By Aarti Bhana
Monetary policy, interest rate cuts, central bank… These terms are being thrown around a lot more in the news lately, especially in light of Covid-19 and the economy. But what does it all mean and why you should care?
Central Banks are pretty important. Knowing how they work can actually empower you – and your finances.
So, let’s break it down for you!
Watch our video below, and scroll down for our simple Q&A.
1. What’s a central bank?
Almost every country has a central bank. In the US it’s known as the Federal Reserve, in Europe, it’s called the European Central Bank and in South Africa, we have the South African Reserve Bank (Sarb). Their main function is to look after the country’s money. The South African Reserve Bank prints money and controls its supply. Basically, they decide how money should be distributed to banks.
2. Who owns it?
In South Africa, the Reserve Bank is an independent institution, meaning that it’s separate from the government. It’s actually owned by shareholders from all over the world but the Governor, Lesetja Kganyago and his deputies are the main guys calling the shots in the bank. They are called the Monetary Policy Committee. They discuss the economic health of the country and decide how to make things better.
3. Why is the Reserve Bank important?
It protects our money using various strategies. These strategies are called “Monetary Policy”. Among other things, the Sarb’s main function is to protect the value of the money in your pocket. Otherwise, they’d just be useless bits of paper. The Sarb ensures it is actually worth something, and that the value of that piece of paper stays relatively consistent.
The two main ways they do this is by adjusting the interest rate and through inflation targeting.
Sorry? Inflation who and interest what now?!
Let’s use a simple analogy to explain this:
Let’s say you borrowed R 2000 from your brother to buy a new phone, but he says: Listen you gotta pay it back – WITH INTEREST. Your own brother, imagine! This means you will end up paying back more than you borrowed and your monthly repayments will increase overtime too. Say he charges you 2% monthly interest. So as time goes by, and you still haven’t paid him back, the original loan amount grows thanks to that interest: from R 40 to R80 to R200 in five months and so on…
He sees that you’re struggling to pay back because you lost your job plus you have other expenses. So, he decides to go easy on you and cuts the interest rate to 1.5%. Great! Now you can pay less every month, and have more money in your pocket.
The Reserve Bank does the same thing. It lends money to commercial banks like Standard Bank, First National Bank, Absa and so on. It also charges interest on this borrowing, this is known as the REPO RATE.
These commercial banks then take this money and borrow it to US to help us pay for our homes, student loans and cars. We’re borrowing from the borrowers! The interest rates banks charge us is known as the PRIME LENDING RATE.
So, we borrow money from banks and have to pay it back with interest and banks borrow from the central bank and have to pay it back with interest.
4. Why do we need interest?
Charging interest is a way of maintaining the VALUE of the loan.
The price of things change, they increase and they decrease. When the general price of things increases, it’s called INFLATION.
Like say, last month a bottle of coke was R12 and this month it’s R15. That’s inflation. No one controls it – there are many factors that contribute to it.
When inflation happens we spend more, and when we spend more there’s more money going around in the economy. This may sound like a good thing BUT retailers will decide to increase their prices even more — meaning your money loses value. And so this cycle continues. It can really get out of control!
Think about Zimbabwe: inflation is over 500% so everything costs A LOT more than it should. That means the VALUE of the money in your pocket is less.
So that’s why banks charge interest rates: to make sure that the money it receives back at the end of the day is actually worth something – that other people would want.
So, what’s inflation-targeting?
It’s when the Monetary Policy Committee looks at how much money is going around in the economy and the current level of inflation. It then sets a target that it would like to see inflation fall within and works on a policy to achieve it. Remember, no one sets the inflation rate, but it uses various tools and measures to influence the rate.
The inflation rate helps the Reserve Bank decide on the interest rate – to once again ensure our money is worth something.
It’s like back in the day when you would look at your school report card and decide that your math mark needs to be between 70% and 80% to pass the grade and then working out a study plan to achieve it.
Makes sense? Let’s move on….
5. When does the Reserve Bank decide interest rates?
The MPC meets every two months to decide on the interest rate. It can either increase the interest rate or decrease the interest rate. Our central bank is known for being quite conservative and cautious compared to others, so most of the time it makes small changes especially when it cuts interest rates. There are two reasons it needs to cut interest rates:
a.The economy is in bad shape and it needs to help people with their repayments
b. The economy is in good shape and it can afford to give people more money in their wallets to buy and invest
When the Reserve Bank cuts interest rates it gives us, consumers a bit of relief and a bit more money in our pockets.
Read more here.
6. I heard the Reserve Bank made an emergency interest rate the other day?
Yes. So this had everyone talking because:
a. No one expected it. The Reserve Bank usually only meets every two months to decide the interest rate. Its last decision was in March and its next decision was only meant to be in May. But, because President Cyril Ramaphosa extended the 21-day lockdown by two more weeks – posing further potential damage to the economy – the Reserve Bank decided to intervene.
b. The recent cut brought our repo rate to 4.25% which is the lowest since 1973! This is because the bank cut rates by 1 percentage point in March, just as the Covid-19 crisis started to escalate. Remember we said the Reserve Bank is usually cautious about cutting interest rates? Well, this latest move was big and bold and NEEDED to stimulate the economy. P.S. Saving the economy is not part of the Reserve Bank’s mandate, but desperate times call for desperate measures. It decided to lend a helping hand and said that there may be more cuts in the future.
7. What does this mean for me?
So, we had a chat with personal finance journalist Maya Fisher-French and she said it depends on your financial situation.
? If you have cash savings as an investment, the interest rate cut may means the interest you earn back from the bank on your savings will be less.
? If you have debt, the interest rate cut is good, because it would reduce how much you payback on a loan to your bank.
? If you are a small business owner, the interest rate cut is good, because it’s now cheaper to borrow money to help you sustain your business.
Read more here.
The main reason the Reserve Bank cut interest rates was to give people room to borrow money at a reduced rate, or to help people with high debt survive, Fisher-French explained.
So, how can you use this information?
Well, things like buying a house or a car seems pretty attractive right now. But Fisher-French pointed out that the cut is a temporary measure and the house or car you’re about to buy is a long-term investment. If the Sarb increases interest rates in six months, you’ll pay more. So, before you decide to make an impulsive purchase, ask yourself if you can AFFORD to absorb an increase in payments if the interest rate increases!
If not, maybe don’t buy! If you can – then by all means.
The one thing you can do is use the extra money to pay off existing debt instead of using it buy luxury items. The more you pay now, the less you’ll pay later and the debt cloud over your head will dissipate faster.
Caveat: if you took out a loan on a fixed interest rate, would have a small effect on you.
8. How does it help the economy?
This is obviously not enough to save the economy. Frankly, one person or policy can’t just SAVE it. But this was a singular measure among many others to help the economy. Finance Minister, Tito Mboweni announced that National Treasury is also looking into loan facilities and funding as well as revising the national budget to prioritise healthcare and growth initiatives. When the Reserve Banks meets again in May, we could see another interest rate cut, which could help us in the near future.
The thing about the lockdown is that it places South Africa’s already weak economy in a compromised position. We had a high unemployment rate before the lockdown and there’s no doubt that it’s going to increase even more. We were in a recession and some economists say this will push us further into a recession. Things are a bit rough for South Africa right now, and unlike other developed nations like the US and UK we don’t really have other means to pull us out of it.
But, we have a President who is leading us well through this crisis and for that we should be proud. Many funds have been set up to help fight the crisis and we have super strong Reserve Bank and Governor who knows what they’re doing.
Let’s keep hoping, and if you can, take advantage of the lower interest rates and try to pay off any bad debt you may have.
References: Investopedia, South African Reserve Bank