The Central Bank Dilemma: Inflation vs Growth

Today I attended a meeting with an official from the South African Reserve Bank (SARB). It was a good opportunity to get some insight into their thinking given that the current stagflationary environment (the combination of low growth and high inflation) places conflicting demands on monetary policy. Low growth necessitates loose monetary policy, while inflation above the 6% upper target implies the need for rate hikes. Interest rates were left unchanged at last week's (19 Sep 2013) Monetary Policy Committee (MPC) meeting, but the Governor Gill Marcus gave a distinctly hawkish speech, which hinted at the real possibility of rate hikes in  the coming months.

I have long held the view that interest rates at 5% in SA are too low given the 3-6% inflation target and the fact that inflation is likely to remain close to or above the 6% upper threshold for the foreseeable future. A few months ago the dominant sentiments was that rates would remain low for an extended period due to the global interest rate environment. Despite a significant depreciation of the Rand and the ensuing inflationary pressure, in April 2013 the market had moved to price in a further rate cut.

This all changed in May when the Fed announced the potential for reduction in the bond purchases (tapering of quantitative easing), which caused the Rand depreciation to accelerate and yields to spike. While the market has since settle, the consensus view has been that a weak economy would preclude the need for rate hikes.

Last weeks MPC had economists scrambling to amend their interest rate forecasts as the MPC’s language seemed to be aimed at preparing the market for a rate hike in the coming months. Like all Central Banks, the SARB has to find a balance between controlling inflation and promoting growth, but in the last meeting the governor repeatedly reminded the market that maintaining inflation within the target band is the Reserve Bank’s primary mandate.

Given the outlook for continued inflationary pressure due to the depreciation of the Rand, as well as the shift in the Reserve Bank's focus back towards controlling inflation, I would not be surprised if the rate hiking cycle starts in the coming months.