Tuesday, 25 December 2007

The cost of money in the South African economy revisited

I am not an economist and make no claims to be one. I have an understanding of some elements of economic theory. I also believe that the policy of inflation targeting is generally correct.

In an earlier blog I suggested that high interest rates can in themselves be inflationary. Perhaps there is a point at which raising interest rates becomes counter productive.

I do understand that imported inflation fuels local inflation. Pressure is placed on suppliers to pass on the costs. Reducing aggregate demand by raising interest rates will reduce the inflationary pressure. The laws of supply and demand apply. The recent property boom was slowed dramatically by increasing rates. House prices have stabilised and perhaps even fallen as a result.

Higher interest rates also serve to make the local currency more attractive to foreign investors. This helps to strengthen the currency thereby reducing the extent and impact of imported inflation.

Under a previous governor of the Reserve Bank many years ago, interest rates soared to about 26% in a futile effort to calm inflation. It didn’t work. Is there a point at which high interest rates actually become inflationary? When the rate of interest becomes a significant cost factor can it contribute towards cost-push type inflation?

Another observation is that when we see interest rate changes in the US, these are usually in steps of 25 basis points. Our interest rate adjustments have all been at 50 basis points. Perhaps we should adapt a more cautious approach?


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