Bottom line: The South African Reserve Bank (SARB) has been in a tightening cycle since November 2021, bringing the policy rate to 6.25% in September from 3.5% at the start. At the time, annual inflation stood at 4.9%, with SARB and market projections pointing to inflation staying close to the mid-point over the forecast period. However, the bank took a prudent approach, citing global price developments and the need to curb the level of policy accommodation. What followed has been the longest tightening cycle since June 2006. Whereas in previous cycles, the SARB had to hike the policy rate close to or above headline inflation, this time there are reasons why the bank could end its tightening earlier. That is why we expect the bank to hike the policy rate once more on Nov. 24 and conclude the current cycle.
Figure 1: SARB Repo Rate and Headline Annual Inflation (%)
Source: Datastream, SARB
Subdued Demand and Rand Performance
As it is the bank’s mandate, the SARB aims to maintain stability in currency markets to avoid eroding purchasing power and keep inflation within its target band of 3-6%. The recent spike in headline inflation has been mainly caused by the global price movements in food and energy in the wake of the war in Ukraine. Domestic demand has slowed in 2022 and is expected to soften next year. Meanwhile, according to Bureau for Economic Research surveys of inflation expectations in the past two quarters, inflation is expected to fall below 6% by the end of 2023. Expectations for 2024 inflation slightly improved in Q3, to 5.3% from 5.4% in the previous quarter. In a year when USD strength has been the main story, the South African rand has performed relatively well, having fallen 11%. As the inflation outlook calms and currency performance remains benign, a more aggressive stance from the SARB will not be needed.
Figure 2: Emerging Market Government Bond Spreads over US Treasuries (10yr, %)
Source: Datastream
South Africa Continues to Offer Yield
The early start of the tightening cycle and the SARB’s firm stance have allowed South African bond yields to remain attractive. As we expect the Fed’s tightening cycle to come to an end at the 4.75-5.0% range, the SARB can end its tightening cycle in November with one last hike, and South African bonds can maintain an attractive yield. The fiscal outlook also supports bond attractiveness, as higher-than-expected budget revenues this year will be directed to reducing gross debt in the coming years. In addition, the National Treasury has been prudent in wage increases, limiting them to average 3.3% per year over the next three fiscal years. There is a risk that politicians may choose a populist approach and offer bigger wage hikes ahead of 2024 elections. Yet until late 2023, risks to the fiscal outlook remain balanced. Current wage increases should also curb domestic demand, preventing inflationary pressures.
As the inflationary process is different from the 2006 or 2016 episodes, when currency depreciation and wage increases had fed through to inflation, the SARB’s current accumulated tightening of 275 basis points will likely come to an end with one last hike of either 50 or 75bps at the November MPC, bringing the policy rate to 6.75-7.0%. The bank will then switch to a wait-and-see mode to observe the impact of its tightening.
