Financial Mail and Business Day

Reserve Bank is still in search of that golden neutral rate estimate

Central bankers are trying to puzzle out when the turning point in the current hiking cycle will be

● Joffe is editor-at-large.

What does the central bank mean when it says monetary policy is restrictive? Reserve Bank governor Lesetja Kganyago said last week that interest rates were “only now in restrictive territory”, after the Bank hiked the benchmark repo rate by another 50 basis points.

No doubt it was a nasty surprise to borrowers who already felt squeezed by interest rates that had more than doubled over the 18 months since the Bank started hiking.

But Kganyago is working with what economists call the neutral or natural real rate of interest, which the Bank estimates at 2.4% currently. On that basis the benchmark repo rate is in real terms finally at the level where it restricts the economy rather than accommodating its growth. It is the medicine the economy has to take to get inflation back to target, he argues — failure to do so could land the economy in intensive care.

In March, when the repo was hiked to 7.75% and inflation was forecast at 6% for this year, the governor’s arithmetic was that monetary policy was not yet tight because the report was at only 1.75% in real terms, which was below what the Bank deemed neutral. Now with a repo of 8.25% and a 6.2% inflation forecast, it has clearly gone over the line. Whether too far or not far enough is the question the market is asking.

The IMF devoted an entire chapter of its latest World Economic Outlook to the natural rate of interest, which is “the real interest rate that neither stimulates nor contracts the economy”. It’s important for both monetary and fiscal policy, says the IMF, as a reference level to gauge the stance of monetary policy and a key determinant of the sustainability of public debt.

Back in the day, SA’s central bankers would look simply at whether interest rates were positive or negative in real terms to gauge the monetary policy stance. That would make zero the neutral rate, but economists now argue there’s no reason it should be zero.

More importantly, the neutral rate changes over time in response to factors such as productivity or demographics. That means in advanced economies, for example, where neutral has fallen for four decades, central banks may not have to raise rates as high as they had to in the 1970s to flatten inflation. Or so they hope.

The concept has come into fashion among monetary policymakers globally and in SA over the past few years. It has been in the spotlight in recent months as central bankers and markets have been trying to puzzle out when the turning point in the current hiking cycle will be, and what the future path of interest rates might look like.

But neutral cannot be observed in the real world. It has to be estimated. And it is the subject of much debate, with some in the market wondering whether central banks, our own included, are using or abusing it.

First is the question of how to calculate it. Broadly, the Reserve Bank adds an SA country risk premium to the global neutral real rate. Currently that is a risk premium of about 2% plus a global 0.5%, which has risen since Covid-era lows, as has SA’s neutral rate.

The concept is that SA is a small open economy in need of foreign capital. If it wants to attract capital it needs to offer international investors an interest rate in money terms that compensates them for SA’s country-specific risk, as well as for inflation. But measurement is complex and contested.

Matrix Fund Managers’ Carmen Nel believes the Bank’s estimate of neutral may be too high given that most borrowing in SA is domestic, not foreign. Codera Analytics’ Daan Steenkamp reckons it’s too low based on financial market indicators of country risk.

Then there is the question of which inflation rate to use as a comparison. Asked to define “restrictive” last week, deputy governor Rashad Cassim conceded this was not straightforward.

The general rule is to ask what is the repo versus forward-looking inflation or inflation forecasts. The repo is restrictive in real terms even based on this year’s 6.2% inflation forecast. Look ahead to the Bank’s 5.1% forecast for 2024 and it is even tighter.

Clearly, if the Bank gets it wrong it could misread its own stance and over-tighten or under-tighten. In any event, relying on estimates of unobservables is no substitute for getting a real feel of what is happening in the real economy and what effect interest rates are having on credit and growth.

The Bank was not too fixated on the exact numbers, Cassim said, but on the general trend in the repo. “We think our balance between doing the necessary tightening in an economy that has come to a halt is a necessary evil to anchor inflation expectations.”

How restrictive does the Bank have to be to achieve that? Some in the market took Kganyago ’ s comments to mean this would be the final interest rate hike, and 8.25% the terminal rate. But he made it clear last week that was not necessarily the case, especially if the rand weakened further.

As it turned out, the rand tumbled after a rate hike that should have strengthened it. Whether the market felt the Bank was over-tightening or under-tightening is still not clear. Market players point to a clutch of foreign sellers putting on the pressure for a 75 basis point hike. It also did not help when the monetary policy committee said in its statement that “further currency weakness is likely”.

It had said almost exactly the same thing in its previous, March statement, without anyone noticing. This time it was evidently just one more straw. The Bank will surely be having a rethink about the relationship between inflation, exchange rates and interest rates, neutral or otherwise.

Not to be forgotten, however, is the other reason the neutral rate is important — to assess the sustainability of the public debt. The fiscal economics is that as long as the real rate of interest is higher than the economic growth rate, government debt will consume more and more of the economy’s resources.

That’s certainly the case in SA. The consequence is that SA’s monetary authorities are forced to tighten or over-tighten interest rates, clamping down on private spending and investment to offset the effects of public spending that continues on an unsustainable path. The implications of this continuing shift from private to public for productivity, efficiency and employment are bleak.

As a former Treasury director-general, Kganyago tries not to comment on the national budget. But the Bank’s urging that “reaching a prudent public debt level ... would enhance the effectiveness of monetary policy” is heartfelt.

OPINION

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2023-06-02T07:00:00.0000000Z

2023-06-02T07:00:00.0000000Z

https://bd.pressreader.com/article/281706914066803

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