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High unemployment requires 1,4% reduction in prime rate

Any premature increase in the repo rate will exacerbate already dire employment situation

Had South Africa been targeting both unemployment and inflation, as opposed to inflation only, the current prime interest rate of banks should be 7,6% instead of the current 9%.

Put differently, the prime interest rate of banks should be equal to the repo rate plus 2,1%, instead of the repo rate plus 3,5%. Alternatively, should the margin of 3,5% between the repo rate and the prime rate be maintained, the repo rate should drop to 4,1% from the current 5,5%.

This is the finding of researchers from the Bureau of Market Research (BMR) at the University of South Africa, commissioned by the trade union UASA.

The research, undertaken by Prof Carel van Aardt and Johann van Tonder at the BMR, is based on the Rudebusch Equation developed by dr. Glenn Rudebusch, senior vice-president of the Federal Reserve Bank of San Francisco in the United States of America. The equation, which targets both unemployment and consumer price inflation in order to determine the optimal prime interest rate, was customised by the BMR for South African circumstances.

“The inclusion of unemployment in the inflation targeting framework is the main reason for the optimal prime interest rate of banks being lower than the current prime rate,” says Van Aardt and Van Tonder (please refer to Table 1 for a summary of labour market indicators).

Table 1: Labour Market indicators

 

Employed ('Million)

Unemployment rate

Expanded unemployment rate

Absorption rate

Q4 2010

13.132

23.96

32.38

40.80

Q1 2011

13.118

24.96

33.43

40.60

Source: Statistics South Africa: Quarterly Labour Force Survey

However, the researchers point out that interest rates are experiencing upward pressure. This is primarily due to consumer price inflation increasing at a faster pace than the unemployment rate (please refer to Table 2 for an indication of the drivers in the consumer price inflation rate).

Table 2: Drivers of the Consumer Price Index (CPI)

 

CPI

(%)

Goods

(%)

Non-durable goods

(%)

Food

(%)

Services

(%)

Administered prices

(%)

End Q4 2010

3.5

2.0

4.4

1.5

5.1

8.5

End Q1 2011

4.1

3.6

6.7

5.0

4.6

10.9

Source: Statistics South Africa: Consumer Price Index

The research shows that both the consumer price inflation rate and unemployment rate (official and expanded) are expected to increase over the forecasting period to Q1 2012 (Please refer to Table 3). However, as the increase in inflation is expected to happen at a faster pace than the increase in the unemployment rate, the pressure on the prime rate is upward. Should the increase in the unemployment rate have been faster than the increase in the inflation rate, the pressure on the prime rate would have been downward.

Table 3: Optimal prime interest rate using official and expanded unemployment rates

 

CPI

(%)

Unemployment rate (Official)

Expanded unemployment rate

Optimal prime rate (Official)

Optimal prime rate (Expanded)

Q4 2010

3.5

23.96

32.38

7.36

5.09

Q1 2011

3.8

24.96

33.43

7.15

4.88

Q2 2011*

4.1

25.16

33.99

7.38

5.01

Q3 2011*

4.5

25.25

34.42

7.64

5.17

Q4 2011*

4.9

25.39

34.93

7.90

5.33

Q1 2012*

5.4

25.42

35.30

8.16

5.50

* Forecast: Bureau of Market Research at the University of South Africa

Source: Statistics South Africa

The increase in the forecasted unemployment rates (official and expanded) despite expected positive economic growth can be attributed to very low elasticities between economic growth and employment growth rates. Moreover, research has shown that 72% of the inflation basket exhibits relatively inelastic behaviour in response to changes in the repo rate.

Table 3 points to a steady increase in the prime interest rate of banks. If the official unemployment rate is used in the Rudebusch equation, the prime interest rate increases from 7.36% at the end of Q4 2010 to 7.64% in Q3 2011 and an expected 8.16% in Q1 of 2012.

However, if the expanded unemployment rate (which includes discouraged workers in the unemployed category) is used in the equation, the prime interest rate should be much lower at 5.17% in Q3 of 2011.

Even though there is upward pressure on the optimal prime rate, the equation shows no need for an increase in the repo rate. This is because the current prime rate of 9% is still higher than the forecasted prime rate of 8,16% expected in Q1 of 2012. The repo rate should according to the equation only be increased once the optimal rate is expected to increase above the current prime rate. Furthermore, because of the abovementioned low elasticities between economic growth and employment growth, any premature increase in the repo rate will only exacerbate the already dire employment situation.