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Economy
Wednesday, August 1, 2007
Causing inflation

I still think the Reserve Bank’s interest rate policy is screwball. They are trying to control inflation by raising rates – maybe on the premise that borrowings will reduce and that this will slow down the money supply. But I still don’t understand it. To my mind higher interest rates actually cause inflation.

Doesn’t it stand to reason?
Interest is simply the price of money. You pay R4, say, to get some oranges; and you pay, say, R15 to get your hands on a R100 loan – that’s the kind of principle. Inflation is caused by a ‘general rise in the level of prices’. So if the cost of oranges goes up that’s not inflationary, but if all food and all goods and services generally increase then that’s inflation. And since money is everywhere, increasing the price of that one commodity, that is money, is actually a general increase in the price and is therefore inflationary.
In any case, what do the authorities think someone is going to do whose existing cost of debt has increased by, say, R2 000 a month (in just a year)?
Obviously he is going to pass it on to the next man (it’s the same if a fruiter gets charged more for the supply of oranges; he is going to pass it on to his customers).
Anyway, back to our example, since he has to pay income tax on earnings he will have to gross up the cost increase of R2 000 to, say, R2 700. And since price increases attract VAT then the government will collect a further 14% tax on top of that for a gross price of R3 078. If that isn’t inflation then I don’t know what is. And I really don’t see how increasing the price of something (money) is going to reduce inflation; surely it is going to contribute to it?
Since June 2006 the SA Reserve Bank Repurchase rate has been increased five times, by a total of 2,5 percentage points from 7% to 9,5%. Prime bank lending rate, which is pegged 3,5% above the repo rate is now 13%. Hopes have been dashed that the rate will ever enjoy single digit figures — it was last below 10% on 23rd January 1981 — it’s tragic.
Why is this; indeed why are South African rates so much higher than global rates and have been on a persistent basis. It’s a question I can’t yet answer. But let’s look at an example of an actual bond — I can work that out.
A R1m bond at 2% below prime has risen from 8,5% to 11% in little over a year. Let’s look at the cost implications. A 20-year mortgage bond for this amount originally cost R8 678.23 a month, now rising to R10 321.88, or by 18,9% (a price increase of R1 643,65). That’s real inflation for you!
The hard-hit bondholder now needs to recover that cost somehow, as we touched on earlier, either by getting a salary increase or if he’s in business by putting up his prices. Either way he needs to gross up by about 35% to cover government company/income tax, so his earnings rise R2 218,93 per month. Since sales attract VAT, the customer will pay another 14%. So the net effect comes to a rise in cost per month of R2 529.58. On the original bond cost that’s an increase of 29.15% to R11 207.81.
Now I know this is playing around with figures but it simply illustrates that an increase in interest rates is inflationary, not deflationary.
I recall previous Governor of the Reserve Bank, Chris Stals held the economy to ransom with his ill-advised monetary policy along the same lines. You constantly felt that nothing could get going.


If I was a cartoonist I’d draw an economic engine with Mr Mboweni trying to smash it up with a sledge hammer shaped like an interest rate symbol. In the words of Phineas Fogg he needs to reassemble his faculties.
You can’t control inflation (reduce the rate) by increasing interest rates. If anything it achieves the opposite in the long run. Higher interest rates might curb borrowing longer term, but it also depends on the nature of the debt. At best it is a blunt instrument that has too many adverse side effects. Essentially, inflation is caused by too much money chasing too few goods and services. A local shortfall can be supported by importing the difference, but this may cause stress on the balance of payments.
Increasing the rate on a bond does not reduce the supply of money, but in fact entrenches its existence because it is harder to pay back.
High interest rates are also not good for capital formation; it increases the cost of money and can make alternative investments more attractive than building machinery to make the engine-room of the economy work better. Without much faster and higher capital formation, South Africa will continue to lag behind in creating exportable goods, in creating jobs and in creating wealth. One way around this might be to increase the return on capital, which is another way of saying that manufactured output prices would need to be increased, and that’s also inflationary! By Nigel Benetton
 

Copyright © Insurance Times and Investments® Vol:20.7 1st August, 2007
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