While the global financial crisis has destroyed many reputations as far as inflation-fighting credentials go, it still seems to give the benefit of the doubt to central bankers. It would seem as if we feel sorry for them. Sure, you never saw that housing bubble coming along. And, of course, you could not do anything about that stock market bubble. But, at least you were focused on combating inflation.

One does not even need a Gallup Poll to see this; one can simply look at bond yields. South African investors, for example, over the next five years require an additional 5%-6% per annum to hold government paper that is not linked to inflation – a mere 5%-6%.

And the further out we go, the more ludicrous it becomes. For instance, South African investors over the next 30 years still do not want more than 5% p.a. to compensate themselves for inflation risk.

It is even worse for the United States: here, the compensation is closer to 2%.

Why is this getting me so mad? I can hear some of you saying these numbers look quite reasonable. After all, does the South African Reserve Bank (SARB) not target an inflation rate between 3% and 6%?

This brings me back to my main point: these numbers are only credible if you assume that the SARB has a successful track record in actually targeting inflation. But does it really?

We have inflation data from literally thousands of years ago. Fortunately, I do not need to go as far back. Let us look at only the period in which the SARB has been targeting an inflation rate between 3% and 6% p.a. – since February 2000. This gives 140 monthly data points to September 2011 (the latest inflation data we have). How often do you think inflation was between 3% and 6% over this period? How often was it at least 5%?

Inflation was between 3% and 6% during 61 of the last 140 months. In other words, it was inside the band only 42% of the time. You would have better odds flipping a coin!

During 82 of the 140 months (i.e. 56% of the time), inflation was at least 5%; and for a staggering 60 months, it was at least 6%.

The SARB was in an interest rate cutting cycle when it announced its intention to adopt inflation targeting. Ignoring this cutting cycle (which mainly fell outside our inflation targeting period), it has increased the repo rate 14 times in two tightening phases; and decreased the rate 16 times in two loosening phases since it adopted inflation targeting in February 2000.

On average, it has changed rates every 120 days over the past 10 years.

This does not seem to have helped much in keeping inflation in the 3%-6% band. Neither is it that different from how it behaved in the past (i.e. before it formally adopted inflation targeting), although here inflation was only between 3% and 6% one-fifth of the time.

We are just at the end of a three-year interest-cutting cycle and, by all accounts (including that of the SARB), inflation is about to breach the 6% band on the upside. What should we assume about inflation and the direction of interest rates this time round?

Ponder what may happen in this cycle. Be cautious of the assumption that inflation is tamed, and that significant rate increases are no more – it seems to be a belief that many market participants hold.

David Crosoer

Head of Research at PPS Investments