One has to pity the Reserve Bank. Having relied too heavily on a strong rand over the past few years to contain inflation, the Reserve Bank is now going to have to raise interest rates aggressively to counter the inflationary effects of a weaker currency. The Reserve Bank has little choice in this matter if it is to regain its inflation fighting credibility. However, it should not expect to win friends in this endeavor since the economy is almost certain to cool abruptly in the process.

Resident Fellow Desmond Lachman

South Africa is a highly open economy, whose imports and exports each account for around 30 percent of its gross domestic product. As such, sustained movements in the country’s currency have a very strong impact on the price level. Indeed, international experience with countries as open as South Africa would suggest that a sustained 10 percent movement of the currency could in time impact inflation by at least 3 full percentage points.

Over the past four years, the rand has been supported by a highly supportive international environment. The country’s exports were boosted by strong economic growth in the industrialized countries and by very favorable international commodity prices. At the same time, low interest rates in the world’s financial centers encouraged strong capital flows to the emerging market economies.

In that favorable environment, the Reserve Bank chose to allow the rand to appreciate strongly from a level of around 11 rand to the US dollar at the end of 2002 to below 6 rand to the dollar by early 2006. The Bank did so rather than follow the Asian central banks’ more cautious approach in such circumstances of intervening in the currency market to prevent the currency from getting too strong.

Given the strong appreciation of the rand between 2002 and early 2006, it is little wonder that the Reserve Bank so successfully achieved its inflation target. Indeed, the Reserve Bank succeeded in bringing inflation down from a high of over 10 percent in 2002 to well within its 3-6 percent inflation target by 2005. It did so while at the same time allowing the economy to grow at a highly satisfactory rate thanks in very large part to the strong deflationary support it got from an appreciated currency.

If one lives by the sword, one finds that one all too often dies by the sword. Now that the exchange rate has weakened so dramatically in the past two months, the inflation shoe is very much on the other foot. For if the rand stays at around its present level, it will have depreciated by around 20 percent from its 2005 level. In time, that could add at least 5 percentage points to the price level in 2007.

Having eschewed the use of foreign exchange intervention to smooth currency fluctuations, the Reserve Bank has only interest rates on which to rely to influence the economy. By raising interest rates aggressively, the Reserve Bank might hope to increase the relative attractiveness of holding the rand and put an end to the rand’s recent inflationary downward spiral. By raising interest rates, the Reserve Bank might also hope to cool an overheated economy. It might do so with the explicit purpose of avoiding second-round inflationary effects from the currency’s depreciation, which would further undermine the Reserve Bank’s inflation fighting credibility.

The degree to which the Reserve Bank might need to cool the economy through higher interest rates will depend very much on how the currency responds to higher interest rates. In the event that the rand were to strengthen markedly in response to an interest rate move, the Bank would not need to raise interest rates to very high levels.

However, in the more likely event that the interest rate response of the rand were muted, the Reserve Bank would need to raise interest rates to levels that would substantially constrain domestic demand. It would have to do so in order to open up output and employment gaps that might offset the inflationary pressure emanating from the weak currency.

There is certainly the possibility that the Reserve Bank might again get lucky in its battle against inflation. The world economy could always resume its goldilocks recovery and international commodity prices could always rebound. However, judging by the way in which the US housing market bubble is now deflating and judging by how speculative commodity positions are being unwound, the Reserve Bank would be ill-advised to count on its luck.

Desmond Lachman is a resident fellow at AEI.