The Reserve Bank must raise interest rates — but how high and how fast?

The Ukraine war is a major shock that was not on the radar during the January MPC meeting

The SA Reserve Bank’s monetary policy committee (MPC) meeting on interest rates this week will be one of the most difficult since the pandemic started.

That interest rates must normalise is no longer the question. The question is how much and how fast to hike them.

The Bank needs to do more than just normalise and front-load interest rate hikes to fight inflation; it must create monetary policy space fast. Failure to do so means that stagflation — high inflation and very low economic growth — is a real risk.

Before Russia invaded Ukraine on February 24, the Bank assumed that oil prices would average $78, $72 and $70 per barrel in 2022, 2023 and 2024.

“Since the previous MPC decision to hike policy interest rates, oil prices have averaged $99 per barrel, $21 more per barrel than the Bank's assumption”

World food prices were expected to decline by 2.3% this year before a marginal rise by 0.7% and 1.2% in 2023 and 2024. Global inflation was expected to average 3.1%, 1.7%, and 1.6% in 2022, 2023 and 2024. International policy interest rates were expected to remain relatively flat in 2022, at 0.1%, and to rise by 0.6% and 1.1% in 2023 and 2024.

That global backdrop is no more. Since the previous MPC decision to hike policy interest rates by 25 basis points, which was the second consecutive hike of the same magnitude, oil prices have averaged $99 per barrel, $21 more per barrel than the Bank's assumption.

For oil prices to average $78 per barrel as per the Bank's January MPC assumption, oil prices for the remainder of the year must average $57 per barrel. This is highly improbable given the war in Ukraine and the normalisation of Covid restrictions — excluding China and its zero tolerance of new infections.

The oil price assumption will have to be substantially higher than before.

Food price inflation will also be higher. Wandile Sihlobo, the chief economist at Agbiz, expects South African food price inflation to average between 4% and 5% in 2022.

He wrote in his weekly note earlier this month that the UN's Food and Agriculture Organisation (FAO) Global Food Price Index averaged 141 points in February 2022, an all-time high exceeding the previous peak in February 2011, which takes the rise in global food prices to 21% in February 2022 compared with February 2021.

For food prices to converge to the Bank's forecast, they will have to contract significantly, which is an unlikely prospect given drought conditions in Brazil and potential disruptions in Russia and Ukraine, which jointly accounted for about 30% of global wheat exports, 14% of maize exports, 32% of barley exports, nearly 60% of sunflower oil exports and 14% of fertiliser exports.

The Bank's global and domestic food price inflation assumptions will have to be significantly higher than before.

On the positive side, domestic electricity prices will be just over four percentage points lower, given Eskom’s permitted increase of nearly 10%. This, however, is outweighed by the fuel price shock and food price inflation.

Whenever supply-side shocks cause prices to spike for products such as oil, food and electricity there are arguments that the Bank must not respond by hiking interest rates as it will merely choke economic growth without influencing the underlying inflation drivers.

The Bank argues that the second-round effects of these supply shocks translate into demands for higher wages that are inflationary. With food, electricity and fuel prices all rising, higher wage demands will likely follow, which will threaten demand-pull inflation.

The Bank will need to explain and show evidence for its reasoning, in order to be understood and have credibility.

“The Ukraine war is a major shock that was not on the radar during the January MPC meeting”

The Ukraine war is a major shock that was not on the radar during the January MPC meeting. Major wars have previously led to recessions or a significant slowdown in foreign direct investment and economic growth. Furthermore, oil price shocks have sent the global economy into recession historically.

The Bank is therefore facing the prospect of a global recession, which implies slow domestic growth, if not a recession, given SA's dependence on external demand, and high inflation driven by commodity prices.

What should the Bank do, given this prospect?

It is a monetary authority tasked with maintaining stable prices in the interest of balanced economic growth. Thus it needs to focus on stabilising prices within its target range. The current trajectory of the drivers of inflation indicates that inflation will likely overshoot the upper target of 6% for a brief period.

The Bank therefore needs to not just normalise interest rates but to respond to the second-round effects in a meaningful way.

What about economic growth and employment? When we lubricate bicycle wheels we are not asking the lubricant to put the bicycle in motion — something else designed to do that must do its job. Likewise, institutions such as the National Treasury, the departments of energy & mineral resources, transport, telecommunications, trade, industry & competition, and others, must do their job of reforming the economy so it can grow and create jobs.

Asking the Reserve Bank to not respond to rising inflation to support economic growth has two risks.

The first is that inflation will spiral out of hand while economic growth continues to slow down, for reasons beyond high interest rates.

The second risk is that the credibility of the Bank will be dealt a major blow and will be difficult to regain.

Given the trade-offs, it will be appropriate for the Bank to hike rates even by 50 basis points this week and to front-load future rate hikes to create policy space and manage second-round effects, for it is better to deal with low growth alone than to deal with stagflation.