SA cannot afford increased interest rates - BoE Private Clients

According to the financial institution's latest domestic market overview, the economy would rather benefit from easier monetary policy.

"As such, we were disappointed by the focus of the last Monetary Policy Committee statement, on potential future inflation," says Sessions. The focus on inflation, despite very poor growth prospects, seems ill-conceived when the inflation mandate was thought to be better for growth.

"The economy remains volatile and estimates are that we will not see growth in excess of 2% in the near future. To achieve sustainable consumption growth, it is essential that interest rates remain stable and inflation low. It is also essential that policy makers reduce certain risks - policy, political, macro and legal risks - to reduce the cost of capital, which is a key factor of production."

Regulatory restrictions must be removed

Sessions says that to allow the economy to put scarce resources to productive use, the cost of doing business has to decline. "This includes the removal of regulatory restrictions that artificially increase the cost of input and thereby the cost of production. There also needs to be the promotion of economic freedom and flexibility that allows resources to flow from less productive areas to more productive ones."

While higher interest rates could potentially lead to a more labour intensive economy, as suggested by Finance Minister Pravin Gordhan last year, such an economy would be smaller than the current economy with both less labour and capital employed productively. "Simply put, by raising the cost of capital, without reducing the cost of labour, all production becomes more expensive. Furthermore, the rising cost of goods and services leads to a shrinking economy as real incomes and wealth decline. The result is an increased project cost which impacts negatively on profitability and serves as a disincentive to investment, ultimately reducing the size of the potential economy."

Prices will be regulated by market forces

The Reserve Bank can only control inflation caused by excess demand. As there is currently little to no evidence that the economy is suffering from excessive demand, it makes little sense to raise rates. Any sectors of the economy that may experience rapid inflation will suffer slower growth. As a result of this negative effect on volumes, the rise in prices will be limited. The resulting effect will be that the prices are regulated by market forces without the need for interest rate intervention.

"Given the already poor growth prospects for the economy, the Reserve Bank would therefore do more for sustainable growth through lower interest rates than worrying about the possibility that inflation may become entrenched in the economy," she concludes.