. how inflation targeting keeps interest rates low from time to time, i hear the argument that if we did not target inflation, we could have lower interest rates. another version of this argument is that if we had a higher inflation target, then interest rates could come down. these claims make superficial sense but are fundamentally wrong. in fact, higher inflation raises interest rates. the best way to get permanently lower interest rates is to bring down inflation – and then keep it low and predictable. to understand why this is so, let us start with a few basic concepts. the fisher equation says that the interest rate charged for a loan will include expected inflation plus a real rate of interest. 2 the inflation part of the interest rate ensures that a lender gets their initial capital back when the loan is repaid ; if that does not happen, then the loan is actually partly a gift because, thanks to inflation, a portion of the loan is not being paid back. on top of that is a small payment to the lender because the capital cannot be used for other purposes while it is with the borrower. furthermore, this equation, also called the fisher effect, was originally set out by irving fisher in his 1930 classic, the theory of interest. page 2 of 12 the lender gets paid some insurance against the borrower defaulting. therefore, if you think inflation will be 10 %, you will start with a 10 % interest rate and then add these terms and risk premiums. these premiums are normally quite small, unless uncertainty and / or risk are very high. the largest part of the interest cost is inflation. this implies that lowering inflation is the easiest way to lower interest rates. consider another example. the south african government borrows in both local and foreign currency. when it borrows for 10 years in rand, it pays an interest rate of close to 9 %. but when it borrows in us3 dollars, the interest rate is a little below 5 %. 4 in both cases the borrower is the same. the most important difference between the two cases is that the rand loses value faster than the dollar : us inflation is normally close to 2 % while south african inflation has been nearer to 6 %. accordingly, lenders demand a higher interest rate on the rand debt to compensate for inflation and inflation risk. another example comes from europe. before 2000, different european countries had different currencies. germany borrowed in deutsche marks, france in francs, and italy in lira.

to the current level of around 16. 7 per cent. this has gone along with reduced turnover in the south african fx markets, which saw the total average daily turnover in the rand market reducing from an average of us $ 12. 5 billion in 2017 to an average of us $ 9. 9 billion in the first 10 months of 2018, caused mainly by lesser activity by non - residents and thus partly reflecting risk - aversion towards emerging markets. what the future holds remains uncertain. the continued tightening in global financial conditions, a change in investor sentiment towards ems, escalating trade conflicts and geo - political developments, together with some idiosyncratic risks, remain the key page 5 of 8 risks to the local currency. as such, it is likely that the rand, along with other em currencies, will remain volatile. as a consequence of the recent volatility, exchange rate forecasts remain widely dispersed. between this quarter and the third quarter of 2019, the exchange rate of the rand is expected to average r14. 50 to the us dollar – this is according to bloomberg median forecasts. 4 however, the difference between the most optimistic and the most pessimistic survey participants on the exchange rate forecast for the first quarter of 2019 is almost r3. 00 – i have little doubt that one of the participants somewhere within that range will be correct! such a wide dispersion around the median forecast over such a short forecast horizon is representative of the uncertainty that has become an inherent part of our lives. and this uncertainty adds significant complexity to the conduct of monetary policy, the most recent outcome of our monetary policy meeting and the finely balanced decision being a good case in point. as regards the exchange rate and monetary policy, allow me to reiterate that forwardlooking and medium - term oriented monetary policy within a flexible inflation targeting framework, requires us to look through volatility and to focus on macroeconomic fundamentals, as we stated in our most recent monetary policy review. in this vein, we will continue to allow the exchange rate to absorb the initial shocks, and focus our policy actions on addressing second - round price effects, much as at times it can become difficult to distinguish first and second round effects in the wake of extended or multiple supply side shocks. however, it is important that policy decisions should not be informed by short - run market developments in either direction. before i conclude, let me briefly touch on some initiatives to strengthen governance issues in the