South Africa’s macroeconomic debate has recently focused on the appropriate inflation target and monetary policy stance given current fiscal conditions. But a lower inflation environment also sharpens an older problem: debt sustainability becomes harder when real borrowing costs remain high and growth remains weak. Our research argues that this tension can be understood through the idea of a fiscal neutral rate, or fiscal r-star.
Fiscal r-star is the real interest rate consistent with a stable debt-to-GDP ratio for a given primary balance, growth rate, and debt stock. It is the fiscal equivalent of the monetary policy concept of the neutral rate, or monetary r-star, which is the real interest rate consistent with inflation at target and output at potential. When the monetary-neutral rate is above the fiscal-neutral rate, the two arms of macroeconomic policy are no longer pulling in the same direction. Monetary policy may need relatively high real rates to stabilise prices, while fiscal sustainability requires lower financing costs or stronger fiscal adjustment. That is the central policy tension we study.
Using an estimated DSGE model for South Africa, we find that this tension has been persistent. First, monetary r-star has tended to exceed fiscal r-star, implying a structural misalignment between the interest rate consistent with price stability and the interest rate consistent with debt stability. Second, market interest rates have also exceeded fiscal r-star, which means that actual borrowing costs have remained above the level that would stabilise debt under prevailing fiscal conditions. In practice, that gap shows up as rising debt-service costs, reduced fiscal space, and more pressure on the rest of the budget.
The source of the problem is not simply the level of the policy rate. A key result from the paper is that the risk premium on South African borrowing has played a major role in widening the monetary-fiscal gap. In the model, the spread between the risk-adjusted rate and the observed real rate remains elevated for long periods, especially from around 2010 onward. Once sovereign risk is taken seriously, the apparent room for policy manoeuvre becomes much smaller. Absent this risk premium, the model suggests that the underlying structural misalignment would be far less severe.
This also helps explain why monetary policy appears more constrained than before. The relationship between the monetary policy gap and inflation deviations weakens substantially after 2010: the correlation falls from about -0.78 before 2010 to around -0.33 thereafter. Simply put, interest-rate changes appear to translate less effectively into inflation outcomes when fiscal stress and risk premia are high. This pattern is consistent with the broader argument of the paper: fiscal pressures can begin to constrain monetary transmission and, if left unresolved, increase the risk of fiscal dominance.
What should policymakers do with this diagnosis? Our model does not support the view that the South African Reserve Bank should take on the fiscal problem by aggressively responding to fiscal conditions. The gains from doing so are limited and can come with higher interest-rate volatility and potential instability. Instead, the heavy lifting has to come from the fiscal side. The main policy implication is that South Africa needs a credible fiscal anchor that improves confidence in the debt path and narrows the risk premium.
That recommendation matters because it clarifies what coordination should mean in practice. Coordination does not require weakening the inflation mandate or asking monetary policy to systematically accommodate fiscal drift. It means fiscal policy credibly stabilising debt, while monetary policy remains focused on price stability and can operate without the overhang of worsening sovereign risk. When fiscal policy is on a better path, monetary policy benefits indirectly through lower risk premia, better transmission, and fewer trade-offs between inflation control and debt sustainability.
The broader lesson is straightforward. South Africa’s macroeconomic problem is not only that borrowing costs are high or growth is low in isolation. It is that the rates required for debt stability and price stability have drifted apart. Aligning those stars requires a fiscal anchor credible enough to lower the sovereign risk premium and restore space for monetary policy to do its job.
This note draws on the ERSA working paper and a forthcoming South African Journal of Economics article, “Monetary-fiscal coordination in South Africa: Aligning the stars.”
