Could SA cut interest rates before the US does?
The South African Reserve Bank (SARB) has been fighting rampant inflation for two years. It has hiked the repo rate by 4.75 percentage points since November 2021, pushing it to 8.25%, its highest level in 14 years. While these aggressive rate hikes were warranted, given the sharp rise in inflation, there is increasing evidence that the SARB’s hiking cycle is over.
Could the SARB start cutting interest rates before the US Federal Reserve (Fed) does? The simple answer is yes. It would not be the first emerging market to do so. Globally, central banks have cut policy rates 52 times so far this year, mostly in developing and emerging markets, including Brazil, Sri Lanka, Vietnam, Georgia, Belarus, Chile, Peru and Poland.
Latin American central banks are at the forefront of the current cutting cycle amid significantly slower inflation. For example, in July Chile was the first major emerging market country to reduce interest rates as its inflation eased from 14% in August 2022 to 5.1% in September 2023. The central bank of Brazil soon followed, cutting its benchmark rate as inflation fell to 3.2% in June 2023 from a 19-year high of 12% in April 2022. Other central banks in the region have since followed suit, and more are expected to do so soon.
This is understandable. When global inflation surged in 2021, many Latin American central banks were the first to raise interest rates, moving months before the Fed began tightening. These countries were extremely aggressive, with Brazil increasing rates by 11.75 percentage points and Chile by 10.75 percentage points. In comparison, the Fed has only hiked rates by 5.25 percentage points.
While SA has not been as aggressive, the SARB’s hiking cycle also started before that of the US. It justified the move as necessary to prevent inflation from moving back to the top end of the inflation target unchallenged and thus undermining gains in getting inflation expectations lower. SA’s inflation rate peaked at a much lower level than that of the US and many Latin American countries. SA’s inflation peaked at 7.8%, while Brazil’s peaked at 12.1% and the US at 9.1%. This not only meant that the SARB did not need to be as aggressive, but it also meant that the path back to target was much shorter.
SA’s headline inflation rate has been comfortably within the 3%-6% target range since June, and was 5.4% in September. Better still, core inflation is 4.5%, the midpoint of the target and the SARB’s preferred target. This implies that underlying inflation remains well under control, despite currency fluctuations and upward pressure on wages. In addition, SA’s long-term inflation expectations have come down since peaking in the second quarter of 2022. Based on these measures, one can argue that SA has won the battle against inflation and the current restrictive interest rate has done its job.
Cutting policy rates, however, is not without risks. Many of the emerging markets that have cut rates this year have been punished for doing so. Cutting rates before the Fed does means a narrower interest rate differential, thereby reducing the compensation investors receive for taking emerging market country risk. This leaves emerging markets vulnerable to currency weakness and increased financial market instability. The currencies of major emerging markets that have cut rates this year have, in general, had a weakening bias since their first rate cut. For example, the Chilean peso has weakened by 11% since July and the Brazilian real by 5% since August 2022. In addition, 10-year bonds for Brazil, Chile, Peru and Poland have been more volatile since the respective cutting cycles started.
Interestingly, it seems that the extent of currency and financial market vulnerability differs between countries. For instance, the currency movements of and capital outflows from Brazil have been largely manageable, as the central bank’s decisions were viewed as appropriate and not driven by a populist or political agenda. This is because Brazil was able to bring inflation within its target for five consecutive months before starting to cut rates (the current inflation target is 3.25%, with tolerance of 1.5 percentage points in both directions). Although the currency weakened shortly after the interest rate cutting cycle began, the Brazilian real has strengthened by 5.7% year-to-date and its 10-year bond yields have decreased by 1.2 percentage points since the beginning of the year.
In contrast, Chile has been punished more severely, given that, despite moderating from record highs, its inflation rate is still significantly above the 2% target. Chile’s currency has weakened by 8% year-to-date, and its 10-year bond yield has increased by 1.5 percentage points since the beginning of the year.
These developments are being closely watched by the SARB, as an indication of the possible response by the market if it were to cut rates before the Fed. It seems clear that if central banks can demonstrate that the decision to cut rates is entirely appropriate and in line with maintaining sound monetary policy, any negative market reaction is likely to be limited.
There is also a risk that the SARB starts to cut rates before the local inflation rate has been brought fully under control. The latest inflation data indicates that there is still some upside risk to South African inflation. Persistently high food inflation and the potential for “second-round” effects from the sharp increase in electricity inflation and recent petrol price hikes could push core inflation higher over the coming months. If the SARB were to cut rates during this time, it risks keeping inflation at an elevated level for longer and undoing the progress made in getting inflation expectations lower.
Fortunately, current upside risks to inflation appear likely to be contained, given already-high interest rates and a sluggish economic environment that makes it more difficult for companies to pass on cost increases. This is why headline inflation is likely to continue to moderate next year, ending 2024 at 4.6%. This should give the SARB room to start cutting rates in the second half of 2024, irrespective of the policy decision made by the major central banks, including the Fed. The one proviso, however, is that in trying to maintain prudent monetary policy the SARB might decide to cut rates gradually until the global interest rate cutting cycle is firmly established. If the SARB were to embark on early and aggressive interest rate cuts, it risks weakening the rand and injecting an unnecessary bout of financial market volatility.