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In December inflation clocked in at 4.5% – right on the number that Reserve Bank governor Lesetja Kganyago keeps referring to.
How does inflation work?
If prices increase, it is either because of increasing demand or decreasing supply. More money chases fewer products and pushes prices higher. Policy can fix this by increasing interest rates.
This reduces the economy’s money supply as consumers pay more to service their debt.The inverse of inflation is falling prices (deflation).
This may be due to lower demand or an oversupply of goods and services.
Here, the lowering of interest rates puts money back into the pockets of individuals.
They have more spending power, which slows or stops falling prices and deflation. We’re seeing record low interest rates worldwide, yet inflation remains low.
Following the 2008 to 2009 global financial crisis, the concern was for high or even rampant inflation, but this has not happened as global inflation remains very low.
This is due to surplus money going into stock markets – mostly in the US – pushing the valuations of shares higher. So, we are seeing inflation, but in asset prices rather than consumer goods.
So, interest rates are the most useful tools for inflation targeting. They’re not perfect and often referred to as blunt instruments in the fight against inflation. They work, but are not absolute.
Of course, we must also consider expectations from consumers. If an economy experiences deflation, why would you buy a product or service today when it’ll be cheaper in a month or a year?
In short, you’d wait.
This reduces the demand for goods and services and sees prices falling even further.
We’ve seen this in Japan in the last few decades where very low inflation, or even deflation, has seen consumers not spending in expectation of lower prices in the future.
The result is a huge savings rate but also an economy that just can’t get inflation going.Inversely, high inflation means that prices are rising and so you’re spending your money now because it will buy less in the next month or year.
I remember when inflation was in the mid-teens in the 1980s and 1990s – the inflation of the 1980s was a global issue. Consumers did not save because they spent their money as they got it, knowing that prices would be higher in a month or a year.
Consumers’ expectations of inflation are important and the response to these is an important part of the process that Kganyago is using effectively.South Africa’s inflation target is between 3% and 6%.
Kganyago, however, has changed things by always referring to 4.5% rather than the range. He is focusing consumers’ minds on 4.5% rather than the upper 6%; in other words, he is lowering inflation expectations.
The Reserve Bank is also slowly dropping interest rates as inflation slows.
So, lower rates mean more disposable income to spend which keeps inflation around that 4.5% level.
It’s a balancing act, but the central bank is doing it perfectly with low inflation and lowered inflation expectations. Assuming we’re in for lower inflation for longer, what’s key for traders and investors?
The answer is expected market returns: If inflation is 4.5%, a market return of 12.5% relates to a real return of 8%; simultaneously a market return of 12.5% with inflation at 8.5% means a real return of only 4%.
Thus, broadly expect lower market returns over the long term.
This article originally appeared in the 5 March edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
