Quantifying the impact of restrictive monetary policy on the South Africa economy since 2022

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D E C E M B E R 2 0 2 5

Author: Dr Roelof Botho & Prof Ilse Botha

Editor: Daryl Swanepoel

CONTENT

INTRODUCTION

SECTION A: Interest rates, monetary policy and the economy

1 PERVASIVE IMPACT OF MONETARY POLICY

1.1 Policy impact during and after the Covid-19 pandemic

1.2 International trade and capital flows

1.3 Monetary policy should be conducted with caution

1.4 Monetary policy objectives

1.5 Economic policy choices

1.6 Monetary policy under the spotlight

2 THE TRUE REASONS FOR HIGHER INFLATION

3 INFLATION EXPECTATIONS – A DUBIOUS EXERCISE

3.1 Unreliable household forecasts

3.2 Volatility of forecasts

3.3 Deviation of forecasts from actual inflation

3.4 Sensitivity to fiscal policy

4 HIGH INTEREST RATES IN EMDEs LEAD TO LOWER GDP GROWTH

4.1 Evidence from key emerging markets

4.2 Public finance stress depresses private consumption expenditure

4.3 Research on 38 developing countries

4.4 The case of Australia

4.5 The case of 20 industrialised economies

4.6 Negative impact on capital formation

5 MONETARY POLICY REQUIRES TAILORING IN EMDEs

5.1 Differences in the transmission of policy

5.2 Higher passthrough rate of cost shocks

5.3 Uneven ability for fiscal stimulus

6 SPIKE IN US TARIFF REGIME

7 RESTRICTIVE MONETARY POLICY AGGRAVATES SUPPLY-SIDE COSTS

7.1 The bluntness of monetary policy

7.2 Amplification of supply-side inflation

8 DIFFERENCES IN THE BASE FROM WHICH RATES WERE HIKED

9 UNEASE OVER GLOBAL FINANCIAL AND FISCAL STABILITY

9.1 The danger of a credit crunch

9.2 Bank failures in the US and Switzerland

9.3 US banks take a hit

9.4 Haunting memory of the 2008 financial crisis

10 THREATS TO FUNDAMENTAL ECONOMIC STABILITY IN EMDEs

10.1 The finance divide between AEs and EMDEs

10.2 Threat to fiscal stability

11 GROWING PUBLIC DISCONTENT WITH HIGH INTEREST RATES

12 INFLATION THRESHOLDS – DEVELOPING COUNTRIES

12.1 Study by Nell (2023)

12.2 Study by Meyer and Hassan (2024)

12.3 Study by Bonga-Bonga and Lebese (2019)

12.4 Money supply endogeneity

13 THE STRATEGIC IMPORTANCE OF EMPLOYMENT CREATION

13.1 Virtuous circles of prosperity and opportunity

13.2 The scourge of unemployment

13.3 Far-reaching negative psychosocial impact

13.4 Employment losses in the UK

13.5 The role of private sector investment

14 HIGHER LEVELS OF INEQUALITY

15 GLOBAL INFLATION LARGELY UNDER CONTROL

16 BENEFITS OF MILD INFLATION IN DEVELOPING COUNTRIES

16.1 Growth via stimulating demand

16.2 Foreign exchange constraints can be overcome

17 NEW-FOUND FLEXIBILITY WITH INFLATION TARGETING

SECTION B: The damage to South Africa’s economy of unduly high interest rates

1 DECIMATION OF CONSTRUCTION ACTIVITY

2 VALUE OF BUILDING PLANS IN FREE-FALL

3 HOME LOAN APPLICATIONS STILL DOWN ON 2021 FIGURES

4 AVERAGE HOME PURCHASE PRICES IN DECLINE

5 FINANCIAL RESILIENCE OF HOUSEHOLDS UNDER PRESSURE

6 THE PLIGHT OF THE SMALL BUSINESS SECTOR

6.1 SMEs struggle to access sufficient credit

6.2 Majority of SMEs in distress

7 SHARP INCREASE IN HOUSEHOLD DEBT COSTS

8 INFERIOR GDP GROWTH TO EMERGING MARKET PEERS

9 AGGRAVATION OF INCOME INEQUALITY

10 LOWER UTILISATION OF MANUFACTURING CAPACITY

11 CAPITAL FORMATION REMAINS IN DECLINE

12 INSUFFICIENT DEMAND

13 SHARP DECLINE IN HOUSEHOLD CREDIT EXTENSION

14 LOWER PER CAPITA DISPOSABLE INCOMES

15 NEGLECT OF THE OBJECTIVES OF GROWTH AND JOB CREATION

SECTION C: Modelling the impact of lower interest rates on the GDP

1 INTRODUCTION

2 DATA AND SAMPLE

3 METHOD AND ANALYSIS

4 ASSUMPTIONS AND FORECASTS

SECTION D: Calculation of GDP impact via a lower household debt cost ratio

CONCLUSIONS

Precis – self-inflicted economic pain

Section A

Section B

Section C

Section D

Recommendations

Postscript

BIBLIOGRAPHY

Cover photo: istock.com - Stock photo ID:1772907466

INTRODUCTION

During 2021, the South African economy managed to stage a swift recovery from the worst effects of the lockdowns induced by the Covid pandemic in 2020, only to be halted in its tracks from 2022 onwards, when a low growth trajectory kicked in. Although various structural impediments, including the poor state of the country’s logistics infrastructure, contributed to the declining trends in most key macroeconomic indicators, it has become clear that the restrictive monetary policy stance of the MPC since 2022 represents one of the reasons for low growth, a further erosion of the real value of household disposable incomes and higher unemployment - in an environment where households were still struggling to recover from the effects of the lockdowns - all of which are threatening the country's fiscal stability. The latter, in turn, is restricting the ability of the public sector to fund the repair and expansion South Africa’s infrastructure – a sine qua non for achieving economic growth commensurate with the mammoth task of creating jobs for millions of impoverished citizens and thereby easing the extent of income inequality.

Replicating the monetary policy approach followed by advance economies (AEs) in emerging markets and developing economies (EMDEs) is fraught with danger, as the latter group are, to a varying extent, faced with pressures on price levels that are not comparable to the more predictable macroeconomic circumstances in North America, the European Union and other high-income countries. It borders on the ludicrous to expect a similar response to monetary policy tightening between AEs and EMDEs that have relatively underdeveloped transmission mechanisms from interest rates to the real sectors of the economy and that are prone to volatile exchange rates.

The main purpose of this study is to provide quantitative evidence of the widespread damage that has been inflicted on the South African economy by a monetary policy approach that is ill-designed for an emerging market & developing economy (EMDE). This is especially true for a country located at the southern-most tip of a continent that has an exceptionally high level of income inequality, low per capita incomes, very low rates of capital formation and is far removed from the lucrative consumer markets in North America, Europe and South-East Asia and that is battling with high levels of unemployment of mostly unskilled or low-skilled labour, co-existing with shortages of high-skilled labour.

Section A provides an overview of the relationship between interest rates and an economy’s ability to expand output and employment creation, with specific reference to the need for fiscal stability, based on scholarly research and empirical data. Due reference is made to two significant events that have re-ignited interest in the impact of a particular monetary policy approach on macroeconomic stability in general. These are, firstly, the so-called sub-prime financial crisis that originated in the US and quickly spread to most other advanced economies and emerging markets alike. The second was the recent Covid-19 pandemic, which, outside of the on-going scourge of HIV/Aids, has caused more deaths than any other pandemic since the Spanish influenza of more than a century ago.

Emphasis is placed on providing readers with a thorough understanding of the causes of the unparalleled global spike in supply-side costs between 2020 and 2021, which led to several central banks raising their official interest rates to levels last witnessed between one and two decades ago. Substantial reference is made to empirical research on the impact of high interest rates on economic growth and employment creation, which involves a rather predictable inverse relationship, especially in EMDEs. The specific impact of higher interest rates in the US on macroeconomic stability in EMDEs is also discussed, due to its particular relevance to South Africa, where the monetary policy authorities mimicked the US Federal Reserve’s relentless pursuit of restrictive monetary policy during 2022 and 2023.

Reasons are provided for the view that monetary policy in EMDEs should be approached with more caution than in AEs, especially due to differences in the policy transmission mechanism, as well as the fiscal threats inherent in depreciating currencies (as a result of higher US interest rates being associated with a stronger US dollar). Growing unease over global financial and fiscal stability in the wake of exceptionally restrictive monetary policy since 2022 is also discussed (with reference to recent bank failures in Switzerland and the US).

This is followed by an overview of recent research on an ideal threshold for inflation in EMDEs, with a clear indication that more flexible target ranges with relatively higher upper target points are required to prevent unduly adverse effects on output and unemployment. It is pointed out that structural inflation and, to a lesser extent, cost inflation, are the natural and unavoidable outcomes of the growth and development process in developing economies. The dire need for sufficient economic growth to prevent unduly high levels of unemployment is also discussed, followed by confirmation of the consequences on inequality of unduly high interest rates.

The penultimate sub-section discusses the benefits of mild inflation for EMDEs, which is mainly informed by the Kaldor-Thirlwall model, based mainly on the way inflation finances fixed investment by businesses, leading to faster economic growth. Section 1 concludes with a note on the new-found flexibility with the practice of inflation targeting, against the background of the fact that this policy approach remains prone to scholarly criticism and has not found universal appeal in EMDEs. A focal point throughout the discussions in section 1 is the threat to output and labour market stability imposed by excessively high interest rates, especially due to the amplification of supply-side shocks and disincentivising of venture capital and investment in new productive capacity in the economy.

Section B identifies several areas where the record high interest rates of 2023 and 2024 have led to a depressing effect on key economic indicators. It is pointed out that, ever since the retirement of the previous Governor of the South African Reserve Bank (SARB), Me Gill Marcus, a dramatic and unfortunate shift has taken place in the conduct of monetary policy. The extent of the damage inflicted on the economy by the increase of 475 basis points in the benchmark commercial lending rate (via the SARB’s official repo rate) is discussed in some detail, with reference to the following (inter alia):

• Sharp declines in construction activity

• A structural decline in the value of building plans passed

• Lower levels of home loan applications

• Declining house prices (in real terms)

• The distress faced by a majority of small businesses

• Lower household disposable incomes (in real terms)

• Aggravation of income inequality

• Endemic decline in new investment in productive capacity in the economy

• Decline in household credit extension

• Sharp rise in unemployment

An econometric analysis of the difference between South Africa’s actual GDP and the output level that would have been achieved with an assumed lower commercial lending rate is provided in section C, which also includes a quantification of the extent to which GDP and total taxation revenue would have increased under two assumed lower ratios of household debt costs to their disposable incomes. Following the customary key conclusions, a number of recommendations are provided, aimed at redressing the decline of South Africa’s economic disposition. This includes a suggested amendment to the composition of the MPC, in order to create a more balanced and informed institution responsible for setting lending rates - the economic indicator that has the single most important bearing on household consumption expenditure, new investment in productive capacity in the economy, economic growth and, ultimately, fiscal revenues and employment creation.

SECTION A

Interest rates, monetary policy and the economy

1 PERVASIVE IMPACT OF MONETARY

POLICY

The economic performance of AEs and EMDEs are permanently influenced by a wide range of policies, most notably fiscal and monetary policy. The latter mainly centres on the control over the benchmark interest rate at which a central bank accommodates the banking sector. In South Africa, this rate is known as the repo rate (an acronym for “repurchase rate”), which is the interest rate at which the South African Reserve Bank (SARB) lends money to commercial banks.

The repo rate is a benchmark for all other interest rates in the South African economy. When the SARB increases the repo rate, it is a signal to commercial banks to raise their interest rates, which leads directly to an identical percentage point increase in the prime overdraft rate of banks. The latter rate is the benchmark for determining the other interest rates on loans and credit facilities for consumers and businesses, including mortgage bond rates. The latter represents the interest rate which determines the debt service cost for the predominant component of total credit extension to households.

After a long spell of relatively low global inflation, things changed abruptly in mid-2020. Consumer price inflation in the US rose by 850 basis points between June 2020 and June 2022, mainly as a result of the oil price shock that followed the lockdown imposed by the Covid-19 pandemic, as well as Russia’s military invasion of Ukraine. The latter act was condemned by the UN General Assembly on 2 March 2022 when it adopted - by an overwhelming majority of 141 against 5 - a resolution rejecting the Russian Federation's brutal invasion of Ukraine and demanding that Russia immediately withdraw its forces and abide by international law. 

Combined with Covid-19 lockdowns, which virtually halted international shipping freight, this resulted in a five-fold increase in the oil price, leading to inflationary spikes in all of the AEs and EMDEs. As a result, monetary policy was thrust into the limelight again, with central banks in most countries resorting to a familiar policy option, namely raising interest rates, in an attempt to bring inflation back to target ranges or target points. Many economists and analysts have questioned this policy priority afforded to combating inflation, due to its negative impact on the interest-sensitive components of aggregate demand and, ultimately on output and unemployment.

Three key causal sequences can be identified for the transmission mechanism whereby interest rates impact on the economy, namely:

1. The influence on investment, aggregate demand, employment and income

2. Changes in interest rates change the market values of financial assets

3. Changes in interest rates income distribution, and therefore also income inequality

Interest rates are a crucial aspect of modern economies, as they influence the cost of borrowing, investment, and spending decisions made by individuals, firms, and governments.

1.1 Policy impact during and after the Covid-19

pandemic

The central bank, usually through its monetary policy, sets benchmark interest rates to control the supply of money, maintain price stability, and support overall economic growth. In recent years, many central banks have kept interest rates low to support their economies during the COVID-19 pandemic and its associated economic downturn. This led to lower borrowing costs for consumers and businesses, boosting spending and investment and, in the process, facilitating a swift recovery from the Covid-19 pandemic. Unfortunately, however, price shocks related to an unheard-of increase in transportation costs, led to a reversal of accommodating monetary policy in 2022 in many countries, taking the US Fed Funds rate to its highest level in more than 20 years.

1.2 International trade and capital flows

Interest rate changes can also have significant impacts on international capital flows, currency values, and trade balances. In general, higher interest rates in one country relative to other countries can attract foreign portfolio investment, leading to an appreciation of its currency. The downside of higher lending rates is the disincentive for domestic firms to engage in capital formation (due to the increase in the cost of borrowing), whilst higher rates also discourage household consumption expenditure on durable and semi-durable goods.

1.3 Monetary policy should be conducted with

caution

Interest rates are a powerful tool that central banks can use to influence economic activity, but they can also have far-reaching and sometimes unintended consequences. As such, it is important for policymakers to consider all factors before making changes to interest rate policy, including the state of the economy and its supporting infrastructure, the unemployment rate, the nature of inflation, and financial stability risks.

Despite interest rates representing a vital tool for a measure of control over inflation, it is a rather blunt instrument that works with little precision. When the prime rate is adjusted (via the repo rate), it creates a ripple effect throughout the economy, affecting borrowers and savers and, ultimately, the level of household consumption expenditure and productive capital formation by the private sector.

Policy-induced changes to interest rates require a thorough understanding of the sensitivities of the different sectors and economic activity in general to interest rates.

1.4 Monetary policy objectives

As a result, there are constant and necessary economic debates about the channels of transmission and efficacy of monetary policy in achieving key economic objectives, mainly is the following areas:

• Economic growth (measured by the gross domestic product – GDP) that is sufficient to achieve full employment of the labour force (whilst allowing for a measure of “frictional or voluntary unemployment”)

• Adequate and timely investment in infrastructure and private sector investment in new productive capacity – an objective that has been long ignored in South Africa as a result of the era of state capture under the previous head of state, combined with incompetence within many public sector agencies, most notably municipalities. The expansion of infrastructure falls in the domain of fiscal policy, which may also include changes to the taxation regime, which is used to incentivise or disincentivise consumption and investment.

• Price stability, which is determined by the levels of consumer and producer inflation. In South Africa (as in all AEs and most EMDEs), this objective is being pursued by means of a target range for inflation, which is determined by the central bank, usually with the approval of government.

1.5 Economic policy choices

In the process of determining the most suitable combination of fiscal and monetary policies, the relevant authorities are often confronted with a choice between the objectives of economic growth and price stability. At a certain point, higher interest rates have a predictable negative impact on credit extension to households and businesses, therefore stifling demand and supply in the economy, which leads to lower growth and, quite often, higher unemployment. Conversely, when interest rates are lowered, banks can borrow money at a cheaper rate, leading to a broad-based increase in spending and economic activity, most notably via more affordable home loans, vehicle finance and other forms of credit.

It is important to note that EMDEs do not possess the same level of development as post-industrial economies and, as a rule, have to cope with higher growth in their labour forces, therefore necessitating a more delicate balance between price stability and economic growth. Substantial scholarly research has been conducted that confirms the presence of a structurally higher level of inflation in EMDEs than in AEs (World Bank 2018).

It is therefore crucial for central banks in developing countries not to merely mimic the inflation targets of countries like the US and those in the European Union, especially when high unemployment co-exists with relatively high inflation. An unduly restrictive monetary policy stance that leads to further increases in unemployment, could foster public discontent, ultimately threatening socio-political stability.

1.6 Monetary policy under the spotlight

Since the turn of the 21^st century, two significant events have re-ignited interest in the impact of a particular monetary policy approach on macroeconomic stability, especially the generation of sufficient economic output to keep unemployment in check and to ensure adequate fiscal revenues to sustain expenditures on basic public services. The first was the so-called sub-prime financial crisis that originated in the US and quickly spread to most other advanced economies (AEs), thereby ending a decade-long phase of stable and predictable growth, combined with low inflation that was present in most AEs and Emerging Market Economies.

The dust had hardly settled on global central bank interventions aimed at relieving stress on financial markets and combating a rising inflationary trend when the Covid-19 pandemic struck the world with a vengeance. Outside of the on-going scourge of HIV/Aids, no other pandemic has caused more deaths since the Spanish influenza of 1918. The Covid-19 pandemic caused global financial system stress and plunged most economies into a sharp, but brief recession. It was subsequently accompanied by the most severe spike in consumer price inflation in half a century, mainly due to supply-side shocks in the form of unheard-of increases in transport and energy costs.

The IMF rose to the challenge and swiftly provided financial assistance and debt service relief to member countries facing the economic impact of the Covid-19 pandemic. By the second quarter of 2020, the IMF had made approximately $250 billion (a quarter of its $1 trillion lending capacity), available to member countries for debt service relief, noting the strain that the lockdowns had placed on the ability of economies to produce goods and services and the resultant decimation of taxation revenue flows in the short term. South Africa was one of 90 countries that benefited from the IMF’s interventions via its Catastrophe Containment and Relief Trust.

Since then, however, the initial swift economic recovery from the worst of the Covid lockdowns was stymied by the decision of many central banks around the globe to combat rising inflation rates with a pronounced shift to restrictive monetary policy, leading to the highest interest rates in almost two decades.

2 THE TRUE REASONS FOR HIGHER

INFLATION

It is perplexing to note that the MPC recently claimed the credit for a lower inflation rate when, in fact, the decline in the consumer price index (CPI) was mainly the result of a steep decline in the producer price index – caused by a normalisation of oil prices and global freight shipping charges. As a result of the Covid pandemic and the Russian military invasion of Ukraine, the latter two key cost factors increased five-fold and eight-fold, respectively, over a period of less than eight quarters, which led to an unheard-of escalation in global price indices.

Transport costs represent a significant part of the composition of cost-push inflation within most sectors of the economy and South Africa did not escape the negative impact on the producer price index (PPI) and the consumer price index (CPI).

Figure 1: Brent crude oil price

(Source: World Bank)

Figure 1 illustrates the rapid and significant rise in the price of Brent crude oil over a two-year period (between the second quarter of 2020 and the second quarter of 2022), followed by a predictable declining trend as the global economy started to normalise after the Covid-19 lockdowns. Not even an attempt by the Opec+ countries to cut oil production during the first half of 2024 could halt the downward trend in global oil prices, due mainly to a combination of excess supplies, subdued global growth and a sustained transition to renewable energy sources.

At the end of September 2025, the price of Brent crude oil had declined by 41% from its level on 10 June 2022, which represents a key reason for the sustained decline in South Africa’s PPI to its average level for 2025 of less than one per cent – raising questions over the MPC’s refusal to lower interest rates more aggressively to pre-Covid levels once it had become clear that both consumer and producer inflation had peaked during the third quarter of 2022.

Furthermore, the monetary policy authorities seem to have placed insufficient weight to the impact and role of the record increase in seaborne freight shipping costs between the first quarter of 2020 and the third quarter of 2022 (see figure 2). It is impossible for higher interest rates to curb the increase in this type of input cost, which was mainly caused by the erratic and unpredictable closure and re-opening of harbours around the world.

Figure 2: Global container freight rate index

(Sources: Statista; Drewry)

As pointed out by Carrière-Swallow et al. (2022), the Covid-19 pandemic underscored the crucial role of the maritime container trade in the global economy. The lockdowns imposed by governments around the world upended supply chains, with ports closing and reopening in unsynchronised fashion, thereby extending the negative impact of harbour closures on maritime shipping costs. In some countries, most notably the US, pent-up demand from fiscal stimulus programs during the lockdowns overwhelmed the capacity of global supply chains, ultimately also extending to increases in other transport-related costs.

The result of the upheaval in global freight shipping resulted in an eight-fold increase in the cost of shipping a container on the world’s ocean trade routes between the first quarter of 2020 and the third quarter of 2021, while the cost of shipping bulk commodities rose even more. Research by the IMF confirmed that the inflationary impact of these higher costs was likely to continue into 2022, with the war in Ukraine also likely exacerbating global inflation.

Studying data from 143 countries over the past 30 years, Carrière-Swallow et al. (2022) found that shipping costs are an important driver of inflation around the world: when freight rates double, inflation picks up by about 0.7 percentage point. Most importantly, the effects are quite persistent, peaking after a year and lasting up to 18 months. This implies that the increase in shipping costs observed in 2021 could increase inflation by about 1.5 percentage points in 2022. Their research also found that, due to the high volatility of shipping costs, their contribution to the variation of inflation can be regarded as quantitatively similar to the variation generated by shocks to global oil and food prices.

It is clear from data published by UNCTAD (2025) that maritime transport represents the backbone of global trade, moving over 80% of goods traded worldwide by volume. Sea freight connects global value chains, carrying raw materials, agricultural produce and semi-processed goods to production hubs and delivering finished products to markets for consumers.

Maritime transport flows are vital for industrialisation, economic growth and job creation and sea freight charges will continue to play a dominant role in producer price indices in every country, as will other transport costs. South Africa is at a particular disadvantage relative to many of its key trading partners when the following factors are considered (Botes 2006):

• The long distance between South Africa and major world markets.

• The distance between the major industrial capacity in Gauteng and the coast. This adds substantially to the already high cost of transportation to South Africa’s main trading partners.

• High cost and inefficiency of ports.

• Poor quality of rail in the transportation of general freight.

• Insufficient intermodal facilities.

• High pipeline transport cost.

• High road freight cost due to price control and taxes on input costs.

The negative impact of the unheard-of spike in maritime shipping costs was even worse for EMDEs, with high import propensities, especially those that are land-locked and at a substantial distance from the world’s most lucrative consumer markets. In concurring with this reality, Havenga (2010), has found that logistics optimisation in South Africa is largely managed from a microeconomic perspective and that the country’s logistics costs are higher than the global average. This paper makes the case for a macroeconomic logistics measurement model to be developed, the results of which could inform government’s national macroeconomic policy framework.

Figure 3 illustrates the structural increase that has taken place in the share of total maritime trade by developing economies.

Figure 3: Total maritime trade – percentage shares by country group

(Source: UNCTAD)

It should be noted that, with or without increases to interest rates, the normalisation of international freight shipping would inevitably have taken place from 2022 onwards. Combined with the high base effect on the subsequent lower fuel and shipping costs, it was entirely predictable that the producer price index (PPI) in South Africa would drop to close to zero – which occurred in 2025.

It was also predictable that oil prices and maritime shipping charges would eventually return to close to pre-Covid levels, resulting in a significant drop in price levels around the globe, as has already occurred (see figure 4). The conclusion from these price shocks is that knee-jerk monetary policy reaction in the form of exceptionally high commercial lending rates was never necessary – all that was required was patience, as eloquently stated by Stiglitz (2022) with the statement that “killing the economy through raising interest rates is not going to solve inflation in any timeframe.”

Figure 4: Median global inflation (forecast for 2025)

(Source: IMF)

3 INFLATION EXPECTATIONS – A

DUBIOUS EXERCISE 

Substantial theoretical and empirical research has been conducted on the relationship between inflation expectations and actual price level trends and its implications for monetary policy, especially by Coibion et al. (2018a and 2020). Drawing on these and other studies, Bonetti et al. (2022), has summarised the motivation for monitoring inflation expectations by monetary policymakers as follows:

• Firstly, if central bankers believe in the theoretical arguments relating to a measure of correlation between inflation expectations and future movements in producer and consumer price indices, it follows that they also believe that taking inflation expectations into account adds important information to their policy decision making.

• A second motivation may be that the policymakers believe that expectations of the different agents polled are correct (in some statistical sense), if anything because they possess some self-fulfilling capacity. In this case, expectations are gauged as providers of direct information about the likely future evolution of inflation.

3.1 Unreliable household forecasts

Although widespread theoretical conviction exists that both of the above conditions hold true, empirical evidence continues to point to controversy. It is well established that the forecasts of households display high cross-variability, gross point misperceptions and endemic inattention towards ongoing developments and announcements relating to inflation indices and the extent to which they are influenced by supply or demand factors. (Coibion et al., 2018a). As far as the intertemporal price effect is concerned, the evidence is also inconclusive. Beside findings of a positive relationship between reported expected inflation and current consumption, other studies cast doubts whether households make consistent use of their forecasts (Schnabel, 2020). Empirical evidence also shows that the behaviour of households in relation to the real vs. the nominal interest rate is blurred (Johannsen 2014).

Barr and Kantor (2023) have pointed out the dangers of confusing the scientific advances of extraordinary technological development with modelling human behaviour, where the application of science related to economics and financial markets has been less successful. In concurring with the view that the interest hikes of 2022 and 2023 were an unfortunate mistake, they note that the Reserve Bank uses an econometric forecasting model as a central lever of input into its economic forecasting, and for formulating its monetary policy.

In the Monetary Policy Review published in April 2023, for example, the Bank published forecast confidence levels for inflation and real growth for levels of certainty ranging from 10% to 70%. Statisticians normally use confidence levels of 95%, so the ones used in the Bank model indicate very low levels of confidence. The forecast chart for these growth rates indicates that the actual South African growth rate by the end of 2024 had only a 70% chance of falling between -4% and +3% (a nugatory and pointless range of 700 basis points).

In reality, this implies the model has very little useful information to convey about what the future real growth rate will be at all. Barr and Kantor conclude that the Bank’s modelling of the South African economy and the associated forecasts may have perceived scientific validity but instead represent an inadequate, even misleading, basis for managing the economy, given its unpredictable nature.

Exchange rate shocks of the kind periodically suffered by South Africa are not predictable and do not easily fit into any model which relies on consistent cause and effect. Interest rate changes do not help an economy recover from an exchange rate shock; in fact, they make it harder to do so. Monetary history, not any forecasting exercise, indicates clearly that central banks should simply ignore these shocks; it is not responsible for them, nor can it help to overcome them.

3.2 Volatility of forecasts 

An issue that is of relevance to policy makers in emerging markets is the importance of distinguishing the forecasts conveyed by ordinary households and firm managers from the ones by professional forecasters. The former are much more volatile and imprecise than the latter. In South Africa’s case, the South African Reserve Bank (SARB) has commissioned the Bureau for Economic Research at Stellenbosch University (BER) to conduct a quarterly Inflation Expectation Survey. The survey is conducted among four societal groups, namely financial analysts, business representatives, trade union officials and households.

It has become clear that the Monetary Policy Committee (MPC) of the Reserve Bank regularly errs on the side of the cautious when making inflation predictions, ostensibly because of a growing list of fears over possible upward pressure on price levels. In recent years, these fears, some of which have not materialised, have included the following:

• The possibility of exchange rate weakness, when, in fact, the rand has been one of the strongest currencies in the world against the US dollar during 2025

• The impact of higher oil prices when, in fact, the price of Brent crude oil has declined by 20% between January and early September 2025

• The impact of the lockdowns implemented during the Covid 19 pandemic, when, in fact, demand inflation was absent during the swift recovery of the South African economy (which was accompanied by a prime lending rate that was 300 basis points lower than before the Covid-19 pandemic)

• Geopolitical instability (which has been around since time immemorial).

• The impact of higher tariffs on the exports of manufactured products.

During the first six months of 2025, South Africa’s consumer price index (CPI) had averaged 2.95%, which is not even within the Reserve Bank’s target range for inflation of 3% to 6%. In a glaring contradiction to the incessant negative sentiments over the prospect for higher inflation that has accompanied most of the MPC statements over the past five years, the CPI has been either below or within the target range since June 2023, which has tallied 27 successive months (until August 2025) – see figure 6.

Figure 5: Consumer & producer inflation remain close to the bottom of SARB's target range

(Source: Stats SA)

3.3 Deviation of forecasts from actual inflation 

The MPC has also been led down the garden path by the misguided results of the BER surveys on inflation expectations, as illustrated by figure 6 and table 1, which illustrates the significant deviation between surveyed inflation expectations one year ahead and the actual inflation in that year (in the case of the survey conducted in the 1^st quarter of 2024, the actual is based on the average for the first seven months of 2025).

Figure 6: Deviation between CPI expectations (one year ahead) surveyed in Q1 2023 & Q1 2024 and actual

(Sources: Stats SA; SARB; own calculations)

During downward phases of the inflation cycle, the inflations expectations survey that is utilised by the MPC has over-estimated future inflation by an average of 140 basis points. It is a point of concern that such an important economic variable as the money market interest rate is co-determined by an opinion survey that is not remotely subjected to scientific method and whose respondents are invariably not trained in economic analysis.

Table 1: Deviation between CPI expectations (one year ahead) surveyed in Q1 2023 & Q1 2024 and actual

(Note: Actual for 2025 = average for January to July)

(Sources: Stats SA; SARB)

Under the assumption that these surveys played a role in the extent to which the repo rate was determined during this period, it follows that the benchmark lending rates were higher than they should have been. A calculation of the negative impact on private sector credit extension, aggregate demand and taxation revenues emanating from this effect is provided in subsequent sections.

3.4 Sensitivity to fiscal policy 

Inflation expectations also tend to be more sensitive to fiscal policy and debt in EMs. This likely reflects increased risks of fiscal dominance and political interference in central bank decisions, which can undermine the public’s confidence in the central bank’s ability to fight inflation. An unexpected increase in government debt tends to boost medium-term expected inflation in EMDEs significantly, while having little effect in advanced economies (Coibion, et al. 2018b).

This is particularly relevant in South Africa, where a combination of weakened public sector institutions, decaying infrastructure, a relatively high public sector wage bill, and low economic growth have combined to place substantial pressure on the public finances. The latter was demonstrated during the initial inability of the National Treasury to pass the 2025/2026 National Budget, mainly due to widespread opposition to a proposed increase in the value added tax rate (VAT).

4 HIGH INTEREST RATES IN EMDEs LEAD

TO LOWER GDP GROWTH

Over the past century, the relationship between interest rates and economic growth has been the subject of a raft of research by economists, without having produced any consensus over the impact of interest rate changes over the long term. The lack of consensus is due to an array of other factors that also influence output, some of which are endogenous, whilst others are dependent on policy interventions, especially fiscal and trade policies. The conundrum is made even more complex by significant imbalances in key economic variables and macroeconomic stabilisation policies that exist between different countries.

Barro and Becker (1989) consider a model with endogenous fertility choice, which posits a relationship between real interest rates and fertility rates. Over the long run, as fertility rates decline, so do real rates of return. This model predicts a negative relationship between real interest rates and economic growth. Several examples can be found in academic support of this view and also contrasting views, but since the Covid-19 pandemic the consensus has tilted towards an acknowledgement of the damaging effects on the economy of excessively high interest rates, particularly in developing economies.

4.1 Evidence from key emerging markets

The extraordinary events related to the Covid-19 pandemic, the Russian military invasion of Ukraine and heightened geo-political instability in general, have served to place the conduct of monetary policy under the spotlight once again. The Bank for International Settlements (BIS) has recently applauded the actions of central banks in forcefully stabilising the financial system and limiting the damage to economies. Unfortunately, this statement might be true for North America and most of Western Europe, but not necessarily for EMDEs. The initial recovery of GDP growth from the worst effects of the pandemic was halted in its tracks in most of the key EMDEs around the globe, not only because of a lack of demand, but mainly due to the pervasive negative effect of restrictive monetary policies in the AEs and several key EMDEs, including South Africa (see figure 7).

It has become clear that the rapid rise in interest rates in the United States and the Eurozone, which was prompted by the global surge in inflation, has exerted a detrimental effect on the economic welfare of many EMDEs. This has occurred mainly because of the associated strengthening of the US dollar, which has led to increased borrowing costs for these countries, whilst the currency weakness of most EMDEs (relative to the US dollar) has also made it difficult for them to lower inflation.

Figure 7: %-point different in real GDP growth rates between 2022 & average for 2023 & 2024 - selected EMDEs

(Sources: World Bank; own calculations)

4.2 Public finance stress depresses private

consumption expenditure

According to research conducted by Arteta et al. (2022), the heightened likelihood of debt distress is disrupting EME financial markets, discouraging capital inflows, and leading to financial market strains, with government debt levels reaching record highs in most of the world’s EMDEs (see figure 8). In South Africa’s case, in particular, this dilemma has been exacerbated by the monetary authorities attempting to mimic the Federal Reserve of the US (the Fed) via a relentless raising of the official bank rate (the repo rate) between the end of 2021 and 2023 (although the SARB was first to raise rates).

Figure 8: Government debt as % of GDP - emerging market & developing economies (EMDEs)

(Source: IMF, Forecast 2025)

An important additional consideration in the evaluation of South Africa’s hawkish monetary policy since 2022 is the impact of rising interest rates in the US on financial and economic conditions and fiscal outcomes in EMDEs. Against the backdrop of the aggressive tightening of monetary policy by the US Federal Reserve, Arteta et al. (2022) explored this issue via three distinct methodologies.

At the outset, the research aimed to identify what mix of inflation, reaction, and real shocks have driven changes to US interest rates since the first quarter of 2022. The analysis applied a sign-restricted Bayesian VAR model to monthly US data on bond yields, stock prices, and inflation expectations and found that rising US rates were driven almost exclusively by continued increases in inflation expectations and a perceived hawkish shift in the Fed’s reaction function as it pivoted toward an exclusive focus on reversing the surge in inflation.

The second focus of the research was how this type of shock behind sharp increases in US interest rates affect the financial markets, capital flows, borrowing costs, and fiscal outcomes in EMDEs. To answer this question, estimates from panel local projection models were determined to assess these impacts at a quarterly frequency of the type of interest rate shock identified by the VAR model. Finally, a logit model was applied to annual data to determine how the relevant interest rate shock affects the probability that an EMDE will experience a financial crisis.

The paper reported the following key findings:

1. Increases in US interest rates, when driven by inflation and reaction shocks, are especially detrimental to EMDEs, due to boosting local-currency bond yields, widening sovereign risk spreads, depressing equity prices, weakening currencies, and dampening capital flows.

2. These tighter financing conditions lead EMDE governments to cut spending to improve primary budget balances and reduce government debt. Generally, these negative spillovers appear to be more pronounced for reaction shocks - that is, increases in US interest rates associated with market perceptions that the Fed has become more hawkish - than for shocks to inflation expectations. Reaction shocks also decrease private consumption and fixed investment.

The relevance of these findings to South Africa in the aftermath of the initial recovery from the Covid-19 pandemic has been largely vindicated by subsequent data, especially with regard to weak economic output.

Figure 9: Year-on-year real GDP growth rate (logarithmic trend line)

(Source: Stats SA)

Initially, the South African economy experienced a swift and impressive recovery from the Covid 19 pandemic, recording an average rate of real GDP growth of 2.4% between the second quarter of 2021 and the third quarter of 2022. Since then, the twin effects of record high domestic interest rates and the negative impacts identified by the research of Arteta et al. (2022) have decimated the country’s economic growth trajectory, with average annual real GDP growth of merely 0.5% having been recorded between the second quarter of 2023 and the second quarter of 2025.

4.3 Research on 38 developing countries

From a short-term perspective, however, recent studies have shown that higher interest rates will lead to a decline in the rate of GDP growth. Shauket et al. (2024) published a research paper aimed at exploring the relationship between real interest rates and economic growth in emerging market economies. It covered 38 countries at different levels of transition during the period 1996 to 2015. The results of the study confirmed a multi-fold inverse relationship between real interest rates and economic growth through the following indicators:

• local and foreign investments

• human capital development

• trade openness and the exchange rate

• inflationary pressures

• institutional strength and political instability

The study found that the real interest rate, which is exogenously determined in transitory economies, exerts a pervasive effect on key macroeconomic variables through a multitude of channels and that high interest rates are detrimental to GDP growth in the short to medium term. The study also concluded that high interest rates restrict the ability of an economy to sustain its respective transitional level via an adequate rate of economic growth. As a policy implication, this work suggests that relatively low interest rates are beneficial for transitory/developing nations to sustain the process of economic development and attain higher GDP growth rates.

Figure 10 provides empirical evidence confirming the hypothesis of the above research for South Africa.

Figure 10: Year-on-year real GDP growth rate & the real prime rate

(Note: GDP = avg)

(Sources: Stats SA; own calculations)

4.4 The case of Australia

Substantial scholarly research has been conducted that confirms the inverse correlation between changes to short-term real interest rates and output, subject to a transmission lag. Research by Gruen et al. (1997) has provided strong econometric evidence that the level of the short-term real interest rate has a sizeable, and statistically significant, impact on output in the Australian economy. Ordinary least squares estimation conducted for the Australian economy suggests that a one percentage point rise in the short-term real interest rate lowers output growth by one-fifth to one-quarter per cent in the first year, one-third per cent in the second year and one-sixth per cent in the third year.

4.5 The case of 20 industrialised economies

A prolonged slowdown in the growth of the industrial countries originated in the seventies, lasting for almost three decades. In their research aimed at shedding some light on the reasons for low growth, D’Adda & Scorcu (1997) determined estimates of the relationship between overall growth rates and the real rate of interest. Their research acknowledges a key theoretical basis for an inverse relationship between growth and the real rate of interest, namely the direct mechanism connecting capital accumulation and growth. Investments remove the constraints to growth coming from insufficient or obsolete capacity and enables the economic system to realise its growth potential. In addition to the new capital stock incorporates technical progress and promotes further expansion of a country’s growth potential.

Utilising ordinary least squares (OLS) methodology, regressions were conducted on data for a group of 20 industrialised economies over the period 1965-94, broken up into six different periods, for a total of 120 observations. To minimise forecasting errors, the data were based on 5-year averages. The result of their analysis suggests that an increase of one percentage point in the real interest rate leads to a fall of one-fifth of a percentage point in the average growth rate. In the latter periods, because of the prolonged increase in the real interest rate, this effect becomes quantitatively more significant. This result confirms the traditional view about the existence of a positive link between economic growth and capital formation and a negative link between the latter and the real interest rate.

4.6 Negative impact on capital formation

High interest rates can exert a pervasive negative impact on fixed capital formation – a key component of aggregate demand in the economy. This takes place via several channels:

• Directly through an increase in the cost of financing the purchases of equipment and property required for an expansion to manufacturing capacity and construction works

• The disincentive for taking business risks when a positive real return can be earned through fixed deposits in the money market or investing in bonds

• Indirectly, when lower levels of private consumption expenditure obviate the need to keep a watch on production capacity constraints

• Further amplification of lower demand can occur via the balance sheets of firms, especially if interest rates eventually result in lower asset prices, which reduces the value of collateral a firm may use to secure borrowing (Bahaj et al. – 2022) 

Research conducted in 2018 by Cloyne et al. provided new evidence on how monetary policy affects investment and firm finance in the United States and the United Kingdom. Their research confirmed that younger firms that are not yet in position to pay dividends exhibit the largest and most significant change in capital expenditure when interest rates increase - even after conditioning on size, asset growth, leverage or liquidity.  The external finance of such firms is mostly exposed to asset value fluctuations, which drives the negative response of aggregate investment. The findings of this research highlight the role of firm finance and financial frictions in amplifying the effects of monetary policy on investment and the financial stability of the private sector.

These findings are especially relevant in EMDEs, which do not remotely possess the extent and quality of infrastructure and price sector capital formation than their counterparts in the AEs. The negative impact on capital formation in EMDEs of the high-interest rate regime since 2022 is illustrated by figure 11. Due to the occurrence of state capture over a period of almost a decade, South Africa is at a particular disadvantage, with a structural decline in new capital formation by the country’s state-owned enterprises hampering the current and future prospects for increased output and employment creation.

Figure 11: Capital formation as % of GDP - EMDEs

(Source: IMF)

5 MONETARY POLICY REQUIRES

TAILORING IN EMDEs

Central banks in EMDEs should be wary of replicating the monetary policy approach of their counterparts in the AEs. Several reasons exist for the need to tailor monetary policy in EMDEs according to the prevailing state of their economies and to guard against policies that may produce perverse side-effects and eventually do more harm than good. They include the following:

5.1 Differences in the transmission of policy 

A lowering of monetary policy rates in AEs quickly translates into lower market rates, which is what triggers the borrowing decisions of households and firms in the private sector, invariably boosting demand and leading to higher economic growth. However, research by De Leo et al. (2024), shows that when monetary policy becomes more accommodating in EMDEs, the transmission to short-term market rates is dependent on what happens to global financial conditions. If global financial conditions tighten enough, then domestic market rates may even rise when the EM central bank lowers policy rates. 

According to De Leo et al. (2022), this is due to the implicit rise in the risk spread facing borrowers, which blunts the effectiveness of monetary policy and makes it harder for EMs to cushion the effects of shocks.

5.2 Higher passthrough rate of cost shocks

Research by Gopinath (2025) confirms the fact that inflation expectations in EMDEs remain less well-anchored than in AEs. Consequently, there is a higher passthrough of cost shocks to inflation, as they feed through much more into inflation expectations as well as through other channels such as de facto wage indexation. In particular, oil price shocks tend to impact core inflation more than twice as strongly in a sample of EMDEs, relative to post-industrial economies, as illustrated by figure 12 (Baba & Lee – 2022). This complicates the design of monetary policy in EMDEs, as second-round effects may be sizeable, especially in the aftermath of the major global trade shock that has occurred in 2025 via punitive US tariffs.

Figure 12: Consumer price index response to an oil price shock

(Source: Baba & Lee – 2022)

A multitude of scholarly research has been conducted to gauge the extent to which changes in oil price affect key macroeconomic variables, especially inflation and output. In one such empirical study to assesses the effects of oil price shocks on the real economic activity in the main industrialised countries, Jimenez & Sanchez (2005), found evidence of a non-linear impact of oil prices on real GDP, in line with most other research studies. In the above case, multivariate VAR analysis was carried out using both linear and non-linear models. Among oil importing countries, oil price increases were found to have a negative impact on economic activity in all cases but Japan.

The underlying logic behind the inverse relationship between oil prices and economic output is related to the multi-dimensional and pervasive way the oil price impacts supply-chains in the economy. One example is freight shipping. Not only does a higher oil price increase the transportation costs of shipping companies, but their cargoes often also become more expensive, especially for a wide range of manufactured products, including motor vehicles, machinery, plastics, fertilizers and asphalt. Secondary effects of significant rises in oil prices will also cause demand-side disruption via lower output for products that are dependent on this energy source. 

When oil prices increase, there is a corresponding rise in the costs to produce an array of goods and services, including the costs of transportation, which automatically decreases supply at a given price. In macroeconomics, total supply is used to explain this phenomenon in the standard model of aggregate demand and aggregate supply (AD-AS model). The AS-curve is upward-sloping to the right, with price on the vertical axis and output on the horizontal axis. The AD-curve is upward-sloping to the left, indicating the negative effect of higher prices on the ability of consumers to buy a particular product (within short-term disposable income constraints). For any given product and service, the intersection of these curves provides the market equilibrium price and quantity, with the aggregate output level equal to a country’s GDP.

An increase in oil prices shifts the IS curve to the left. This occurs because higher oil prices lead to increased production costs for firms, which raises their selling prices. The equilibrium output now shifts to the left, as consumer spending declines in reaction to the price increases. Many affected export sectors will also experience a loss of output, which will exert a negative impact on a country’s balance of payments. This means that national output of goods and services at each price level will fall when oil prices rise by a sufficient margin.

In a study conducted by De Pratto et al. (2009), an estimation was done via a New Keynesian general-equilibrium open economy model to examine how changes in oil prices affect the macroeconomy. The model allowed for oil price changes to be transmitted through temporary demand and supply channels (affecting the output gap), as well as through persistent supply side effects (affecting trend growth). The model was estimated for Canada, the United Kingdom, and the United States over a 37-year period (1971 to 2008). The conclusions were:

• Energy prices affect the economy primarily through the supply side

• Higher oil prices have temporary negative effects on both the output gap (the difference between potential and actual GDP) and on trend growth

Consequently, the result of a higher oil price is inflationary, but the price rises occur via cost-push inflation, with real GDP contracting, leading to a possible economic recession.

5.3 Uneven ability for fiscal stimulus

Another reason why EMDEs should caution against replicating the monetary policies of AEs is because of stark differences in the nature of the inflationary spike that occurred in the wake of the Covid-19 pandemic. The price level can also rise due to higher demand in the economy (at each price level). The latter phenomenon shifts the aggregate demand (AD)-curve to the right, which inevitably stimulates output and employment creation, but also puts upward pressure on the price level.

The latter was the case recently in the US during the Covid-19 pandemic, when extensive fiscal intervention occurred to relieve the financial stress of households. This was done via grant payments (also known as “stimulus checks”). The total amount paid to tax filers earning less than a prescribed threshold (over three rounds) was $814 billion – roughly twice the value of South Africa’s GDP in 2024.

It should be noted that this was a luxury that hardly any other country could afford. For a qualifying couple with one child, the total payout was approximately R160,000 – clearly an inflationary exercise that ultimately prolonged the higher inflation in the US that was initially caused by the price shocks of a seven-fold increase in sea freight costs and a four-fold increase in the Brent crude oil price. The irony of this intervention is clear – due to a remarkably swift recovery of demand, which occurred in any event, it proved to be stimulatory, aggravating inflation whilst the US unemployment rate hardly budged.

The policy option of fiscal stimulation to the above extent was never available in any EMDE. Although South Africa did implement a so-called “Covid-relief-of-distress-grant” the amount in question (currently R370 per month) is not sufficient to have any meaningful impact on demand inflation.

6 SPIKE IN US TARIFF REGIME

Since the second quarter of 2025, the effective tariff rate of the US has increased to levels last seen more than a century ago, leading to a surge in uncertainty surrounding trade policy and geopolitics. The economic effects of these developments are expected to be profound, as witnessed by the latest IMF World Economic Outlook, which projects that higher tariffs will reduce both global and EM output growth by roughly 0.5 percentage points relative to the previous IMF forecast.

Figure 13: South Africa's top-10 export trading partners for high value-added goods 2024

(Source: SARS)

These shocks to trade policy will inevitably disrupt supply chains and place upward pressure on input costs. The impact on inflation, however, is expected to be more varied. In the case of countries that are facing higher tariffs on their exports (including South Africa), the higher tariffs will essentially operate as a negative demand shock, exerting downward pressure on inflation. For countries that are imposing significantly higher tariffs (especially the US), the tariffs will act more as a supply shock, leading to higher inflation and lower growth.

This issue is highly relevant to monetary policy in EMDEs, as any decision to follow a likely policy rate increase in the US could seriously hamper economic growth prospects. South Africa is highly likely to follow the former route, which will stifle output growth from a depressingly low level of between zero and one percent. It is also important to point out that the US was South Africa’s second most important export trading partner in 2024 for high value-added products (excluding minerals and metals – see figure 13). To the extent that Germany (South Africa’s largest export trading partner for high value-added products) and other key export destinations such as the UK and European Union countries may retaliate against the US tariffs, the ultimate outcome of the so-called tariff wars could eventually drag the South African economy into recession.

7 RESTRICTIVE MONETARY POLICY

AGGRAVATES SUPPLY-SIDE COSTS

The use of historically high increases in interest rates to curb the abnormally higher inflation experienced after the worst of the Covid-19 pandemic has been severely criticised by an array of renowned economists, most notably Stiglitz & Regmi (2022), Schaefer & Semmler (2024), Korinek & Stiglitz (2022), Blanchard (2022), Merz (2023) and Chen & Semmler (2023). In an attempt to combat a rising price spiral that was not fuelled by excess demand, central banks started pursuing so-called ‘quantitative tightening’ from 2022 onwards.

Restrictive monetary policy via higher interest rates reduces demand, eventually contributing to slower price increases, but it represents a very inefficient way of lowering inflation, whilst also imposeing an additional and unnecessary cost to an economy via its dampening effect of GDP growth and employment creation.

Against this background of the cause of higher global inflation in 2021 and 2022, Schaefer & Semmler (2024) argue that the monetary policy goal of effectively weakening the demand for labour through historically large interest rate hikes seems unwise. Significant negative side effects of interest rate hikes include the aggravation of cost pressures on the supply-side (due to lower capacity utilisation in the manufacturing sectors) and increasing the risk of insufficient investment in new productive capacity. For emerging markets and developing economies (EMDEs) that are faced with high levels of unemployment, these risks may be severe.

7.1 The bluntness of monetary policy

One of the criticisms of the most effective instrument of monetary policy - the short-term interest rate – is its inability to be fine-tuned to which sectors of the economy are over-heated or in need of stimulus. It is a blunt instrument whereby aggregate demand in the economy is affected in broad strokes. Korinek & Stiglitz (2022) point out that a stark difference between fiscal and monetary policy is that the latter affects aggregate demand more through investment whereas fiscal policy, particularly that related to the overall size of the fiscal deficit, operates comparatively more through consumption expenditure (in the private and public sectors).

As a result, monetary policy affects not only the demand side but also the supply side of the economy. Restrictive monetary policy reduces investment in future productive capacity, potentially exacerbating future inflationary pressures. The process of designing an appropriate macroeconomic stabilisation policy mix for extraordinary circumstances such as occurred in the aftermath of the worst of the Covid-19 pandemic requires a thorough understanding of the disaggregated impact at a micro level. It is important to understand what is happening beneath the surface of the economic aggregates such as GDP and employment, where individual firms and households are engaged in a myriad of sectors and activities.

According to Korinek & Stiglitz (2022), the intertemporal substitution effects of interest rates play a far smaller role in resource allocations than simple textbook models suggest. As economic policy practitioners should know, most of the real effects of monetary policy occur through other transmission channels. Monetary policy affects financial conditions and asset prices, for example via the bank lending channel and the balance sheet channel, by driving changes to market liquidity and by influencing the extent of credit rationing or availability, as demonstrated by the research of Barone et al. (2025).

7.2 Amplification of supply-side inflation

Several simple theoretical explanations underpin the necessity of caution when interest rate increases are utilised for purposes of curbing inflation in a blunt manner, especially in the absence of excess demand in the economy and where temporary supply shocks are responsible for higher price levels.

Firstly, utilising a standard utility function for a worker-consumer and a representative firm that combines labour 𝐿 with imported non-labour inputs 𝑁 to produce output according to a constant-returns production function 𝑌=𝐹 (𝐿, 𝑁), the optimal level of production can be determined. In the case of a rigid nominal wage, firms will still price output at marginal cost. However, the wage no longer correctly reflects the marginal social value of labour. If the wage is too low, consumers supply too little labour, and firms’ labour demand is rationed, forcing them to resort to a suboptimal ratio of factor inputs, which inefficiently raises their costs and leads to a convex marginal cost curve. In the case of an exogenous increase in the cost of non-labour inputs (e.g. an oil price shock), the marginal cost curve becomes elevated, which increases goods prices and leads to a decline in real wages, reducing labour supply and exacerbating the labour market imbalances.

A second example whereby supply bottlenecks can introduce tendencies likened to stagflation may occur where two oligopolistic firms compete in Cournot fashion, a model that was developed in 1838 (De Bornier 1992). Before a price shock (e.g. a higher oil price), the firms are capable of setting prices at a higher level, due to taking each other’s production as given (at the intersection of a horizontal marginal cost curve and their marginal revenue curves. Not only does this contribute to higher prices, but it also lowers employment and output. When the firms are faced with supply bottlenecks that restricts the non-labour inputs that they can contractually access (e.g. with harbour closures, as occurred during the pandemic), it creates a kink in their cost curves, with a positive slope. It now becomes optimal for the two firms to reduce output, which raises prices, thereby reducing real wages, employment, and output further and making the consumer-worker worse off, triggering the possibility of stagflation (Korinek & Stiglitz – 2022).

8 DIFFERENCES IN THE BASE FROM

WHICH RATES WERE HIKED

Several of South Africa’s key trading partners have recently adopted a more accommodating stance towards monetary policy, with central banks in the Euro zone, Switzerland, Canada and Australia having lowered rates since February. Although the Australian monetary authorities have stated caution with a further easing of monetary policy, the reason for this is related to the existence of a strong labour market – a luxury that does not remotely exist in South Africa. It should also be pointed out that all of South Africa’s key trading partners enjoy a significantly lower real commercial lending rate than South Africa. This serves to erode South Africa’s international competitiveness.

In reaction to the recent tumultuous and inconsistent experience with different policy measures aimed at restoring global price stability, a number of authoritative research studies have recently been published. In one of them, by Schäfer & Semmler, published in 2024, an important point is highlighted, namely the base from which interest rates were increased in the US and in the European Union. Early in 2022, the Fed began with a steep increase in its benchmark interest rate, starting from the historically low level of zero to 0.25 percentage points.

This was quickly followed by the European Central Bank (ECB), which started to raise its deposit facility rate from minus 0.5 percentage points to zero. In the process, the ECB departed from negative interest rates for the first time since 2014.

By July 2023, the Fed had raised the Fed funds rate to 5.5%, where it remained for 14 months, before a modest return to a more accommodating monetary policy stance set in. In July 2025, the Fed funds rate stood at a level of between 4.25% and 4.5%, with most central banks around the world also having cut their benchmark interest rates since the second half of 2024.

To establish the wisdom of the restrictive monetary policy stance adopted by the AEs and some EMDEs in the aftermath of the Covid-19 pandemic, it is important to also take the changes to consumer price indices (CPIs) into account. In the US, the CPI was at 2.4% just before the Covid-19 pandemic struck, which translated into a negative real Fed funds rate of 0.65% (based on the upper level of the Fed funds rate). In July 2025, this rate was at 2.8%, which implies a substantial percentage increase in the real interest rate, despite the narrowing of the gap between the inflation rates over this period. As a result, mortgage lending rates in the US remain at their highest nominal rates in two decades, which has stifled home buying activity in the country, in line with the experience of several other countries, including South Africa.

Once mortgage lending rates rise to a level that also raises the ratio between the debt servicing costs and disposable incomes of households, a predictable inverse relationship (with a lagged effect) comes into play, as also occurred in the US since the beginning of 2022 (see figure 14). Following the lowering of interest rates in the US to virtually zero at the beginning of 2020 (in response to the Covid 19 pandemic), average real house prices increased by 23.3% up to the second quarter of 2022. Record high interest rates then started taking their toll, with the average real house prices subsequently having declined by 11.4%.

Figure 14: Fed funds rate and average real house prices in the US

(Source: Federal Reserve Bank of St Louis, USA)

The impact of the vicissitudes of monetary policy in the US since the onset of the Covid 19 pandemic are even more stark when observing data on the number of new one-family houses sold. Between the first quarter of 2019 and the second quarter of 2021, sales of these houses increased by 40%. Following the switch to restrictive monetary policy and record high interest rates, these sales have since declined by 22.4% (Federal Reserve Bank of St. Louis, USA - 2025).

9 UNEASE OVER GLOBAL FINANCIAL

AND FISCAL STABILITY 

9.1 The danger of a credit crunch

Due concern has been raised over the destabilising effect of high interest rates on banks and the capital market. The turbulence in the banking sector, particularly in the US and Switzerland, has raised the question of whether restrictive monetary policy is destabilising the financial markets. Schaefer & Semmler (2024) point out that central banks face two main problems when raising interest rates. First, raising interest rates to fight inflation also tightens the borrowing conditions faced by the real economy, possibly even up to the point of a credit crunch and credit supply disruptions. However, sufficient and affordable loans for the working capital required by businesses, new investments and entrepreneurial innovation are prerequisites for eliminating the production bottlenecks. Stricter conditions and restrictions on the availability of credit have the opposite effect, as these supply-side constraints and sectoral upward price pressures are intensified.

9.2 Bank failures in the US and Switzerland

The restrictive monetary policy is also a double-edged sword for banks. It is true that the increase in the interest rate will make new lending more profitable and a bank’s own central bank deposits will be remunerated more. At the same time, however, the investments by banks in fixed-income securities are falling in value. When a critical number of depositors have doubts over the value of their investments on the assets side of the bank, e.g. because large holdings of government bonds have lost substantial value as a result of interest rate hikes by the central banks, then a “run on the bank” may occur, which usually ends in bank failure. This was proven in 2023 by the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank in the US. The non-compensated withdrawals at the liabilities side of the balance sheet inevitably result in a shrinking of the assets side, which is done either through the sale of assets to pay off depositors, or through depreciation and impairment.

Also in 2023, Switzerland faced a major shock to its highly reputable financial system when structural weaknesses at Credit Suisse – one of Switzerland’s oldest and most prominent banks – triggered a sharp loss of market confidence and massive liquidity outflows. The crisis culminated in the emergency takeover of Credit Suisse by UBS, the country’s largest bank, facilitated by a public liquidity backstop established under emergency legislation by the Swiss government (French et al. – 2025). In response, Switzerland is now considering a formal legal basis for such a public liquidity backstop.

The proposed framework is designed to support the orderly resolution of a systemically important bank that has reached the point of non-viability – as determined by the market regulator – and lacks sufficient collateral that can be pledged to access emergency liquidity from the Swiss National Bank (SNB). In such a crisis scenario, the federal government would act as a guarantor for potential losses on SNB loans to the systemically important bank, thereby shifting the default risk of last resort lending from the SNB to the government. Depending on the finalisation of the fee structure for this facility, this framework may have negative fiscal consequences for the Swiss government.

9.3 US banks take a hit

In the run-up to the Fed’s decision to eventually raise its official interest rate to 5.5%, unrealised losses in the US banking system rose sharply, with the Federal Deposit Insurance Corporation (FDIC), estimating these losses at $620 billion at the end of 2022. More recent estimates of the unrealized losses in the US banking system have been provided by Drechsler et al. (2023), which assess that, within a year (from March 2022 to March 2023), US banks lost about $1 trillion in deposits due to the Fed’s interest rate hike and the widening interest rate differential between bank deposits and investments in money market funds. This is more than 43% of the total equity of FDIC-insured banks in the US.

The threat to the financial stability of banks has also recently been confirmed by research conducted by Barone et al. (2025), which investigated the impact of a tighter monetary policy in the US on financial stability within a novel macroeconomic environment, with a particular focus on the banking sector. The research utilised a vector autoregressive (VAR) model, incorporating time series data up to January 2024. It was contextualized within the post-pandemic economic landscape, where significant monetary intervention by the Federal Reserve was necessitated by pandemic-induced economic disruptions.

One of the conclusions was that the contractionary monetary policy shock increased financial market risk and volatility, as well as tighter credit conditions. Furthermore, the banking sector experienced a decrease in loan volumes and an increase in non-performing loans. The balance sheets of banks were found to be adversely affected by restrictive monetary policy, with declines in the capital adequacy ratio, liquidity ratio, and tier one leverage ratio (tier one capital is composed of a bank's common stock, retained earnings, accumulated other comprehensive income - AOCI, noncumulative perpetual preferred stock, and any regulatory adjustments to those accounts). The research highlights the importance of considering the overall economic and financial context when assessing monetary policy effectiveness and its implications for financial stability.

9.4 Haunting memory of the 2008 financial crisis 

Although the value of total bank equity has increased by almost 5% since the recovery from the Covid-19 pandemic, the dangers to the stability of global banking systems posed by overly restrictive and misguided monetary policy should not be under-estimated. The memory of the 2008 financial crisis, which turned into the worst recession in 75 years, should still haunt monetary authorities that believe they have all the answers for preventing undue macroeconomic instability. In 2006, the value of the off-balance-sheet assets of Citigroup amounted to $2.1 trillion, far exceeding the value of the assets on the balance sheet of $1.8 trillion (IMF, 2008). Towards the end of 2007, declining residential property prices, higher risk premiums and credit rationing started taking their toll on financial sector stability, which eventually spread to a sharp decrease in stock prices and a dramatic fall in consumer and corporate confidence around the world.

Blanchard (2008) identified two related, but distinct, mechanisms that triggered the amplification of these events: First, the sale of assets to satisfy liquidity runs by investors and, second, the sale of assets to re-establish capital adequacy ratios. Together with the initial conditions, these mechanisms helped create the worst global recession since the 1930s.

Although these conditions are distinctly different from the current environment of relatively high inflation, negative real wage growth and low GDP growth, two of the mechanisms identified by Blanchard not only still hold today but have expanded within the global financial system. Firstly, a large number of banks around the world possess a large exposure to US securities. The expansion of securitisation, combined with globalisation in general, has led to a relentless interconnection of financial institutions – both within and across countries. Secondly, the increase in leverage led to financial institutions financing their portfolios with less and less capital, thus increasing the rate of return on that capital.

Fortunately, some of the gaps in financial regulations that had existed during the financial crisis 17 years ago have been addressed, especially the removal of bank assets from balance sheets to so-called structured investment vehicles.

10 THREATS TO FUNDAMENTAL

ECONOMIC STABILITY IN EMDEs

10.1 The finance divide between AEs and EMDEs

Over the last two years, the world economy has been rocked by multiple shocks—from the COVID-19 pandemic to the war in Ukraine. But not all countries have been impacted in the same way. A so-called financing divide is sharply curtailing the ability of many developing countries to respond to shocks and invest in recovery (Schwank and Spiegel 2022).

In the wake of the COVID-19 pandemic, developed countries were in a position to finance substantial fiscal response packages (worth an estimated 18 percentage points of GDP) at very low interest rates, backstopped by their central banks. Developing countries were more constrained, with the poorest countries in particular being forced to cut spending in areas such as education and infrastructure, contributing to a more protracted crisis. Even before the fallout from the war in Ukraine, one in five developing countries was projected not to reach 2019 per capita income levels by the end of 2023, with investment rates not expected to return to pre-pandemic levels for at least two years. In South Africa’s case, such a recovery has remained out of reach, with real GDP growth not having been able to move above one percent and remaining well below pre-Covid levels. Real capital formation also remains in decline, whilst unemployment has continued to rise.

Rising energy and food prices due to the war in Ukraine have put additional pressures on fiscal and external balances of commodity importers, and tightening global financial conditions are raising risks of a systemic crisis. Debt sustainability concerns, which tend to arise at lower levels of debt in developing countries, translate into higher risk premia. Even in countries where debt is considered sustainable, the high cost of borrowing precludes the dire need for investment in infrastructure and productive capacity in the private sector.

Developing countries’ average interest cost on external borrowing is three times higher than that of developed countries (Aitken and Volz 2022). In the low interest environment of the last decade, developed countries borrowed at an interest cost of an average of merely one percent. Least developed countries (LDCs), which have increasingly tapped international markets in recent years, borrowed at rates over 5 percent, with some countries paying over 8 percent. This has dragged up their average borrowing cost and translated into less fiscal space: LDCs dedicate an average of 14 percent of their domestic revenue to interest payments, compared to only around 3.5 percent in developed countries, despite the latter group having much larger debt stocks (Schwank & Spiegel 2022).

As pointed out by Meyer (et al. 2019), foreign currency borrowing can be expensive for developing countries. Since the start of the so-called ‘emerging market bond finance era’, around 1995, total returns to investors (net of losses from defaults) have averaged almost 10 per cent - a historical high, with a credit spread of around 6 percentage points over the risk-free rate. According to Schwank & Spiegel (2022), investments in external sovereign bonds have been the best performing asset class over most of the past three decades, outperforming other asset classes such as equities or corporate bonds. Unfortunately, these high investor returns equate to high borrowing costs for developing countries, thus diverting government expenditures to the servicing of debt.

10.2 Threat to fiscal stability

Real interest rates have risen to levels that are significantly higher than in the aftermath of the recovery from the global financial crisis of 2008. Unfortunately, the decision in the beginning of 2022 by many central banks to raise interest rates to record high levels has (predictably) been accompanied by low economic growth, with very little prospects for a reversal over the next 24 months. According to Adrian et al. (2024), persistently higher interest rates raise the cost of servicing public debt, adding to fiscal pressures and posing risks to financial stability. Public debt sustainability depends upon a number of factors of which the following three are especially important: primary budget balances, real economic growth, and real interest rates.

Real output growth and higher primary budget balances (the excess of government revenues over expenditures excluding interest payments) assist the achievement of public debt sustainability, whilst higher interest rates make this task more challenging.

In the aftermath of the global financial crisis, public debt levels were at rather benign levels, mainly due to real interest rates remaining below real GDP growth rates in most advanced economies (AEs) and a number of emerging markets and developing economies (EMDEs). As a result, the need for fiscal consolidation took a back seat, with a global average real GDP growth rate of 3.2% between 2010 and 2019 taking pressure off the fiscal and monetary policy authorities.

The lockdowns that were implemented by virtually all countries during the Covid-19 pandemic changed the course of public finances, with several EMDEs now facing a potential sovereign debt crisis. A dire situation has developed since 2020 for the level of public debt in the EMDEs, with nine different sovereigns having defaulted. They are Argentina, Belarus, Belize, Ecuador, Ghana, Lebanon, Sri Lanka, Suriname, Ukraine and Zambia, five of which are rated by Fitch Ratings (2023).

According to a special report published in March 2023, the ratings agency disclosed that the average emerging market sovereign rating fell to an all-time low at the beginning of 2023, noting that several other countries were faced with the probability of default, including El Salvador, Ethiopia, Mozambique, Pakistan, the Republic of Congo and Tunisia. The combined number of defaults since 2020 amounts to more than a third of the 45 sovereign foreign currency defaults since 2000. According to Mammadov (2025), emerging economies are bracing for what could become a new sovereign debt crisis.

The spike in the debt service burden of EMDEs was initially driven by the pandemic fallout, commodity shocks, Russia’s military invasion of Ukraine and surging inflation. Record high interest rates in the US, the EU and several other countries have exacerbated the fiscal dilemma faced by developing countries, with the risk of default spreading across Sub-Saharan Africa, Latin America and South-East Asia. Tighter financial conditions and increased financing costs are currently being experienced by emerging markets. The cost of dollar-denominated debt has increased because of the swift raising of rates by central banks in advanced economies, particularly the US Federal Reserve.

Due to the flight from risk in, the US dollar was exceptionally strong against EMDE currencies between the second quarter of 2022 and the first quarter of 2025, as illustrated by figure 15. At the end of January 2025, the US dollar index (a measure of the value of the U.S. dollar relative to a basket of six key foreign currencies) rose to above 108 for only the third time in more than three decades.  This has increased the external debt burden of many EMDEs, with servicing costs rising sharply in local currency terms. Countries with minimal reserves are particularly vulnerable, and many are witnessing capital outflows and currency depreciation.

These forces are straining government budgets to the extent that socio-economic stability is also being threatened, as witnessed by recent protests in Ghana and Nigeria. Various commentators have recommended that countries need to enact fiscal reforms, enhance transparency, and stimulate growth to ensure sustainable public debt management. The latter will hardly be possible until central banks reverse the hawkish stance of the past three years and lower interest rates to pre-Covid levels.

Figure 15: US dollar index (3-month moving average)

(Sources: Trading Economics; own calculations)

11 GROWING PUBLIC DISCONTENT WITH

HIGH INTEREST RATES

Over the past year, protests over poor economic conditions have erupted in several developing countries, including Bangladesh, Kenya, Nigeria, Pakistan, Angola and South Africa. The specific triggers that set off these protests may vary, but they share a common thread - anger over an economic system that feels intolerable. The cost of living has been rising globally without a commensurate rise in wages for most people, while an increase in interest rates has forced many governments to divert a substantial share of their revenues to servicing debt, eroding spending on already underfunded public services like health care and education (Saadoun 2024).

The refusal by the South African monetary policy authorities to reduce the country’s real repo rate to the levels that existed prior to the Covid-19 pandemic has become a source of increasing frustration amongst consumers, businesses, trade unions and spokespersons for economic sectors that have been hardest hit by the record high interest rates over the past three years. 

Despite a measure of normalisation of price pressures that has been experienced in all AEs and many EMDEs, as well as negative GDP growth in several EU countries during the second quarter of 2025, central banks have been loath in reverting to accommodating monetary policy – resulting in rising pressure from groups across the political and economic spectrum. Notably, real GDP decreased at an annualised rate of 0.5% in the US during the first quarter of 2025, marking the first quarterly contraction in three years. Following a measure of financial market volatility in the US in August 2024, calls to reverse the interest rate hikes became louder and broader as investors and businesses joined many economists and advocacy groups in the effort to convince the Federal Reserve that interest rate cuts are long overdue.

These sentiments are shared by most AEs and EMDEs. In an address to a media conference held on 6 August 2024, Michele Bullock, the Governor of the Bank of Australia was candid enough to acknowledge that the use of higher interest rates to curb inflation was causing a measure of distress amongst consumers and businesses. She acknowledged that many households and small businesses in Australia that were struggling with interest rates at their current levels. Despite also stating that the country’s high interest rates were hurting everyone, particularly people on lower incomes, Me Bullock declared that restrictive monetary would remain in place until further notice. In South Africa, the current real prime lending rate remains more than 100% higher than between 2010 and 2015, when the economy expanded at an average real rate of 2.6%.

12 INFLATION THRESHOLDS –

DEVELOPING COUNTRIES

12.1 Study by Nell (2023)

To identify whether there is a non-linear relationship between per capita income growth and inflation, Nell (2023), has summarised 14 different studies for developed and developing countries, based either on GDP growth or GDP per capita growth as the dependent variable and using panel data. These empirical studies were conducted between 2001 and 2022 and 12 of them also incorporated investment as a control.

The evidence for developing countries confirms a positive and statistically significant effect of inflation on economic growth up until relatively high thresholds that range be­tween 6% and 21%. This is in contrast to the results for developed countries, where most empirical studies found that the effect of inflation on growth up until 1%-5% was positive and statistically significant. Nell (2023) points out that it would be a fallacy to conclude that disinflationary policy was costless in terms of output and employment losses, and that restrictive demand-side measures could be justified to reduce the welfare costs of inflation.

Such a view, however, disregards the underlying reason why the threshold inflation rates of 6%-21% in developing countries are much higher than in developed countries, namely because structural sources of inflation are more dominant in underdeveloped economies. These include:

• Supply bottlenecks between expanding and contracting sectors.

• Foreign exchange bottlenecks.

• A relatively underdeveloped agriculture sector.

• A widening budget deficit from autonomous increases in food prices.

Furthermore, an overview of the empirical evidence for African countries suggests that structural and cost-push sources of inflation tend to dominate monetary factors (Nell 2018; Durevall et al. 2013).

Most inflation-growth studies reviewed by Nell (2023) include investment as a control variable. In most of these studies the investment variables are positive and statistically significant, implying that inflation affects the productivity of investment. This finding is entirely consistent with models that predict a direct channel from inflation to investment, once it is recognised that mild demand inflation affects the composition of total investment, with shifts out of inventories and residential investment into productive machinery, struc­tures and plant.

12.2 Study by Meyer and Hassan (2024)

The results of the comprehensive literature study conducted by Nell are aligned with another study conducted by Meyer and Hassan (2024), which assessed the linkage between inflation and economic growth in South Africa to determine the optimal inflation rate threshold for sustainable growth of the economy. The study pointed out that, since 2019, the gap between the official central bank interest rates of South Africa and the US has narrowed, which typically causes a higher outflow of capital from South Africa, whilst also leading to rand exchange rate weakness. This occurred between 2019 and 2024, with South Africa’s currency depreciating by 21% over these five years.

Utilising autoregressive distributed lag (ARDL) estimation technique for quarterly data spanning the first quarter of 1995 to the third quarter of 2022, the threshold that changes the direction of the linkage between inflation and economic growth in the long run was determined at 6%. As an alternative to the ARDL estimation, a threshold regression was also conducted by ordinary least squares (OLS) methodology, which produced the same result. In summary, the study provides support for maintaining an optimal inflation level within the inflation target range of 3% to 6%.

12.3 Study by Bonga-Bonga and Lebese (2019)

Inflation targeting has been widely criticised as an inappropriate element of a monetary policy framework for developing countries, mainly due to the fact that they are more susceptible to the negative effects of external shocks, as well as bouts of uncertainty amongst international investors regarding their political and economic stability. It is in this vein that Bonga-Bonga & Lebese (2019) assessed whether the 3%-6% inflation target is the optimal inflation target band in South Africa. Their research followed the methodology developed by Ball & Mankiw (2002), which rests on the premise that there is a short run trade-off between inflation and unemployment. Their paper utilised an expectations-augmented Phillips curve to estimate a time-varying non-accelerating inflation rate of unemployment (NAIRU) for South Africa from 1980 to 2015.

The results of the empirical analysis indicate that, if South Africa were to put in place an inflation target range based on the NAIRU, it would have to target an inflation range that is considerably broader than the current one, with an upper level of 11.5%. The policy implication of these findings is that the SARB should think about revising its current inflation target, as it is too narrow for an emerging market economy. The paper concludes that the current relatively low inflation target range could have a negative effect on output and unemployment in the country. The study recommends that the SARB should rely on the realities of the South African economy rather than on external concerns when defining the range of inflation target (a view that is shared by several other economists).

12.4 Money supply endogeneity

In addition, there is growing evidence that the money supply in developing economies is endogenously determined (Vera et al. 2022). It is important to reiterate that money supply endogeneity does not necessarily mean that monetary policy is ineffective in controlling inflation, but rather that central banks may choose to accommodate structural and cost inflation, otherwise slow growth and high unemployment may well be the inevitable outcomes.

But the more fundamental policy issue is to recognize that structural inflation and, to a lesser extent, cost inflation, are the natural and unavoidable outcomes of the growth and development process in developing economies. To reduce structural inflation with restrictive demand-side policy measures is to impair growth, even in developing countries where the inflation effect is insignificant below the threshold. The only way to squeeze structural inflation out of the system without harming growth is to design measures that directly address the rigidities in the real economy.

13 THE STRATEGIC IMPORTANCE OF

EMPLOYMENT CREATION

13.1 Virtuous circles of prosperity and opportunity 

Economic growth and employment creation are widely regarded as the most powerful instruments for reducing poverty and improving the quality of life, especially in developing countries. Both cross-country research and country case studies provide overwhelming evidence that rapid and sustained growth is critical for progress towards the 17 Sustainable Development Goals (SDGs), which were formulated by the United Nations in 2015 and unanimously adopted (replacing the Millenium Development Goals).

The strategic importance of job creation features in one of the SDGs, namely, to create conditions for sustainable, inclusive and sustained economic growth, shared prosperity and decent work for all (formulated as goal number eight). Three of the targets identified under this goal that are highly relevant to the macroeconomic policy objective of employment creation are:

• The promotion of development-oriented policies that support productive activities, decent job creation, entrepreneurship, creativity and innovation, and encourage the formalization and growth of micro-, small- and medium-sized enterprises, including through access to financial services

• The achievement, by 2030, of full and productive employment and decent work for all women and men, including for young people and persons with disabilities, and equal pay for work of equal value

• The substantial reduction, by 2020, of the proportion of youth not in employment, education or training

According to the United Nations (2015), employment-led growth can generate virtuous circles of prosperity and opportunity. Jobs provide incentives for parents to invest in their children’s education, from the primary level through to tertiary and vocational training. To the extent that this fosters the emergence of growing group of entrepreneurs, it should also generate pressure for improved governance. Strong economic growth therefore advances human development, which, in turn, promotes economic growth. Despite the economic headwinds from the Covid-19 pandemic, global unemployment hit a historic low of 5 per cent in 2023, projected to decline further to 4.9 per cent in 2025 (United Nations 2025.)  Persistent roadblocks nevertheless remain in achieving progress with formal employment in developing countries. In sub-Saharan Africa and Central and Southern Asia, nearly 9 in 10 workers are informally employed.

In an estimation of sector-specific GDP-employment elasticities based on data from 2000 to 2016, conducted by Burgi et al. (2024), South Africa fared quite well for the job creation potential in the services sectors, with a ranking of 27^th out of 127 countries. Unfortunately, South Africa was ranked fifth lowest for the capability to create jobs in manufacturing, with a negative reading.

The challenge for policy is to combine growth promoting policies with policies that allow the poor to participate fully in the opportunities unleashed and so contribute to that growth. This includes policies to improve labour market expansion and mobility and to increase financial inclusion, both of which can be greatly facilitated by a modestly expansionary monetary policy.

Economic growth generates job opportunities and hence stronger demand for labour, the main and often the sole asset of the poor. In turn, increasing employment has been crucial in delivering higher growth. Strong growth in the global economy over the past 10 years means that most of the world’s working-age population is now in employment. At the same time, in every region of the world and particularly in Africa, youth unemployment is a major issue. This is reflected in higher-than-average unemployment rates: young people make up 25 per cent of the working population worldwide but 47 per cent of the unemployed.

Between 1999 and 2003, for every one percentage point of additional GDP growth, total global employment grew by 0.30 percentage points – a drop from 0.38 for 1995 to 1999. This may prove a problem for some countries in the Middle East, South Asia and sub-Saharan Africa, where the number of jobs being created may not be high enough to absorb their growing workforces. This suggests a stronger rationale for a higher growth strategy in the future.

13.2 The scourge of unemployment

The financial, budgetary and economic effects of unemployment are profound. Many of those who leave the workforce unwillingly do not have the resources for a comfortable and long retirement. The price paid by society is increased income support, health and community support costs and a reduction in human capital and productivity. Entrenched unemployment results in a divided nation where those with jobs benefit from economic growth while those missing out may be relegated to secondary status. The potential for societal conflict is raised in the presence of a growing mismatch between those with decent jobs and the unemployed.

Unemployment is a multi-dimensional scourge. It can have a devastating impact on people’s lives, affecting not only the unemployed person but also family members and the wider community. The impact of unemployment can be long-lasting. As unemployment becomes more long-term, its impact becomes more far reaching, often affecting living standards in retirement, whilst the loss of income by parents can damage the prospects of the next generation.

The economic loss to the individuals and their family members cannot be overstated. In the short-term, unemployment significantly reduces a person’s income and, in the long-term, reduces their ability to save for retirement. It eliminates both the pension fund or provident fund contributions of both the employee and the employer. It should also be pointed out that the longer a person is unemployed, and the earlier they retire, the greater the adverse financial effect of unemployment.

From a fiscal perspective, any permanent increase in unemployment reduces current and future tax revenues and, in some cases, has a secondary negative effect through increased welfare expenditures. Due to the loss of income, private consumption expenditure, which is the key driver of demand and GDP in all of the world’s advanced and emerging economies, is also lowered. As part of a study into the financial and fiscal consequences of unemployment, the Boston Consulting Group (2000) found that  failed termination-back-to-work transition that ends up in a stint of long-term unemployment costs society in the order of $50,000 to $150,000 per episode, depending on the age, salary level and family circumstances of the worker whose employment is terminated. In South African currency terms at the exchange rate on 20 August 2025, this translates into a range of R570,000 to R1.7 million.

Higher unemployment levels also have a negative impact on a country’s economic growth. This occurs primarily because of the elimination of the value added by the persons who lose their jobs and, secondly, via lower consumption expenditure as a result of lower disposable incomes.

Figure 16: Unemployment rate in South Africa (broad definition)

(Source: Stats SA)

High unemployment is often cited as the most pressing socio-economic problem facing South Africa, especially due to its debilitating effects on the aggravation of poverty and inequality. Unfortunately, the country’s monetary policy stance since 2015 does not reflect this concern, with broadly defined unemployment having increased by 30% over the past decade (see figure 16).

13.3 Far-reaching negative psychosocial impact

In addition to employment serving as a cornerstone for economic subsistence, it also plays a critical role in shaping individuals’ social, psychological, and community well-being. Consequently, as pointed out by Nvo- Fernandez et al. (2025), job loss has far-reaching implications, affecting the physical, psychological, and social domains. Despite cyclical and structural changes to the performance of the global economy, unemployment consistently remains above 5% worldwide, reaching nearly 7% during the 2020–2022 pandemic, according to World Bank data (2023). This rise in unemployment rates has been closely linked to a significant deterioration in mental health, increasing the risk of conditions such as anxiety, depression, and other psychiatric disorders.

The psychosocial impact of unemployment is well-documented. Previous studies have shown that job loss significantly increases psychological distress among affected individuals. Notably, Gedikli et al. (2023) reported that unemployed individuals with limited financial resources are at a heightened risk of experiencing severe psychological distress. This finding underscores the relationships between unemployment, economic constraints, and mental well-being, highlighting the magnitude of the impact on vulnerable groups. Moreover, mental health issues not only emerge as consequences of unemployment but also act as barriers to reemployment, perpetuating a cycle of poor mental health and unemployment. Prolonged unemployment exacerbates vulnerability, with depression rates reaching 50% among individuals who have been unemployed for over 12 months (Nvo- Fernandez et al. 2025).

13.4 Employment losses in the UK

• Via the property channel

Substantial evidence exists that different types of firms react heterogeneously in response to a change in monetary policy. Dimensions such as turnover, total employment, economic sector, leverage, and liquidity are contributing factors to a firm’s reaction to a change in interest rates (Cloyne, J. et al. – 2018). As these dimensions are typically proxies for financial constraints, the inference that has been drawn in the literature is that the firm-level heterogeneity arises from financial frictions and, as a result, monetary policy transmits to activity through altering financial constraints at the firm-level. Research by Bahaj et al. (2022) finds that the employment adjustment to monetary policy is considerably more prominent and also large amongst firms that are younger and more leveraged than for older and less leveraged firms. This heterogeneity becomes even more pronounced for firms whose collateral value, specifically the house value of their directors, is more sensitive to monetary policy. This finding is mirrored by the response of corporate debt to monetary policy shocks.

The main result of the research is that the heterogeneity in firm responses depends both on firm-level financial constraints and the shifts in these constraints induced by monetary policy. First, within the younger and more-levered group, employment responds significantly more for firms whose directors live in local areas where house prices are most sensitive to monetary policy. The impact of rising interest rates therefore also has a residential property channel, with real estate sensitivity joining corporate debt, working capital, and fixed assets as another factor that is significantly influenced by changes to monetary policy.

A simple counterfactual exercise conducted by the research, omitting general equilibrium effects, shows that the two-year aggregate employment response of financial constraints imposed by restrictive monetary policy would be worsened by 13% if all directors lived in areas with the lowest sensitivity of house prices to monetary policy, suggesting the aggregate importance of this channel. When younger and less-leveraged firms are faced with increases in the cost of capital and start facing financial constraints, it may be concluded that these constraints are worsened by negative asset price movements and that unemployment will increase.

• Survey results confirm lower employment

Businesses play an important role in the transmission of higher interest rates via restrictive monetary policy to the economic activity. This includes direct negative effects on investment and employment in response to higher borrowing costs, as well as indirect effects via weaker aggregate demand, which usually lead to lower growth and a further increase in unemployment. The corporate sector may also amplify the impacts of interest rates on the financial system if a significant number of firms become insolvent or lenders become distressed.

Using data from a survey of firms, Shah et al/ (2024) studied how the UK corporate sector is being impacted by the significant and rapid increase in interest rates since 2021. The Decision Maker Panel (DMP) survey is a collaboration between the Bank of England and academics from King’s College London and the University of Nottingham surveying Chief Financial Officers from around 2,500 firms. The DMP is unique in providing insights into firms across a broad range of sectors. Between November 2023 and January 2024, firms in the DMP were asked questions about how changes in interest rates since the end of 2021 (both on existing and new borrowing as well as on deposits) have impacted their sales, capital expenditures, and levels of employment.

Figure 17: Average firm estimates of higher interest rates impact on sales, employment, and investment in the UK

(Source: Shah, et al. – 2024)

At the aggregate level, firms reported, as of 2023 Q3, that higher interest rates have resulted in 8% lower capital expenditure than would have been the case if interest rates had remained unchanged. They also report that their sales were 4% lower, and that the number of workers they employ is 2% lower, as illustrated by figure 17.

13.5 The role of private sector investment

Public finance alone cannot deliver the investment necessary to develop an economy with a vibrant private sector that creates jobs and sustained growth. After all, as determined by the World Bank Group (2025), the private sector accounts for 90 percent of jobs in developing countries. The private sector also needs to be mobilised as part and parcel of a comprehensive policy initiative designed to catalyse entrepreneurship, competition, and, ultimately, the demand for labour. But an adequate level of private sector investment will only occur when the conditions are right and where a clear probability of a positive return on investment exists.

One of the common themes in various analyses of the strategies required for increasing employment in developing countries, especially in Africa, is related to removing barriers to small and microenterprises. One such barrier is the difficulty in obtaining credit and access to the finance required for working capital (ILO 2012). The overarching economic function of a lending institution is the enhancement of the swiftness with which economic transactions take place. Their unique contribution in reducing the inconveniences, costs, risks and term structure incompatibilities of direct liaison between lenders and borrowers translates into a higher level and more rapid flow of funding for real economic activity, where GDP is generated and where jobs are created.

The ability of small businesses to secure working capital is directly related to a country’s benchmark lending rate. The higher the lending rate, the higher the cost of capital, which acts as a disincentive for investment in new productive capacity and, as an inference, on growth and employment creation. The positive relation between unemployment and the level of interest rates is well documented, as discussed in Meyer (2017), as well as in more detail in subsequent sections.

14 HIGHER LEVELS OF INEQUALITY

Although changes to interest rates have undeniable distributive consequences, the income distributive channel has not been subjected to the same volume of scholarly research as conventional studies of the effects on price stability, output and employment. Nevertheless, the relationship between monetary policy and income distribution has recently emerged as a topic of renewed interest, especially due to the threat to socio-political stability of high levels of income inequality, especially in EMDEs.

Central bank policies based on an inflation-first approach carry important consequences for income distribution, as identified by Rochon (2022) and Borio (2021), who has coined the phrase ‘The ‘Distributive Footprint’ of monetary policy. Lavoie (1996) has stated that monetary policy should be designed in such a way as to find the level of interest rates that will be proper for the economy from a distribution point of view. The aim of such a policy should be to minimize conflict over the income shares of the labour force, in the hope of also keeping inflation low and maintaining a high level of economic activity.

Despite empirical evidence supporting the weakness of automatically resorting to higher interest rates when inflation increases, most central banks have in recent years pursued a restrictive monetary policy approach, using interest rates as a blunt instrument, and raising them repeatedly until economic growth started faltering in many economies. Between 2022 and 2024, the US proved to be a notable exception with average annual GDP growth of 2.7%, but this was made possible by expansive fiscal intervention in the form of an estimated $5.6 trillion in federal tax cuts and so-called stimulus checks to taxpayers (known as the Biden plan).

Measured by the Gini coefficient, which is widely used to determine the wealth or income inequality in a country, South Africa is ranked as having the lowest level of income equality in the world. Abundant literature confirms the positive impact of employment creation on achieving a more balanced level and higher level of income and wealth distribution, including research by Zore (2024), Schoeman (2025) and Fortuin, et al. (2022),

The mathematics underpinning the important role of employment creation in lowering income inequality is straightforward. In virtually every developing country, including South Africa, social security programmes (SSPs) are the domain of government, especially those related to welfare payments. For every formal sector job that is created via relevant macroeconomic policies, the fiscal authorities benefit in two ways: Firstly, there is one less grant that needs to be paid and, secondly, there is one more taxpayer that contributes to the fiscal resources necessary to implement SSPs.

It stands to reason that a central bank, as the implementing agency for monetary policy, wields considerable influence over an economy’s ability to match growth and employment creation policies with the overall priority afforded to a government’s economic policy objectives. In this regard, it is illuminating to consider the recent research by Zore, which examined the causal effect of monetary policy on income inequality in emerging economies using a dynamic panel analysis with the Generalised Method of Moments (GMM). The sample consisted of 46 emerging economies (including South Africa) from 2000 to 2018. The results indicate that restrictive monetary policies contribute to an increase in income inequality. It is noted that these policies have a minimal impact on income distribution until the third year after their implementation, indicating a delayed effect on inequality.

Fortuin et al. (2022) examined how macroeconomic policies influenced wealth inequality in South Africa over the period 2010 to 2019 using a behavioural life-cycle model. The results show that the South African government’s current policy model to redirect wealth via grants from a very small tax base is unable to meet wealth redistributive targets.

A key recommendation is that government should rather switch to creating an environment in which private enterprises are able to absorb the labour capital that South Africa possesses. An open labour market would support private and foreign direct investment into the economy, thereby strengthening economic growth and upliftment through increased income and the consequent ability to accumulate wealth.

In a discussion of the roots of inequality in South Africa, Schoeman (2025) notes that South Africa’s rising unemployment, ongoing pay gap, and deep-rooted inequality stem from a mix of historical, economic, and structural factors. The country’s exceptionally high unemployment rate has been caused mainly by slow economic growth over the past decade.

Most empirical findings on the impact of interest rates on income redistribution point to the conclusion that either expansionary monetary policy decreases inequality, or that contractionary policy increases income inequality, as discussed in more detail by Kappes (2023). An important finding that appears in the work of Furceri et al. (2018), is that contractionary monetary shocks have statistically significant effects on income distribution, while expansionary shocks effects are not statistically different from zero. This points to long-run distributional consequences, since the impact of changes in interest rates do not net out over the business cycle.

Monetary policy entails a choice over which objective is more important – low inflation or job creation via incentivising higher levels of capital formation and economic growth. Under the current socio-economic circumstances and based on the evidence provided in this section, it seems clear that the monetary authorities have neglected the latter policy objective – at a huge cost that includes growing unemployment and a higher level of income inequality.

15 GLOBAL INFLATION LARGELY UNDER

CONTROL 

According to the July 2025 World Economic Outlook Update by the IMF, core global inflation has eased considerably and is now below 2 percent (see figure 18). Despite cross-country differences, global headline inflation is expected to fall to 3.6% in 2026. Tentative signs of marginally higher inflation have appeared in the US, mainly due to a weaker dollar and higher import tariffs, affecting some import-sensitive consumer categories (IMF 2025).

According to Regmi (2024), the rationale for maintaining high interest rates in order to curb inflation seems increasingly outdated. In most countries, inflation has largely returned to levels within or close to target ranges/points, which has eliminated the data-driven rationale for keeping interest rates high.

Figure 18: Annual inflation rates - US, Euro area and East Asia

(Notes: 5-year averages until 2021; forecasts for 2025)

(Sources: European Central Bank; East Asia Development Bank; Statista)

It should also be pointed out that inflation target ranges were never designed to ignore the downside of restrictive monetary policy, namely lower demand, lower growth and higher unemployment. The option for flexibility in targeting inflation remains open – at all times, as inflation target ranges are not legislated and may be altered at the discretion of central banks.

Furthermore, it should be noted that most of the inflation reduction that has occurred since 2024 was a result of the normalisation of supply chains due to much lower freight shipping charges and oil prices. Demand-side pressure was not the culprit in the post-pandemic rise in price indices, making the need for the Fed’s initial rapid tightening with higher rates - and continued tightening - questionable. According to Regmi (2024), expectations of a further cooling of the labour pipeline in the US has made it necessary to correct the course of monetary policy, given the lags with which monetary policy operates.

16 BENEFITS OF MILD INFLATION IN

DEVELOPING COUNTRIES

Various economic research studies have emphasised the benefits of an element of demand inflation during the process of economic development, most notably Thirlwall (1974) and, more recently McCombie (2023). A key premise of this theory is that the growth ben­efits of mild inflation come from demand inflation instead of structural or cost-push inflation. Structural inflation is the unavoidable outcome of the growth and development process itself. To reduce structural inflation through restrictive demand-side policy measures would be to impair growth, as has been vividly demonstrated in several key EMDEs in the aftermath of the Covid-19 pandemic.

16.1 Growth via stimulating demand

In its simplest form, the growth effect of demand via the Thirlwall model (Nell and Thirlwall 2018) implies that the growth rate of supply is endogenous to the growth rate of demand through static economies of scale associated with large scale production techniques and lower average production costs, as well as dynamic economies of scale from a faster rate of capital accumulation, embodied technical progress and learning-by-doing ef­fects. Formally, Setterfield (2006) shows that the growth rate of supply adjusts to the growth rate of demand through a rise in the so-called Verdoorn coefficient. The latter is based on the existence of a positive statistical relationship between the growth rate of labour productivity and the growth rate of output in the industrial sector, with causality running from the latter to the former.

A more detailed examination of the Kaldor-Thirlwall model of forced saving and the inflation tax mod­el reveals the way inflation finances fixed investment by businesses and faster economic growth. This can occur if the Central Bank decides to implement more expansionary demand-side policy measures and operates as follows:

• The initial response of the private sector to the demand-side stimulus is to raise planned investment relative to planned savings to match the increase in demand for goods.

• Excess demand in the product market generates inflation, which redistributes income from wage earners to profit earners through a fall in real wages.

• If the marginal propensity to save out of profit income exceeds the marginal propensity to save out of wage income, the aggregate saving ratio rises.

One of the implications of tolerating a relatively mild rate of inflation in the economy is that real wages do not necessarily decline. It also means that a faster rate of capital accumulation through inflationary finance may reduce structural unemployment in capital scarce developing economies (Thirlwall 1974).

Another benefit from mild inflation that emanates from a money-financed fiscal deficit is the reduction in the cost of borrowing through lower real interest rates, which then act as stimulus to investment (Galí, 2020). The Keynesian approach further emphasises that the nominal rate of return on investment in physical assets, such as machinery and equipment with embodied technical progress, tends to rise with inflation. Mild inflation, therefore, encourages investment in productive physical assets to maintain profitability relative to money assets, hoarding, inventories and more speculative activities (Nell 2023).

16.2 Foreign exchange constraints can be overcome

One of the biggest obstacles to a successful policy of inflationary finance is an economy’s balance of payments, as acknowledged by Thirlwall (1979). Nell (2023) provides evidence from substantial research on this topic to show that a policy of inflationary finance can be reconciled with the balance-of-payments-constrained growth model, provided that the demand-induced inflationary finance policy is accompanied by sufficient foreign capital inflows to finance the current account deficit during the initial stages.

Since the fourth quarter of 2022, South Africa has enjoyed substantial net inflows on the financial account of the balance of payments and is on course for a ninth successive trade surplus in 2025. The country’s gold and foreign exchange reserves are also at a record high (see figure 19), whilst the real effective exchange rate of the rand is at its strongest level in more than a decade. These trends represent ideal circumstances to shift the emphasis of macroeconomic policy towards enhancing growth, development and employment creation.

Figure 19: South Africa's gold & foreign exchange reserves

(Source: SARB)

As pointed out by Nell (2023), the merits of money-financed government deficits to mitigate the recessionary conditions caused by the 2008-2009 global financial crisis and the Covid-19 pandemic have gained popularity. One of the main advantages of a money-financed deficit relative to a debt-financed fiscal stimulus is that the former involves no future debt obligations and is therefore more effective in stimulating aggregate demand (Agur et al. 2022).

A standard caveat in the application of inflationary finance as a policy option for streamlining development is the acknowledgement that excessive inflation can be detrimental to economic growth and development (Thirlwall, 1974). However, as pointed out by recent scholarly research, many standard textbooks and surveys on the topic tend to place the emphasis on the costs of inflation relative to the benefits of mild inflation and often ignore the fact that some inflation may be regarded as the inevitable outcome of the development process itself.

17 NEW-FOUND FLEXIBILITY WITH

INFLATION TARGETING

The practice amongst central banks to set numerical targets for the desired level of price stability, known as inflation targeting, has been around since 1990, when this monetary policy was first adopted in New Zealand. Most AEs have followed suit, but most developing nations have preferred to steer away from a policy that has profound pitfalls for economies with relatively small output levels and that are heavily dependent on international trade.

Despite its universal appeal amongst central bankers in post-industrial economies, the question of where exactly to strike the balance between official constraints and a measure of discretion remains unanswered. According to research by Borio and Chavaz (2025), policymakers and academics have worried about both too little and too much flexibility in the pursuit of an ideal framework for targeting price stability. Research by Eggertsson and Kohn (2023) has highlighted the fact that the optimal specification for an inflation targeting framework remains up for debate.

The study by Borio and Chavaz contributed to this debate by developing a new database of changes to inflation targeting frameworks since the regime's adoption to document systematically how the flexibility of frameworks has evolved. A sample of 26 central banks from both AEs and EMEs was utilised to determine, inter alia, the extent of flexibility in the design and application of inflation targeting. It is important to note that flexibility is here defined as the degree to which the framework tolerates fluctuations in (headline) inflation and allows for the pursuit of other macroeconomic objectives, specifically employment (or output) and financial stability.

To measure the degree of flexibility, the study constructed a range of quantitative indicators for each central bank and year. The information was drawn exclusively from official documents laying out formal objectives and how to make them operational. The analysis was similar in spirit to the construction of de jure indices of central bank independence or exchange rate flexibility developed by Romelli (2022) and the IMF (2004).

Two of the conclusions arrived at by the study are:

• While numerical targets have become stricter (e.g. points rather than ranges), greater flexibility has taken the form of less strict or longer horizons to achieve the targets and also greater weight on other economic policy objectives, especially employment and economic growth.

• These trends have typically been stronger in advanced economies, tending to widen differences with their emerging market peers

In 2012, Jeffrey Frankel of Harvard Kennedy School, called into question the role of inflation targeting in the face of asset bubbles and supply side shocks, suggesting that nominal GDP targeting should replace it. He points out that one reason for inflation targeting having gained wide acceptance during the end of the 20th century was the failure of its predecessor, exchange-rate targeting, in the currency crises of the 1990s, when pegged exchange rates had succumbed to fatal speculative attacks in many countries.

Proponents of a flexible approach to inflation targeting have been around for quite some time, including Svensson (2009), Blanchard et al. (2010) and Krugman (2012). In the 1990s, Krugman and Ben Bernanke actually advised the Bank of Japan to raise its inflation target, in order to get out of the country’s deflationary trap. The rationale was straightforward – when the nominal interest rate is close to zero, it becomes extremely difficult to lower the real interest rate (Frankel 2012).

In realising the predictable opposition from the central bank fraternity to the idea of even a temporary increase in the inflation target, Frankel (2012) points out that a relatively low nominal GDP target of between 4% and 5% over a one-year period would in effect incorporate a fairly low inflation target. According to Frankel’s research, nominal GDP targeting, unlike inflation targeting, would avoid the problem of excessive monetary tightening in response to adverse supply shocks. Nominal GDP targeting would assist in stabilising demand when supply shocks occur, which would prevent the possibility of stagflation.

These findings are highly relevant for the current debate on the inflation targeting regime in South Africa, as the MPC of the Reserve Bank has recently replaced the current target range of 3% to 6% by a target point of 3% with flexibility up to 4%. This decision has been widely criticised and runs counter to the latest international trends and could reduce flexibility to such an extent that output growth and employment creation could be seriously curtailed. The latter has already occurred as a result of zero de facto flexibility within the current target range.

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