South African economic policy makers will be faced with a dilemma over interest rates in 2003 — whether to lower them as quickly as possible to support economic growth or to cut them more slowly to maintain capital inflows to support rand stability and to lower inflation expectations, according to Standard Bank economist Dr Johan Botha.
Writing in the bank’s Economic Review for the fourth quarter of 2002, Botha observes: “The combination of relatively high interest rates and a strong currency has created policy dilemma for monetary authorities. After peaking in the final quarter of 2002, it is generally accepted that inflation will fall rather sharply (supported by a base effect) in the first half of 2003. This will signal that interest rates can start to decline-which will be positive for economic growth.
“A strong and stable rand, however, is also positive for the inflation outlook and thus economic growth down the line. But a rapid decline in interest rates is likely to weaken the currency as capital inflows slow or turn negative. This raises the policy issue of whether interest rates should be allowed to decline almost automatically in response to the expected lower inflation numbers. Although different opinions prevail, internationally there has been a movement away from such quasi-automatic responses.”
There are two general prevailing ideas on what a suitable policy response should be under these circumstances, Botha goes on to say. The first argues for a rapid decline in interest rates to stave off defaults and promote more investment, higher economic growth and job creation. Higher economic growth would in turn be conducive to more capital inflows, thus supporting the balance of payments.
The second view, meanwhile, holds that a more measured approach to cutting interest rates-say by lowering them by 50 basis points at a time rather than 100 basis points-could be better by trading off a somewhat slower decline in interest rates for a relatively more stable rand exchange rate.
Proponents of this approach contend that a rapid decline in interest rates will lead to lower returns on investment, which will encourage capital outflows and put pressure on the rand to depreciate. A weakening currency will then fuel inflation and reinforce the perception of the rand as a volatile and intrinsically weak currency, which is negative for economic growth.
In the short run, the current account will temporarily strengthen as imports fall more quickly than exports rise, and investment will not necessarily grow, due to higher macroeconomic uncertainty. Although consumption could increase as a result, this alone will not ensure sustainable growth, therefore creating the danger of exchange-rate-led stagflation.
Botha points out that another argument in support of this more nuanced approach to monetary policy over the medium-term is that South Africa’s real interest rate for September, October and November was below 2,5% — the lowest level in more than a decade.
“Although the real interest rate will increase sharply as inflation falls, part of the decline will be the impact of the base effect on the calculated numbers. An immediate reduction in interest rates thus seems not to be warranted,” he concludes. – I-Net Bridge