Policy tightening in the US prompted by inflation shocks and reaction shocks has a material, adverse impact on South African financial developments, says a working paper published by the Reserve Bank.The paper, written by Benedicte Baduel and Franz Ruch, senior economists at the World Bank, as well as Rudi Steinbach, a research fellow at the South African Reserve Bank (SARB), finds that US policy shocks have marked spillovers to South Africa.It examines, for the first time, the broader implications of US interest rates on various dimensions of the South African economy, including macroeconomic policy, and analyses the effect of three US interest rate shocks on South African outcomes. The research is the first to investigate the possibility that the South African economy responds asymmetrically to these shocks, the writers say.The paper defines real shocks as changes in interest rates that are caused by changing prospects for US economic activity, while inflation shocks are changes in interest rates that reflect changing prospects for inflation and reaction shocks are changes in interest rates due to market perceptions of the US Federal Reserve’s reaction function. “Though US real shocks (expectations of stronger economic activity) have more muted effects on the South African bond market, they do lower country risk, appreciate the rand, and boost equities,” the writers say.“We also showed that a significant degree of asymmetry accompanies the South African economy’s response to US policy shocks, with policy tightening generally having larger spillover impacts than policy easing.”The researchers analysed the impact of several US monetary policy shocks on a set of macroeconomic and financial variables for South Africa, based on data spanning January 2000 to September 2024. They noted that two-year US Treasury yields collapsed in March 2020 as the Covid-19 pandemic hit, prompting the Federal Reserve to rapidly lower policy rates by 150 basis points back to zero by late March. As the pandemic progressed and Fed policymakers concluded that the economy would require prolonged policy support, reaction shocks became increasingly negative. Throughout 2021, the Fed was perceived as dovish, even as the economy and labour market improved, actual inflation climbed and inflation expectations rose. In early 2022 it embarked on its steepest and fastest hiking cycle since the early 1980s, raising policy rates by 75 basis points at multiple meetings. The federal funds rate was raised further in 2023, and the market perceived a significant hawkish shift in the Fed’s policy stance, leading to an increase in two-year bond yields. “The postpandemic period was similarly turbulent in the South African economy. The initial policy easing in 2020, as growth slowed and inflation remained muted, was followed by rising interest rates in 2022-23,” the SARB paper notes.“This was accompanied by elevated country risk, substantial currency weakness, accelerating inflation, a muted economic recovery, persistent capital outflows and continued primary deficits, albeit markedly smaller when compared to the substantial deficits of 2020 and 2021.”The paper finds that US inflation shocks also led to an increase in inflation in South Africa — likely reflecting common global inflation drivers such as rising oil prices.Inflation has trended higher in the US as the US-Iran war drives global oil markets higher, with new data showing a jump to an annual rate of 4.2% in May, a three-year high and the third consecutive monthly increase since the start of the war with Iran.Similarly, in South Africa, inflation is also expected to spike to 4.6%-5.2% year on year in May from 4% in April, pulling further away from the SARB’s 3% target.