Navigating a 3% inflation target: what it means for South African markets - Angles & Perspectives Q2 2025

Navigating a 3% inflation target: what it means for South African markets

The South African Reserve Bank (SARB) has been making the case for a lower inflation target since 2021, and it now looks like the proposal is gaining traction. But what is driving the push, are there benefits, and what are the potential risks?

In February 2000, South Africa formally adopted an inflation targeting framework with the SARB setting a target range of 3% to 6%. At the time, this was consistent with global practice and aligned with South Africa’s emerging market (EM) peers, many of whom were grappling with persistently high inflation. Twenty-five years later, however, much has changed. EM central banks narrowed and lowered their inflation targets, with several converging around 3%. South Africa, despite having a strong and credible central bank, remains an outlier with its higher target. In 2017, the SARB began to explicitly target the midpoint of the 3% to 6% range (4.5%) even though the official target remained unchanged.

Why a lower inflation target?
A growing body of research from the SARB, including a recently published working paper series, argues in favour of shifting the official inflation target to 3% over the medium term. The SARB’s motivation for lowering the target is clear: lower inflation would reduce the economy’s average interest rate over time, bringing the cost of borrowing down, resulting in billions of savings in debt service costs for the fiscus over the next 10 years. If successful, the combination of stronger real growth and lower borrowing costs could lower the cost of capital across the economy, potentially driving investment and also lifting valuations across multiple asset classes. For households, lower inflation protects the purchasing power of income and savings into the future, and this can be particularly beneficial for the poor.

Risks in moving the target lower
However, the transition to a lower inflation target is not without risks. In order to lower inflation, the SARB’s Monetary Policy Committee (MPC) typically increases interest rates (via the repo rate). South Africa is already grappling with weak GDP growth, supply-side bottlenecks and fragile consumer demand. High interest rates are likely to stifle already fragile growth even further in the short run. In addition, a shift to a lower target may expose structural inflationary pressures − particularly from administered prices such as water, electricity and municipal rates − which are likely to remain sticky due to municipal dysfunction and long-standing infrastructure backlogs. If the Reserve Bank is not successful in anchoring inflation expectations at the lower level of 3%, it could result in more volatile inflation and a loss of credibility that the central bank has worked hard to build up over the past two decades – a scenario reminiscent of Brazil’s challenges in recent years.

Thus, while the long-run benefits from shifting the inflation target lower are promising, maintaining the SARB’s credibility will be critical.

At the July 2025 MPC meeting, the SARB clearly stated that they now prefer a 3% inflation target and are no longer targeting 4.5%. However, it was not clear which path the committee would adopt in moving their target (which has not been officially changed by National Treasury at this point). The SARB could consider two potential approaches drawing lessons from international experiences. The first is a one-off adjustment to the 3% target, similar to Chile’s approach where a decisive shift provided clarity and helped anchor expectations. Chile formally adopted the 3% target in 1999 in a single step, and the central bank has since been successful in maintaining well-anchored inflation expectations, supported by consistent monetary policy and sound fiscal policy. Alternatively, the SARB could pursue a gradual transition to avoid destabilising the economy, as seen in Brazil where the inflation target was lowered incrementally between 2017 and 2021, including annual reviews of the target. However, fiscal dominance and political pressure have at times undermined the central bank’s credibility and inflation expectations remain above their 3% target. The Brazil experience is a warning that inappropriately loose fiscal policy can undermine monetary policy credibility – markets will not adjust their expectations for future inflation lower if fiscal risk premia continue to expand.

Why change the inflation target now?
The SARB argues that conditions are currently favourable to shift the inflation target lower. Domestic headline inflation has been consistently printing close to the lower end of the 3% to 6% target range, hovering between 2.7% and 3% in recent months. This disinflationary trend has been supported by lower fuel prices, a relatively stronger rand and a benign global inflation environment. Inflation expectations in South Africa are adaptive – in other words, they tend to follow recent outcomes. Price setters and wage negotiators base their forward-looking assumptions on recent inflation prints. This provides the Reserve Bank with an opening to guide inflation expectations towards the 3% level while inflation is already low.

A change in the inflation target can only be implemented through close alignment and agreement between the SARB and National Treasury. Government bond yields have rallied this year due to the SARB’s clear preference for a lower inflation target. Finance Minister Godongwana has since criticised the SARB for ‘declaring’ a lower target without following a consultation process with National Treasury and stated that there are no immediate plans to change SA’s inflation target, yet the bond market remains buoyant – seemingly anchoring to the SARB’s 3% preference despite an official change in the inflation target appearing unlikely in the short term.

What could this policy shift mean for investors?
A lower inflation target implies that the SARB will be more hawkish and less tolerant of inflation surprises as they pursue anchoring inflation expectations lower over the implementation period of about two to three years. As seen in June, the global macroeconomic environment is volatile and susceptible to sudden shocks. The geopolitical tensions in the Middle East between the US, Iran and Israel pushed oil prices from US$66 per barrel to US$80 per barrel, albeit briefly. In a 3% inflation targeting regime, such external shocks from a fragile global environment could elicit a stronger monetary response from the SARB. This means potentially keeping the repo rate higher in the short run in order to defend the credibility of the lower inflation target. As the monetary policy stance remains tighter to anchor inflation expectations lower, yields at the front end of the government bond curve are also likely to remain elevated, reflective of the restrictive interest rate environment.

If the SARB succeeds in guiding inflation expectations lower to 3% (from the current level close to 4.5%), this will raise real yields offered by South African bonds, which will make them more attractive to foreign investors. Elevated real yields, combined with a credible lower inflation regime, could be highly supportive of rand-denominated assets across the board. The rand could also benefit from enhanced credibility, contributing to greater longer-term currency stability.

As inflation expectations begin to trend lower in line with a credible shift towards a 3% target, the yield curve is likely to respond accordingly. A more stable inflation environment would be supportive of a compression in inflation risk premia, particularly at the long end of the yield curve. This, together with monetary policy credibility, could result in a flattening of the yield curve over time as long-end yields adjust to a structurally lower inflation outlook.

In conclusion, the shift to a lower inflation target would mark a structural change in the SA macro framework. For investors, this introduces both opportunity and risk: the transition will not be linear, and it will depend on the SARB’s ability to maintain its credibility and to guide inflation expectations lower without stifling the already struggling economy. In the interim, investors should position for a world where lower inflation and tighter policy coexist, and where portfolio strategy must adapt to a more anchored, but possibly more demanding macro regime.