Why Raising Interest Rates by 50 Basis Points Was a Terrible Idea: And What South Africans Can Do About It

You don’t need to be a genius to have an elementary understanding or working knowledge of monetary policy and its function in the economy. Don’t ever let anyone tell you you are just too stupid to understand, or that it would take too long to explain.

It all comes down to a principle of demand and supply. Average price is (or at least is said to be) at the level of sales where demand and supply meet on a graph.

Governments can intervene in economies either by fiscal (tax) policy, or by monetary policy (there are a couple of other elements to this, but for the ordinary person, this means interest rates).

The idea is that if you lower interest rates, households, businesses and government have a greater ability to spend.

Since households and businesses usually deposit money into the bank that they earn – and since banks can borrow a (large) percentage of this deposited money to someone else, who then spends it and the recipient deposits into the bank, which lends it out to someone else (and so the cycle continues) the “credit multiplier” means that lower interest rates is linked to higher rates of lending – and thus to increased consumption of goods and services, which is how we measure the growth in the economy (Gross Domestic Product, or GDP).

There is some debate as to whether GDP is really an appropriate measure for growth, but generally, there is a consensus that high growth in the consumption of goods and services is a good thing.

So, what happens when you increase interest rates? Well, households, businesses (and to an extent governments) have a decreased ability to spend.

Since there is now less money deposited, banks can lend less, the effect of the credit multiplier is smaller and the consumption of goods and services decreases.

Now, since there is less demand for goods and services, firms engaging in price competition can ask less for their goods and services to protect their market share, so the average price level goes down, or at least increases at a slower rate.

Generally, economic theory as it stands accepts that there cannot be an increase in the consumption of goods and services (or “growth” as they call it) without an increase in average price levels. The idea is to keep this increase in the average price low and predictable.

An increase in the average price level is called “inflation”.

To make it very clear: Unpredictable and / or high inflation is a bad thing: As things become more expensive, money becomes worth less. Which is particularly bad if you are on a fixed income.

Inflation is measured by StatsSA by taking a “basket” of goods and services that the average household is assumed to consume. So, depending on the types of goods and services an individual household consumes, its individual inflation rate can vary tremendously from the official national inflation. Food and transport are usually the hardest hit by inflation, which means that inflation is particularly bad for the poor, who spend a larger percentage of their income on these items.

No man is an island and neither is South Africa. We import goods and services from other countries and export goods and services to them.

Depending on the ratio between imports and exports, the demand and supply for our currency determines our exchange rate.

So basically, after NeneGate, other countries (including their businesses and their individual citizens) did not want a whole lot of Rands, because they did not trust that South Africa was a good place to have their money invested. This while we still import a lot of stuff from overseas (like oil, for example), for which we (including our businesses and individual citizens) have to pay for in other currencies – often in U.S. Dollars. This lead to a virtual free-fall in the value of our currency. Which, in turn, means that imports become very expensive.

So the idea here is that if you raise interest rates, you tempt businesses in countries like America and Europe, that have very low interest rates, to invest in South Africa. Which means that they have to buy our currency, which stabilizes it. A strategy the Reserve Bank will claim was successful, because the Rand was around 50 cents stronger against the Dollar a few hours after the announcement of the interest rate hike.

However, this is a short term (and short-sighted) solution.

Firstly, because interest rates are only one of many factors affecting an economy. Remember, we compete against other emerging markets, some who offer higher interest rates than we do. So, what is the distinguishing factor? Quite simply, it is how much investors trust the governments of emerging economies, in being financially prudent and to regulate labour markets. So, the last thing we need right now is another strike season (as much as nearly everyone of us really needs an increase).

In addition to this, accepting foreign investment means selling your future profits to someone else in exchange for a short term capital injection. But that is worthy of another post all on its own.

Those clever analysts and economists who think that the interest rate hike is a good thing need to consider price and demand elasticity.

This basically means, that regardless of how much the price of petrol increases (something that is likely with our weakened currency), people still need to travel to work. Regardless of how much the price changes, demand stays relatively constant.

The same with electricity. Regardless of the fact that Eskom wanted to hike tariffs (again) by over 20%, there is only so much electricity that households and businesses can save.

In cases of “cost-push” inflation (where rising input costs such as imports), raising interest rates can very easily lead to “stagflation”.

“Stagflation” is where you have a decrease in the total consumption of goods and services (recession, if this lasts for two consecutive quarters), as well as increasing prices.

Stagflation is characterized by high levels of unemployment – because as people consume less, they lay off workers, who then can’t spend, so more businesses close or lay off workers (and so the cycle continues).

 

Now, to the important bit: What South Africans can DO:

The problem with today’s decision, is that it assumes South Africans are not all that clever and are better off having the Reserve Bank do their thinking for them. This is in sharp contrast with previous South African Reserve Bank (SARB) governors Titu Mboweni and Gill Marcus, who found appeals to the public exceptionally effective.

The thing is, you can’t just keep telling people to tighten their belts and not tell them how. There is simply not that much that can be tightened in most households anymore.

The whole idea with the 50 basis points interest rate hike was to deter people from creating debt, thus reducing their ability to afford goods and services, leading to a decreased rate of increase in average price levels, i.e. “combat inflation”.

Thing is, you are not just deterring people from creating new debt, you are also punishing those with existing debt – in particular, those who “own” homes with mortgages.

Most analysts predict that this is only the start of a cycle of rising interest rates, which means that many people are likely to be unable to afford their homes. Which means that there will be many people trying to sell their homes. As more and more homes come onto the market and less people are able to afford mortgages to buy them, house prices will fall and many people may end up owing the bank even though they no longer own their home.

This also impacts on the rental market. Basically, cost of renting a place to live will increase, as there are less landlords and more tenants. Again, this is particularly bad for the poor and the middle classes.

So, what should the Reserve Bank be doing instead?

It should be working with Parliament, other organs of State and ordinary South Africans.

South African households spend up to 70 percent of their monthly income servicing debt. That is staggering and a sobering thought. It might even convince one that raising interest rates is a smart idea.

Thing is, there is not really much you can do about existing debt – you need to stop NEW debt from being created.

The National Credit Act is arguably one of the most needed pieces of legislation passed in South Africa.

The current climate makes its implementation even more important than ever.

Credit providers should be compelled to be responsible in their lending practices. New unsecured debt should be considered very, very carefully by both lenders and borrowers. So, ordinary South Africans are not off the hook…

The Reserve Bank needs to be very careful to increase the costs of owning a home, buying (an entry level) car and gaining an education – all of which are linked to the prime lending rate.

Instead, maximum rates allowed by the NCA on “discretionary spending” credit types, such as credit cards, could be increased to deter new debt, which essentially finances cost of living or unnecessary luxury items, from being created.

Simply put, ordinary South Africans can stop creating new debt and pay off existing debt in order to minimize the need for interest rate hikes. Hiking the cost of existing debt is surely not the best way to allow South Africans to lower their debt!

And, if the Reserve Bank truly respected South Africans, they would have at least given us the chance to do so before taking the choice out of our hands and doing even more damage to an already damaged economy.

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