Pushing to a tighter target

Reserve Bank governor Lesetja Kganyago has been signalling for about the past two years that he believes SA needs a lower inflation target than the current 3%-6% range — preferably a point target of 3%, in line with other major emerging markets.

The call for a lower target has been back in the spotlight in the past week. The timing could hardly be more interesting, or more appropriate.

First, in an opinion piece in Business Day on February 19, the Reserve Bank’s head of research, Chris Loewald, pointed to the Bank’s success in lowering SA’s inflation rate. But he also called for a more ambitious approach that would cause SA to move to a better and lower inflation target, closer to that of its trading partners. Such a move could bring greater currency stability and lower long-term borrowing costs, improving welfare for all SA households, Loewald argued.

Then the Treasury signalled in the debut edition of its Macro-Economic Policy Review that it was looking at a target that was more in line with that of SA’s peers and trading partners, and was busy with technical work on this.

SA’s average inflation rate has come down dramatically in just more than two decades since SA implemented inflation targeting and it has become much less volatile. That’s allowed for lower interest rates, with the Bank building a credible record for keeping inflation under control and expectations well anchored in the target range most of the time. And when expectations are well anchored, businesses and trade unions pitch their prices and their wages accordingly, so that inflation doesn’t spiral out of control, even when there are temporary shocks.

SA has done relatively well lately. Inflation, which peaked at 7.8% in July 2021, never reached the double-digit levels seen in many other countries and was brought back within target relatively swiftly, without excessive interest rate hikes.

Yet SA’s average inflation rate, and its target range, remain above the levels of our advanced economy trading partners — which target 2% inflation — and of emerging-market peers such as Brazil, which has a 3% target. As the Treasury pointed out, the differential between SA’s inflation rates and those that prevail internationally means the rand exchange rate is constantly under pressure, which in turn creates inflationary pressures. That differential also undermines SA’s competitiveness, discouraging exports and undermining imports.

Kganyago has suggested a point target of 3%. That seems mere fantasy given the politics of this election year.

But with the populist critics of inflation targeting waiting in the wings, it is important for policymakers to stress that what SA needs to support economic growth and welfare is not a higher, looser target but a lower, tighter one.

There is, of course, nothing to prevent the Bank effectively targeting the 3% bottom of the range and tailoring monetary policy decisions to this. It already effectively targets the 4.5% midpoint. That it has been making this clear since 2017 has helped to manage down inflation expectations and inflation towards that level. With inflation subsiding and the cutting cycle ahead, this is a good time to keep the cuts modest and push towards that 3% level. The Bank could well try that, as we wait for the Treasury’s verdict.