of
doing business, which, if implemented on a larger scale in the coming years, could
boost productivity. Automation, e-commerce and remote working are all likely to
play a greater role in economic activity in the coming years. Yet it is not clear
whether all economic sectors would benefit equally from such changes and, also,
whether these changes in the ways of work could be implemented as easily in
emerging economies that still rely more heavily on primary and secondary
industries.6
And what about inflation? Economists at a large global investment bank recently
reviewed major 'regime shifts' in the inflation of key economies over the past
century, and found that common drivers are a combination of supply-side
constraints or reforms, exogenous shocks, fiscal issues and institutional changes.7
At present, central banks across the world remain, by and large, committed to
inflation targeting, and when changes are being made to the framework, these are
generally moderate and aim to correct durable undershoots of targets rather than
to 'shift the goalposts'.8 However, several of the potential influences on real
economic growth I just mentioned could also alter inflation in the future. Productivity-
enhancing shocks such as automation and e-commerce may further weigh on
prices; at the same time though, further trends towards deglobalisation, as well as
more active policies to reduce inequality, mean that some of the major
disinflationary forces of the past few decades could wane.
Rising government debt levels also present a risk to equilibrium interest rates in the
future. Up to now, public debt has risen in most jurisdictions over the past decade,
without seemingly affecting the level of interest rates. Perhaps, as Larry Summers
and Lukasz Rachel argued in 2019, rising public debt just prevented equilibrium
real interest rates from falling even lower.9 Nevertheless, in countries whose
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currencies are not reserve currencies, the risk of fiscal dominance even if it is not
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strong enough to meaningfully lift inflation expectations may raise the risk
premium that investors require on longer-term interest rates. Consequently,
countries with vulnerable public finances may face permanently steeper yield
curves.
6. Implications for future South African interest rates
All the long-term drivers of interest rates I just discussed have implications for South
Africa. However, determinants of the equilibrium interest rate would be somewhat
different in an open economy such as ours, with a structural current account deficit,
than in a large and relatively closed advanced economy where most drivers of
equilibrium rates are internal. When a country is dependent on external financing,
it requires an equilibrium interest rate that attracts foreign as well as domestic
the SARB's
savings to finance investment. Indeed, models link the domestic neutral
real interest rate to both its global counterpart and a South Africa-specific risk
premium.
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Hence, a lower global equilibrium interest rate would everything else being equal
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imply that the policy rate should also be lower, on average, in South Africa.
Equally, in a world where global drivers of inflation have, over time, played a greater
part in influencing country-specific price developments, continued moderation in
global inflation may make it easier for inflation expectations to remain low and stable
in South Africa.
However, there is no certainty that the risk premium which investors require on
South African assets will remain low over the medium term. Of course, the major
central banks in advanced economies have indicated they are in no rush to raise
rates from very low levels, or reverse the continued increase in the size of their
balance sheets. As they did in the aftermath of the global financial crisis, these
policies should provide incentives for global fund managers to seek higher returns
outside traditional 'safe' markets, encouraging capital inflows towards emerging
market securities. In light of the size and liquidity of its markets, South Africa should
benefit from these trends.
Yet the COVID-19 crisis has exposed differences in vulnerability between emerging
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market countries those countries that enjoy stronger public finances have been
able to respond more effectively to the macroeconomic shock and, hence, have
been able to potentially limit medium-term economic losses. Some economists are
also arguing that in a world where globalisation forces are on the decline, the
economic and financial cycles of respective countries may become less
synchronised.10 In that respect, the unfavourable debt/growth dynamics of South
may reflect in the country's sovereign risk and potentially perceived risks of
Africa11
dominance. Furthermore, South Africa's loss of
fiscal its investment-grade status
could expose us to greater volatility of non-resident capital flows in the future, with
a higher risk premium required to compensate for such volatility.
7. Conclusion
In conclusion, I would again like to stress that decades of gains in stabilising inflation
and inflation expectations, both in South Africa and abroad, have assisted central
banks in responding quickly to the COVID-19 pandemic, limiting financial sector
spillovers that would otherwise have made the economic recovery even more
challenging and lengthy.
As we enter a new decade, fraught with uncertainties about whether and how the
pandemic will have lasting consequences on key macroeconomic and financial
variables, an important tool in enhancing the resilience of our economy is for the
SARB to ensure that we retain this monetary margin of manoeuvre in the future.
This involves a continued anchoring of inflation expectations around the midpoint
of our target range in the coming years and ensuring that financial markets are
functional.
At present, achieving our goals appears consistent with a relatively low level of
interest rates, in the next year or two, compared with the average of earlier cycles.
But we must remain vigilant and watch for potential changes in drivers of equilibrium
interest rates in the future.