Reserve Bank’s lowering of the inflation target could damage South Africa’s prospects for growth

The South African Reserve Bank’s (SARB) recent push to lower the country’s inflation target has sparked an important debate about South Africa’s economic future. While the proposal may appear sound on the surface, a deeper analysis reveals that lowering the inflation target could damage the country’s fiscal health and economic growth prospects, particularly when our economy remains vulnerable.

The Bank’s argument is straightforward: First, they contend that South Africa’s relatively high inflation is merely a policy choice, not an inevitable feature of our economy. To support this, they point to Chile, which adopted inflation targeting in 2000 (the same year as South Africa), but chose a lower 3% target and achieved better price stability.

Second, they argue that the evidence of the post-Covid inflation spike is that people strongly dislike inflation and would prefer price stability.

Third, they challenge the common belief that high administered prices prevent South Africa from achieving lower inflation. 

Finally, they suggest that having higher inflation than our trading partners makes our exports uncompetitive.

These arguments are mostly correct but ignore the impact of South Africa’s already challenging debt dynamics. The size of the country’s debt portfolio depends on two factors: the rate of interest paid on debt and the growth rate of the economy. 

If the economy grows faster than the rate of interest we pay, then the debt load will be reduced as a share of GDP. Lowering the inflation target will reduce both the nominal growth rate of the economy and the rate of interest we pay on debt. Crucially, the nominal growth rate of the economy will fall immediately, while the interest rate will only fall as new debt is issued. Because our average debt maturity is long (more than 10 years), it takes a substantial amount of time for lower interest rates to feed into our debt. Thus, lowering the inflation target results in worse fiscal dynamics, meaning that South Africa will have more debt as a share of GDP.

This is exactly what happened when the SARB previously lowered its target from 6% to 4.5%. This resulted in nominal GDP being 10% lower than it would have been otherwise, pushing our debt-to-GDP ratio higher. This is not just a statistical concern; it has real implications for government spending on essential services and infrastructure because the government has chosen to cut services to reduce debt.

Therefore, the interaction between debt and inflation is straightforward. Consider a simple example: if one has a R1-million fixed-rate loan repayable in 10 years, higher inflation reduces the real burden of that debt over time as the purchasing power of each rand falls. This same principle applies to government debt. Historical evidence, including recent research from the IMF, shows that successful debt reduction often relies on a combination of economic growth and moderate inflation, rather than harsh austerity measures alone. In fact, the IMF’s World Economic Outlook of April 2023 found that in successful debt consolidations in emerging markets, two-thirds of the reduction in debt was achieved through economic growth and inflation, with austerity playing a smaller role.

The SARB’s argument regarding export competitiveness is particularly problematic. Economic theory and empirical evidence show that differences in inflation rates between countries are typically offset by exchange rate movements, a principle known as purchasing power parity. Multiple studies have confirmed that this holds true in South Africa. For example, if inflation in South Africa is 4.5% and 2.0% in the US, the rand typically depreciates against the dollar by about 2.5% annually, maintaining a competitive position. Sophisticated research has demonstrated that any deviations from this pattern are temporary, meaning that there is no long-term competitive disadvantage from higher inflation.

However, perhaps the most concerning aspect of the SARB’s proposal was its timing. South Africa is currently implementing fiscal austerity measures to control government debt. Adding a lower inflation target to this mix would force the Bank to maintain higher interest rates than necessary, creating a toxic combination that would further suppress economic growth and employment. This double whammy of tight monetary and fiscal policy would disproportionately impact the poor and middle class, potentially deepening our already severe inequality.

The consequences would cascade through our economy. Reduced government spending means fewer resources for law enforcement, education and regulatory agencies. The World Bank’s Investment Climate Assessment has shown that increased crime rates discourage both domestic and foreign investment; therefore, cuts to policing undermine growth. Similarly, recent research by Gust, Hanushek, and Woessmann has demonstrated strong links between educational quality and future economic outcomes. Budget cuts that reduce teacher numbers would disproportionately affect the poorest schools, perpetuating and potentially worsening inequalities while hampering future growth prospects.

Moreover, setting the inflation target too low carries its own risks. Even small economic shocks could push the economy into deflation, which is generally more damaging than moderate inflation, because it encourages consumers to delay purchases and increases the real value of debt. It would also reduce the SARB’s ability to respond to future economic crises by limiting how much they can cut interest rates during downturns, a constraint that many countries, including Chile, faced during the Covid-19 crisis.

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The path forward is clear: South Africa should maintain its current inflation target while focusing on policies that promote sustainable economic growth and efficient debt reduction. If fiscal consolidation is necessary, it should be performed in a way that minimises both the depth and duration of austerity measures, prioritising the maintenance of vital institutional capacity and infrastructure.

In an economy that still grapples with the aftermath of State Capture and the pandemic, we cannot afford to experiment with policies that could exacerbate our challenges. The SARB’s proposal, while well-intentioned, risks creating more problems than it solves. The combination of austerity and a lower inflation target creates a self-reinforcing cycle: lower inflation increases the real value of existing debt, necessitating deeper expenditure cuts and potentially extending the duration of the austerity measures. The result would be a longer period of reduced public services and investment, causing more sustained damage to economic fundamentals.

Sometimes, the cure can be worse than that of the disease itself. In this case, the pursuit of lower inflation could result in lower growth and employment over the next decade. What South Africa needs now is not more economic constraints, but rather policies that support sustainable growth while maintaining moderate inflation. Only then can we address our fiscal challenges without sacrificing our country’s development prospects. DM

Owen Willcox is a visiting researcher at the Public Economy Project, Southern Centre for Inequality Studies at Wits University.