Quick explainer: the new inflation target

An estimated R5 billion in income to the Bakgatla community cannot be accounted for. Archive photo: Ashraf Hendricks

What is the inflation target?

Inflation is measured by the rise in the consumer price index (CPI), as monitored by StatsSA. The CPI measures the cost of a basket of goods and services representative of the monthly spending of average South African households.

The inflation target is the rate of inflation the government sets as a guideline for the Reserve Bank. The Reserve Bank is tasked with keeping inflation near this target, to protect the value of the rand (higher prices mean your rand is worth less.) The Reserve Bank does this by raising or lowering interest rates, which affect borrowing and spending in the economy. Higher interest rates are intended to keep inflation down by reducing spending and investment.

Until now the inflation target range set for the Reserve Bank was 3% to 6% a year.

But South Africa’s inflation has been well below 6% a year for some time, and Minister of Finance Enoch Godongwana has now announced that there will be a new target of 3%, with a “tolerance band” of 1% on both sides. Since mid-2024, CPI inflation has been within this new tolerance band. The new target is to be implemented gradually over the next two years.

Why is this?

The National Treasury hopes that over time, the lower inflation target will be achieved and that this will in turn lead to lower “inflation expectations”. When businesses set their prices for the year ahead and when unions negotiate for wage increases, they take into account their “expectations” for future inflation.

For lower inflation to be sustained, inflation expectations have to come down. But if households and businesses expect prices to rise, they will spend more now and seek higher wages and prices, contributing to rising costs.

Lower inflation expectations should mean less pressure on prices. Then the Reserve Bank will be able to keep interest rates low, instead of using the interest rate tool to curb spending. In time, these lower interest rates will boost household spending and investment, and economic growth, the National Treasury says.

But there are costs: in the short term, the National Treasury has acknowledged, lower inflation will mean slower economic growth and, as a result, lower tax revenues. Government debt will take longer to be repaid.

“After careful consideration, government has concluded that the benefits of a lower inflation target outweigh the costs,” the National Treasury said.

Who’s in favour

The lower inflation target has been welcomed by business and by many economists. Business Unity South Africa says lower inflation expectations could reduce the cost of borrowing for business and reduce the cost of living for households.

Who’s against

But critics such as the Institute for Economic Justice say that the decision was taken without sufficient consultation, and that it is a mistake. They say

• the sort of moderate inflation we have been having is not a problem;

• there is no evidence to show the lower inflation target will work;

• the use of interest rates to keep to the new inflation target will make it harder for households to survive (because higher interest rates makes their loans more expensive) and for businesses to invest in job-creating projects;

• anyway, the cause of inflation in South Africa is not high demand for goods and services from business and households, but rising prices of imported goods and of services like electricity; and
• interest rates have no effect on these prices.

What the Reserve Bank says

The Bank’s Monetary Policy Committee met last week and decided to reduce its key interest rate from 7% to 6.75%.

Announcing this, the Reserve Bank said that though inflation had ticked up in the last few months, “we remain on track to deliver 3% inflation over the medium term”.

But this does not mean inflation will always be at 3%, the Bank warned: “no central bank has the tools to deliver inflation at an exact point all the time”.

“Monetary policy actions have their main effects on prices after 12 to 24 months, so you should expect us to achieve our target over that horizon.”

This is part of an occasional series explaining issues in economics. GroundUp is grateful to Andrew Donaldson of the Southern Africa Labour and Development Research Unit for advice on the series.

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