The Governor of the Reserve Bank, Gill Marcus, saw fit in her Q&A session after the Monetary Policy Committee (MPC) meeting to adopt a more hawkish tone about the direction of interest rates. This came after the MPC decided to leave short rates on hold.
Perhaps the MPC needs to be reminded that raising short term rates will not do anything useful for the inflation rate unless the rand responded favourably to such a move.
Judged by the relationship between daily changes in short rates and daily moves in the rand since 2007, there is in fact as much chance of the rand weakening as strengthening when short rates rise. This relationship since 2008 is shown below in a scatter plot and has a correlation of zero.
Higher rates however can be expected to slow down domestic spending that, as the Reserve Bank is well aware, is growing very slowly and is putting deflationary, rather than inflationary, pressure on prices. The risk is that higher rates will damage the economy without having any favourable impact on inflation or inflation expectations.
It is a risk not worth taking. The Reserve Bank should have lowered interest rates long ago but in current circumstances of “tapering” risk on US rates and the rand, the best approach the Reserve Bank could take is to do nothing at all. It almost appears, from the body language of the Governor, as if doing nothing about interest rates or the exchange rate is a hard act for the MPC. Doing nothing for now and until domestic demand has picked up momentum, which it shows no signs of doing, is highly recommended.
Just in case the Bank thought its tough talk had any favourable impact on the rand it should know that any strength in the rand on late Thursday and Friday was due to a favourable upward move in emerging equity markets that helped the rand as much as it did other emerging market currencies. Absent SA political risks (over which the Bank has no influence) the rand remains exposed to global economic forces for which emerging market (EM) equity and bond markets are a very good proxy. We show the links between the rand and the MSCI EM Equity Index and also those between EM credit spreads over US Treasuries and the rand below. Clearly global forces are driving the rand and will continue to do so – independently of short rates set by the Reserve Bank.
The recent Brazilian experience with hiking short rates – to which reference was made at the MPC meeting – should be salutary for the SA Reserve Bank. In response to dollar strength and weakness in the Brazilian real, the Brazilian central bank hiked short term rates aggressively in mid year. As we show below, such aggression) no doubt harmful to the domestic economy) has not has any favourable impact on the Brazilian real/rand exchange rate. The weak rand has more than held its own with the real without support from higher interest rates as we show below.
The reason that currencies weaken in the face of higher short rates is because higher interest rates can damage longer term growth prospects and frighten capital away.
The path to a stronger rand and lower inflation is faster SA growth – this will encourage portfolio inflows and foreign direct investment to SA. Slowing down growth can be highly counterproductive: by discouraging foreign capital, it can weaken the rand and lead to more, not less inflation. Such possibilities should give strong pause to thoughts of higher short term interest rates.