Over the past decade, South Africans have witnessed substantial price increases in goods and services, influenced by factors from both the demand and supply sides. Following the COVID-19 pandemic, pricing pressures have intensified, particularly due to high food and energy costs. To combat rising consumer prices, the South African Reserve Bank has been increasing interest rates. Both inflation and interest rates directly influence consumers’ financial planning decision making and outcomes, as disposable income may vary due to fluctuations in inflation and interest rates, respectively. In this article, we explore the relationship between inflation and interest rates and the considerations investors should keep in mind when conducting annual review of their investment portfolios.
Relationship between inflation and interest rates:
The Consumer Price Index (“CPI”) measures prices of a range of consumer products (in South Africa, there are currently 393 items in the basket), and the change in the index is called inflation. Inflation, therefore, is the general increase in the price of goods and services which has the effect of reducing the purchasing power of consumer’s income. Inflation generally occurs when there is an imbalance between the supply and demand for goods and services which allows market forces to adjust prices up or down. For example, if there is an over-supply of goods and services in the economy, all other factors remaining unchanged, prices fall, which leads to an increase in demand, bringing the market supply and demand in equilibrium. Similarly, if there is a shortage of goods and services in the economy, prices rise, reducing affordability and demand.
The invasion of Ukraine by Russia in 2021 which resulted in shortages of several soft commodities and energy products is a good example of a supply-side induced inflation. The subsequent sanctions imposed on Russia by the US and its European allies caused a disruption in global supply chains within energy and food, among others. Price of Brent crude oil spiked from $88 per barrel just before the invasion of Ukraine to over $112 per barrel, peaking at around $116 per barrel and has remained volatile ever since. This had direct and indirect impact on various consumer goods and services. It has not only increased the price of transporting goods and services but has also resulted in the increase of production cost. The increase in the price of petrol coupled with a surge in demand due to the constrained supply off oil has caused headline inflation to rise, rapidly. Headline inflation has spiked from 3% on 30 September 2020 to 7.5% on the 30th of September 2022, and currently sits at 6.3%.
The South African Reserve Bank (SARB) maintains an inflation target range of 3% to 6%, with a primary goal of anchoring inflation around the midpoint of 4.5%. Its primary tool for managing inflation is the adjustment of interest rates. While the SARB also has the ability to manipulate the money supply and the required reserve ratio for banks, these measures tend to have limited impact. Unfortunately, interest rates are considered a blunt instrument in this regard.
The SARB uses the fluctuation in the repo rate (the lending rate to commercial banks) as a transmission mechanism for controlling inflation. When the inflation rate is high, the SARB will increase repo rate, prompting an increase in the prime interest rate (the rate at which commercial banks lend to consumers or businesses). Consequently, the cost of borrowing for consumers and businesses rises, resulting in a reduction in consumer spending. This decrease in spending subsequently leads to lower sales, an increase in the supply of goods and services, and ultimately slows down economic growth. The tightening of money in circulation due to reduced spending leads to a decrease in the demand for goods and services, leading to a decline in general prices. As a result, this decline in prices helps to alleviate inflationary pressures. Conversely, when the SARB decreases the repo rate, there is a decrease in the prime interest rate, which lowers the cost of borrowing for consumers and businesses. Borrowing and spending becomes more attractive in this environment, and the increased money supply causes the economy to grow. The increased demand for goods and services makes prices more expensive, increasing inflation.
It is important to note that while inflation and interest rates move in the same direction, there is a lag. This essentially means that the desired outcome of changes in interest rates will only be felt at a later period. The SARB attempts to predict future inflation trends and the corresponding interest rate changes to be considered by the Monetary Policy Committee. Therefore, assessing the impact of the central bank’s response is backward-looking.
At current levels of 6.3%, inflation seems to be sticky. The SARB recently increased the repo rate by 50 basis points (bps) to 8.25% (prime is at 11.75%). However, it has indicated that it may pause rate hikes due to fears of a recession and to assess the impact of its most recent interest rate decisions. Market sentiment is that we may have reached our terminal rate (peak), and expectations are that, depending on how things go, we may see interest rate cuts over the next year or two.
Financial advisory considerations:
During the covid-19 pandemic in mid-2020, the SARB reduced the repo rate to 3.5% to stimulate the economy by encouraging spending. By the end of 2021, the SARB started increasing rates off this low base as inflation started to creep up. In an environment where inflation and interest rates are high, highly indebted people and businesses will struggle as they need to endure higher finance costs. Monthly mortgage payments take up a significant component of your monthly budget, so with the prime lending rate moving from 7% in 2020 to 11.75% currently, this increase of 4.75% will have a significant impact on your monthly budget planning. Always account for a buffer to factor in any interest rate hikes.
From an investment perspective, equity markets often exhibit higher volatility due to the increased uncertainty surrounding company earnings. In contrast, bonds are generally considered more attractive than equities in environments where their compensation for holding equity (equity risk premium) is low.
How should you be positioning your portfolios considering the environment? The basic principles of investing still hold true in that your time horizon will ultimately determine your optimum asset allocation mix. For long-term investing goals, it’s important not to be influenced by short-term market movements. In an environment where cash and bonds are more attractive when rates go up, they rarely provide real returns (inflation beating) over an extended period of time. Equities are a good hedge against inflation. Your chances of achieving your long-term investment goals are increased by having a diversified approach and by speaking to a qualified financial advisor. They can help you to select the appropriate investment funds to meet your goals.
Keep calm and stay invested through the cycle.
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