Rethinking inflation: SARB’s governor on achieving lower rates without sacrificing growth

As South Africans gradually emerge from the steepest inflation surge in decades, policymakers are reflecting on the lessons learned and questioning whether high inflation is inevitable or if a lower rate, influenced by policy changes, is achievable. According to Lesetja Kganyago (pictured), governor of the South African Reserve Bank (SARB), the answer is “yes”.

The Consumer Price Index (CPI) dropped to 3.8% year-on-year in September – its lowest level since March 2021.

Delivering a guest lecture at the Department of Economics, Stellenbosch University, on 17 October, Kganyago stated that discussions often frame relatively high inflation as a structural inevitability and not a policy choice.

“But the fact is, we could have a lower inflation target, like almost all our peers, and with it, lower inflation,” he said.

Reflecting on nearly 25 years of inflation targeting since its implementation in 2000, Kganyago noted that the framework has generally been successful, with both inflation and interest rates lower than before. Inflation has averaged 5.85% within the SARB’s 3% to 6% target range. However, it has often exceeded the upper limit, going above 6% nearly 40% of the time.

After evaluating SARB’s performance following his appointment as governor in 2014, Kganyago pinpointed three primary shortcomings:

• Frequent target misses: Despite the broad target range, they often missed the 3% to 6% target.
• High average inflation: Although better than the double-digit rates of the 1980s and 1990s, an average near 6% was not satisfactory, because it leads to significant price increases over time.
• Structural growth issues: After the global financial crisis, South Africa’s growth slowdown was attributed to weak demand. In response, higher inflation was tolerated to avoid rate hikes and stimulate growth, which ultimately failed.

Recognising these challenges, the SARB adopted a new strategy in 2017, aiming for an inflation target of 4.5%, rather than treating the 3% to 6% range as a “zone of indifference”.

“We also adopted a new flagship forecasting model, the Quarterly Projection Model, which included an explicit 4.5% objective and projected a path for the policy rate that would deliver on that goal. The new strategy worked. Over the next few years, we achieved lower inflation, and we also secured broad stakeholder understanding of our revised objective,” Kganyago said.

The administered price problem

Kganyago said that in discussing inflation, analysts often misrepresent the administered price problem. He explained that the government sets prices for essential services such as water and electricity, which often see inflation rates exceeding the SARB’s target.

Administered prices account for about 16% of the CPI basket.

“It is an important category but hardly a dominant one,” he stated.

Kganyago noted that a common objection when considering a lower inflation target is: “What about administered price inflation? You cannot control administered prices. If you aim for lower inflation, you will hurt the rest of the economy.”

He noted this concern has persisted since SARB began targeting 4.5% inflation and continues to come up in current discussions.

He said it is crucial to recognise that high administered price inflation adversely affects everyone. The SARB observes that administered prices are undergoing what he called a “relative price adjustment”, with these goods and services becoming more expensive compared to others.

However, he clarified this does not imply that the problem of administered price inflation is worse at a target of 4.5% than at 6%. Similarly, increasing the inflation target would not necessarily lead to an improved situation.

“If you have a higher target, you would expect all prices to rise faster across the economy. You would expect your currency to lose its buying power for global commodities, such as energy and food, faster. You would expect more currency depreciation, meaning your currency would become less valuable compared to others that hold their value better,” he explained.

In such circumstances, administered price inflation would likely increase. He added that price setters, still focused on making relative price adjustments, would maintain their power to implement even larger price increases.

“If this situation is turned around, it becomes clear how it is possible to achieve lower headline inflation even with high administered price inflation. The overall price level rises more slowly, the currency depreciates at a slower pace, and the rate of administered price inflation slows, even as the ‘wedge’ to other prices remains,” he said.

Kganyago noted this was what SARB observed after 2017.

“Headline inflation slowed, and so did inflation for administered prices. The gap between the two was largely unchanged. From 2010 to 2016, it was 2.4%; since 2017 it has been 2.3%,” he said.

In other words, he argued it is not necessary to push the entire economy into deflation because of high administered prices; rather, smaller increases across the board would suffice.

“Yes, administered price inflation is too high and damaging for the economy. Yes, if it were lower, that would help deliver lower inflation and lower interest rates. But administered prices are also responsive to economy-wide inflation, and they are not such a large part of the basket that disinflation can only be achieved by forcing everyone else into deflation. The conversation about lower inflation should not be held hostage by administered prices,” he said.

True or false: lower inflation means lower growth

Another concern about lower inflation is the assumption that the short-term costs are high. Kganyago said it is still often assumed that lower inflation means lower growth, despite studies showing that sacrifice ratios can be low.

He said the expectation is that with a lower target, the central bank will raise rates, squeezing the economy. Unemployment will then rise, firms will be unable to raise prices because of weak demand, and so inflation slows.

“This trade-off between growth and inflation strikes some people as unacceptable, even when they understand that lower long-term inflation would be desirable,” he noted.

Although testing counterfactuals in the real world is impossible – you cannot rewind time to experiment with SARB aiming for the top of their target range instead of the middle – two economists created a counterfactual model to compare actual outcomes with projected economic trends had the 4.5% target change not occurred.

Kganyago said the results made for interesting reading.

“Perhaps the most striking is, they find no reduction in aggregate demand during the move to 4.5%. Growth in gross domestic product is in line with the counterfactual. Unemployment is generally unaffected. Credit extension is higher.”

The study concluded there was little or no cost to getting inflation to 4.5%. The explanation it provides is that the SARB’s commitment to 4.5% was heard and understood. Inflation was not forced down by a recession; it was managed lower by clear and credible communication.

This conclusion lined up with another study, by SARB economists, of sacrifice ratios in South Africa

A sacrifice ratio is the cost of reducing inflation, measured as the amount of GDP growth lost for each percentage point of lower inflation.

He said for the period SARB moved inflation to 4.5%, the study found a negative sacrifice ratio, which means there was no cost. The authors also found that disinflation costs had generally been low in South Africa.

“This is, once again, contrary to the popular intuition that lower inflation is achieved by slower growth and higher unemployment. And once again, the key seems to be the SARB’s credibility and communication. If the public understands and believes the central bank’s objectives, disinflation can be achieved with little or no pain.”

Kganyago concluded that South Africa has an opportunity to achieve permanently lower inflation and, therefore, permanently lower interest rates.

“Executed effectively, a lower target could be achieved at little cost – just as we moved to 4.5% at little cost,” he said.