Three Cheers for Three Percent: Re-anchoring Expectations in the South African Macroeconomy

Daily Maverick

11-06-2025

The ongoing discourse surrounding a downward revision of the inflation target to a proposed point target 3.0%, has gained significant momentum following the May 2025 MPC statement. The Governor's language, suggesting such a change is nearing inevitability, reflects both technical, research-based consensus and evolving macroeconomic realities.
In this article I offer some empirical and theoretical rationale for such a policy shift, focusing on its implications for yield curve dynamics, term premia and macroeconomic performance, while anchoring the argument in some popular econometric decompositions of the 10-year nominal bond yield.
A cornerstone of the SARB's justification is the view that a lower inflation anchor promotes more favourable currency dynamics through both real and nominal channels. The SARB's own Quarterly Projection Model (QPM) simulations indicate that a credible downward revision of the target reduces expected inflation differentials with South Africa's trading partners, thereby fostering real exchange rate appreciation. A more competitive real exchange rate contributes to cheaper imported inputs, lowers domestic cost pressures, and ultimately deepens trade linkages.
This appreciation is not merely mechanical. It is conditional on perceived credibility. As the SARB's working papers on the topic reveal, markets respond to a credible policy signal by re-weighting expectations of future average inflation, risk premia (including term premia and inflation-risk premia), and macro-volatility. In a series of demonstrated scenarios, the SARB shows that a 3.0% inflation target lowers the probability of inflation overshoots, narrows the confidence bands around forward inflation projections, and supports an appreciation of the rand in equilibrium.
Such currency effects play a non-trivial role in aggregate demand dynamics. Lower expected inflation tightens the domestic-foreign interest rate spread via uncovered interest parity relationships and strengthens capital inflows. Notably, the Quarterly Projection Model includes a more complete uncovered interest parity condition that links real interest rate differentials, inflation expectations, and term premia. As fiscal credibility is enhanced and inflation is better anchored, the neutral real rate itself declines, supporting a more accommodative stance even as nominal policy rates remain unchanged.
From a debt sustainability perspective, the commonly voiced concern is that tighter inflation targeting could elevate real interest rates and suppress growth, thereby worsening debt-to-GDP ratios. However, this argument presumes static risk premia, and fixed growth dynamics. When explicitly modelling the feedback between the fiscal balance and macroeconomic variables, analysis reveals that lower inflation expectations reduce risk premia and debt-service costs, especially on long-dated sovereign debt. This attenuates the risk of a deteriorating debt path.
At the core of theoretical descriptions of the term structure of interest rates is the Expectations Hypothesis, which can be described somewhat informally by stating that the expected return from holding a long-dated bond of a given maturity should be the same as the expected return from rolling over a series of shorter-dated bonds for the same total maturity, or, more concretely, there should be no additional expected compensation (for example) priced in for the investor in a 10-year bond, than for an investor who embarks on a strategy to buy a series of 1-year bonds, rolling them over ten times consecutively.
Traditionally viewed within the framework of the expectations hypothesis, the term premium encapsulates deviations from the hypothesis as it accounts for the uncertainty surrounding future short-term interest rates and economic factors that might impact long-term bond returns. Therefore, term premia are pivotal for central banks and financial institutions, as they provide insights into market expectations and the risk landscape within long-dated securities.
Several competing econometric routines for term premia estimation have emerged in the relevant literature, but a particularly attractive one is that of Adrian, Crump, and Moench of the Federal Reserve Bank of New York, henceforth ACM. The graph below shows the decomposition of the 10-year yield into its constituent components using the ACM procedure: Adrian, Crump and Moench.
From the diagram shown, on the assumption of a shared market assessment of credibility regarding the SARB, by lowering the official inflation target, the average expected inflation (last node on bottom-right of diagram) will gradually move towards the communicated 3.0% level, pulling the overall 10-year bond yield down along with it, ceteris parabus. In addition, empirical literature reveals that the inflation risk premium (top-right of diagram) is lower in regimes where average expected inflation is lower. The inflation risk premium, is, informally, something of a 'hazard based' compensation which the market demands as protection for inflation that may spike at times when the marginal utility of consumption is high (economic downturns).
Moreover, the ACM framework and its associated literature empirically supports the view that term premia are sensitive to changes in the perceived stability of macroeconomic policy. The SARB's simulation exercises suggest that a more credible inflation target leads to tighter pricing of currency forward rates, lower volatility in excess returns, and enhanced arbitrage conditions across the yield curve. Such developments not only anchor inflation expectations but also reduce the expected compensation investors require for bearing duration risk.
The so-called 'sacrifice ratio', or the GDP cost of reducing inflation, is often invoked in policy debates. However, empirical estimates (such those provided by the SARB themselves) for South Africa suggest that this ratio is comparatively low. As they note, the transmission from policy rate increases to output is dampened by the weak investment multiplier and a limited credit channel. As such, the disinflationary cost of moving from 4.5% to 3.0% is modest, relative to long-term gains in lower macro-volatility, tighter risk premia, and a more stable fiscal outlook.
A further misconception is that a lower inflation target necessitates an uncomfortably higher path for the policy rate, and by extension, popular consumer credit rates. While this may hold mechanically in the short run, but interaction between central bank credibility, inflation expectations, and neutral real interest rates alters the equilibrium dynamics. In particular, the updated QPM includes a revised Taylor Rule that adjusts the policy stance not merely to inflation deviations, but also to movements in fiscal risk premia and global financial conditions. Under this richer framework, the policy rate need not increase materially to maintain a 3.0% inflation path.
An additional layer of support comes from external benchmarking. Compared to emerging market peers, many of whom operate with 3.0% or even 2.0% inflation point targets, South Africa's 4.5% midpoint appears uncomfortably high. A floating bar chart of inflation target ranges, reconstructed from a recent peer comparison, reveals South Africa as something of an outlier. In targeting a lower rate, SARB would be moving into alignment with countries like Thailand and Chile, jurisdictions with stronger currency performance and lower sovereign spreads.
Moreover, a lower inflation target enhances the SARB's ability to conduct countercyclical policy. As the lower bound on nominal interest rates becomes less binding, the central bank gains more policy space to respond to adverse shocks. This is particularly valuable in a global environment of volatile capital flows, asymmetric shocks, and rising geoeconomic fragmentation.
In the context of South Africa's high unemployment and fragile growth, the case for 'expansionary disinflation' may seem counterintuitive. But as the SARB working papers stress, credible disinflation raises expected returns to investment, reduces the cost of capital, and improves budgetary outcomes by lowering interest burdens. In this sense, disinflation becomes a mechanism for reducing real distortions rather than amplifying them.
One of the clearest benefits of improved inflation credibility is its impact on wage and price setting. Lower forward-looking inflation expectations enter directly into the wage bargaining process. This contributes to more stable unit labour costs, improved competitiveness, and less risk of cost-push spirals. These real effects are substantial and accumulate over time.
Fiscally, the gains are self-reinforcing. As nominal GDP stabilises and interest payments fall, the primary balance improves. This reduces the borrowing requirement, compresses sovereign spreads, and ultimately reinforces the very dynamics that sustain the new inflation target. The SARB's internal simulations show that under a 3.0% objective, debt/GDP remains stable or declines in the outer years, which is an outcome driven not by fiscal consolidation, but by improved macro stability.
A final benefit is reputational. Central banks that deliver on ambitious but credible targets enhance their standing in international capital markets. The rand's volatility, an enduring concern for global capital allocators, is dampened by tighter inflation targeting, improving the appeal of rand-denominated assets. The ACM research literature and associated yield decompositions confirm that a lower inflation target leads to flatter term structures and narrower risk premia.
In conclusion, the move to a 3.0% inflation target constitutes a structural enhancement to South Africa's macro-financial framework. It tightens the link between policy credibility and financial market outcomes. Far from suppressing growth or worsening fiscal conditions, it unlocks a virtuous cycle: lower inflation expectations, stronger currency, reduced premia, and enhanced trade competitiveness. The SARB's own models, supported by international evidence and term structure theory, affirm that this path is not only feasible, but desirable. DM
Author: Reza Ismail, Head of Bonds at Prescient Investment Management
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