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How do interest rates affect inflation? And why does it matter?

There’s a sense of uncertainty out there. Inflation is rising, interest rates have just been increased and share prices have dropped. Predictions of a possible recession are looming.

It’s easy for purchasers looking to buy a property to get disheartened, but it’s more important to consider short-term market announcements in the context of long-term economic trends.

Increase in the prime lending rate

On 21 July 2022, the South African Reserve Bank (SARB) raised the repo rate by 75 basis points, the steepest hike since September 2002. This brings the repo rate up to 5.5%, resulting in an increase in the prime lending rate (of commercial banks) to 9%.

The Monetary Policy Committee (MPC) meets six times a year to set the repo rate. The MPC consists of up to seven members, including the Governor of the SARB and other senior officials appointed by the Governor. The SARB hosts a media briefing every two months to release its MPC statement, following the meeting.

The inflation situation is currently outside the SARB’s target of 3 - 6%. On Thursday, the SARB's forecast of headline inflation for this year is revised higher to 6.5% (from 5.9%). Higher food, fuel, and core inflation are expected to keep headline inflation elevated at 5.7% in 2023 (up from 5.0%).

Whilst this is not historically high, the rate of increase in the inflation rate is a cause for concern. If left unchecked, inflation could spike further, which would potentially cause the economy to slow down quickly and unemployment to increase.

But how do raising interest rates counteract inflation?

Inflation occurs when too much money chases too few goods. When people have a lot of cash and not that much to spend it on, they often bid up prices. A small but positive inflation rate is economically useful, while high inflation tends to feed on itself and to impair the economy’s long-term performance.

Interest rates are one aspect that can influence inflation (along with fiscal policy, production costs, supply chain disruption and increase in money supply). By raising rates, the SARB is trying to make you slow down your spending. That happens when the cost of money goes up for a car loan or mortgage or something else you want to spend money on.

At some point, you’re going to pull back. The higher cost of money reduces your purchasing power — what you can afford to buy — and the SARB is effectively making you buy less. With less buyers in the market, demand for goods goes down and so does inflation.

However, if inflation is too low, the price and production of goods decreases. An economic slowdown associated with a decline in the rate of inflation could deteriorate into an outright recession. Additionally, if interest rates go high enough for long enough, economic growth will slow and some people will lose their jobs.

How interest rate increases can cause unemployment and GDP to decline

Rising Interest Rates

If a future drop in inflation is forecasted, this is when the SARB will drop interest rates, to help increase credit-financed consumer spending again.

How interest rate reduction causes prices of goods to rise

Interest Rates Dropping

As you can see, inflation at both the higher and lower end are bad for the economy. The SARB is constantly assessing and forecasting the rate of inflation to avoid spikes and engineer a “soft landing” — a state of Goldilocks perfection, in which growth is neither too fast nor too slow, and prices are just right.

These processes don’t happen overnight, but incrementally and slowly over time, with many contributing factors. This is why the MPC must meet regularly to keep an eye on economic trends. Financial markets react not just to what the SARB does but also to what it says it is going to do.

The SARB provides constant feedback to the market about where it expects interest rates and inflation to go, so that companies and consumers can make reasonable projections for short and medium term-planning.

Keep in mind that, in the last 20 years, the SARB has done an exceptional job at controlling inflation and potential recession events.

So what’s the best way to weather the storm of a short-term interest rate hike while inflation is still high?

Real estate, energy commodities and value shares have historically outperformed during periods of high or rising inflation. Unfortunately, this disproportionately affects the poor as they are less likely to own assets like real estate – which has traditionally served as an inflation hedge.

Although property ownership may require a mortgage bond, which is affected by the rising prime rate, it is still a form of secured “good” debt that consumers should prioritise. In contrast, credit cards and personal loans which typically carry a higher rate linked to prime, will become much more costly for consumers.

The best thing consumers can do is convert as much of their unsecured “bad” debt to asset-based debt, like owning a property. The catch is to buy a property in a good investment area that you can afford.

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