September 19, 2024
Interest Rates: Expecting the Unexpected
What has happened internationally
The Federal Reserve Bank in the U.S. has cut its benchmark interest rate by 50 basis points, 25 basis points more than most market analysts anticipated. This unexpected monetary shift could pave the way for the South African Reserve Bank (SARB) to consider a similar move in its interest rate decision the following day. While most analysts predicted a 25-basis point reduction, it is understood that the SARB makes its decisions based on what it deems best for the economy, considering inflation expectations.
It is prudent to examine the actions of South Africa’s peers regarding interest rates. For instance, Brazil, as an emerging market and BRICS partner, has taken a different approach by raising its Selic rate by 25 basis points in September. The Central Bank of Brazil cited stronger economic activity and labor market indicators, along with current inflation levels exceeding the target range, as the reasons for this decision. Following this interest rate hike, the Brazilian Real appreciated against the U.S. Dollar by nearly 20 cents since the announcement, which may help lower inflation by reducing import prices in Brazilian real in the short to medium term.
In South Africa, the exchange rate remains volatile and sensitive to interest rate movements from the South African Reserve Bank (SARB) and decisions made by the Monetary Policy Committee (MPC) regarding the repo rate. With the U.S. Federal Reserve lowering its rate by 50 basis points, South Africa finds itself in a favorable position. A subsequent 25-basis point reduction in South Africa could positively impact the exchange rate and the broader economy.
Lowering the interest rate by 25 basis points would widen the spread between South African and U.S. interest rates by the same amount, potentially making the South African financial market more attractive for portfolio flows. This influx of capital could lead to a strengthening of the Rand, even with the interest rate reduction.
The Rand has already appreciated significantly since the formation of the Government of National Unity (GNU) and is currently trading around R17.50 per U.S. Dollar. This appreciation is attributed to improved confidence levels, fewer electricity supply constraints, and slightly higher-than-expected economic growth recorded in the second quarter of 2024.
Exchange rates also play a crucial role in shaping inflation expectations. A “weaker” currency generally makes imports more expensive in rand terms, and vice versa. This dynamic applies not only to goods but also to imported fuels used for transporting goods and services in South Africa. A “stronger” Rand can effectively translate into lower fuel costs and reduced expenses associated with imports, ultimately contributing to lower inflation across the economy.
Lower interest rates lead to several positive effects on the economy, including:
- Reduced borrowing costs for goods and services purchased on credit or financed assets.
- Increased consumption expenditure, as lower credit costs enhance disposable income for households and consumers.
- Refinancing of assets, which could release funds and further increase disposable income, potentially driving demand in the economy and fostering economic growth.
However, there are some downsides to lowering interest rates:
- Decreased savings incentives for savers, as lower rates result in reduced income from savings over time.
- Potential inflationary pressure, as lower interest rates may boost demand for goods and services, possibly restarting the inflation cycle.
- Rising asset prices, as lower rates can lead to significant increases in prices for assets like homes.
What does mean for South Africa
The impact of interest rate cuts on borrowing costs, particularly for mortgages, clearly illustrates the difference between a 25-basis point and a 50-basis point reduction in savings.
The table below shows the potential savings households could experience if interest rates are reduced by either 25 basis points or 50 basis points. This table accounts for bond and administration costs, which may differ from other asset amortization calculators available. A 50-basis point cut would free up more funds in household budgets, allowing for spending on other discretionary items that households may desire.
Lowering interest rates could further boost confidence in the South African economy, signalling that we are moving in the “right direction.” Increased confidence may lead to higher demand and supply, ultimately driving improved economic growth and job creation.