Month: September 2013

Inflation targets are proving to be a very unhelpful guide to monetary policy settings

With the SA inflation rate above the upper band of the target it was inevitable that the Reserve Bank’s Monetary Policy Committee (MPC)  at its latest meeting and Press Conference, would focus on inflation and the risks to it rather than the unpromising growth outlook and the prospect of even slower growth to come. The question that should have been asked of the Governor and the members of the MPC is why they appear to believe that higher short term interest rates would help to reduce inflation in SA. The connection is by no means as obvious as traditional monetary theory might suggest- that higher interest rates lead to less inflation and vice-versa.

The answer, following conventional theory, might have been that higher rates would slow down spending and so further inhibit pricing power at a retail and manufacturing level. It might well do that- slow down spending further and harm the economy accordingly. But by slowing down the economy it would discourage foreign investors from investing in South Africa. This could mean a weaker rand and so more rather than less inflation. Slower growth with more inflation is not something the Reserve Bank should wish to inflict on South Africans. The evidence is however very strong that interest rate changes in SA do not have any predictable impact on the exchange rate and therefore on inflation.

The reality is that the exchange value of the rand is highly unpredictable and volatile, highly independently of SA short term interest rates, for both global and SA reasons that encourage or discourage the demand for risky rand denominated assets. This means that inflation is beyond the immediate control of the Reserve Bank. Therefore while low inflation is a highly desirable objective for economic policy – inflation targeting –becomes a very bad idea when domestic demand is growing too slowly rather too rapidly for economic comfort. Higher interest rates in these circumstances are a bad idea because higher interest rates leads to still slower growth in the economy and because growth determines capital flows and so the exchange value of the rand, higher short rates imposed by the Reserve Bank may in fact lead to more rather than less inflation.

In the figure below this point is made. It is a scatter plot of daily percentage moves in the ZAR/USD exchange rate and short term interest rates, represented by the 3 month Johannesburg Inter bank rate (JIBAR). As may be seen there has been about the same chance of an interest rate move leading to a more or a less valuable rand since January 2008. The correlation statistic for this relationship is very close to zero, in fact 0.000006 to be exact.

A scatter plot- daily percentage moves in short rates and the ZAR ( daily data January 2009- September 2013)

Source I-net Bridge Investec Wealth and Investment

The theory behind inflation targeting is that exchange rates follow rather than lead domestic inflation. The theory does not hold for an economy that depends, for want of domestic savings, on a highly variable flow of foreign capital. This leads in turn to a highly variable and unpredictable exchange rate. The best monetary policy can do in the circumstances is to accept this reality. That is to allow the exchange rate to act as the shock absorber of variable capital flows and to accept the consequential short term price trends – while using interest rates as far as they can be used – to moderate the domestic spending and credit cycles.

In practice this is how the Reserve Bank has reacted to recent exchange rate weakness that was so clearly not of its monetary policy making. Doing nothing by way of interest rate changes or intervention in the forex markets was the right thing to do. It remains the right thing to do until the global capital markets calm down. It is just as well that in the past week the rand has strengthened, improving the inflation outlook and so helping to keep the Reserve Bank on the interest rate fence, where it should stay.

If the rand stabilizes – better still strengthens further in response to global forces or SA reasons – for example better labour relations – one may hope for lower interest rates. The weakness of domestic spending calls for lower not higher interest rates. Lower rates would will help stimulate faster growth. And so doing would add expected value to SA companies, especially to those heavily exposed to the SA economy and the domestic spender. This would add to the incentives for foreign investors to buy JSE listed shares. It would also encourage foreign controlled businesses in South Africa to add to their plant and equipment and retain cash rather than pay out dividends to foreign shareholders. Such a more favourable outlook for the SA economy and the capital that flows in response may well strengthen the rand and improve the inflation outlook.

A focus on inflation targets, beyond Reserve Bank control via interest rate determination, prevents the Bank from doing the right thing for what interest rates do influence in a consistent way and that is domestic spending. Lower interest rates and the demands for credit that accompany them can stimulate demand and higher interest rates can be used to discourage demand when it becomes excessive. When domestic spending growth is adding significantly to domestically driven pressures on prices higher interest rates are called for. This is clearly, and by the Reserve Bank’s admission, not the case now. The opposite is true, domestic demand is more than weak enough to deny local price setters much pricing power. And in these circumstances higher wages conceded to Union pressure lead to fewer jobs and on balance less rather than more spending. Prices are set by what the market will bear rather than operating costs. Operating margins rise and fall with operating costs- – in the absence of support form customers- and prices do not necessarily follow.

A target for what is judged to be sustainable growth in domestic spending might be a useful adjunct to monetary policy that regards low inflation as helpful to economic growth. A target for inflation, without a predictable exchange rate, just gets in the way of interest rate settings that should be helpful for growth.

Inflation targets are proving to be a very unhelpful guide to monetary policy settings

With the SA inflation rate above the upper band of the target it was inevitable that the MPC at its latest meeting and Press Conference would focus on inflation and the risks to it rather than the unpromising growth outlook and the risks of even slower growth to come. The question that should have been asked of the Governor and the MPC is why they appear to believe that higher short term interest rates would help to reduce inflation in SA. The connection is by no means as obvious as traditional monetary theory might suggest.

The answer following conventional theory might have been that it would slow down spending – even more than it has slowed down to date – and so further inhibit pricing power at a retail and manufacturing level. It might well do that- slow down spending further and so harm the economy accordingly. But by slowing down the economy it would discourage foreign investors from investing in South Africa. This could mean a weaker rand and so more rather than less inflation. Slower growth with more inflation is not something the Reserve Bank should wish to inflict on South Africans, as it might well do. The evidence is very strong that interest rate changes in SA have had no predictable impact on the exchange rate and therefore on inflation.

The reality is that the exchange value of the rand is highly unpredictable and volatile for both global and SA reasons that encourage or discourage the demand for risky rand denominated assets. This means that inflation is beyond the immediate control of the Reserve Bank. Therefore while low inflation is a highly desirable objective for economic policy – inflation targeting –becomes a very bad idea in these circumstances. A bad idea because it may well lead to higher interest rates, slower growth and because growth determines capital flows, may mean more rather than less inflation.

The theory behind inflation targeting is that exchange rates follow rather than lead domestic inflation. The theory does not hold for an economy like the SA economy that is dependent for its growth on a highly variable flow of foreign capital that leads to a highly variable and unpredictable exchange rate. The best monetary policy can do in the circumstances is to accept this reality. That is to allow the exchange rate to act as the shock absorber of variable capital flows and to accept the consequential short term price trends while using interest rates as far as they can be used to moderate the domestic spending and credit cycles.

In practice this is how the Reserve Bank has reacted to recent exchange rate weakness that was so clearly not of its monetary policy making. Doing nothing by way of interest rate changes or intervention in the forex markets was the right thing to do. It remains the right thing to do. It is just as well that in the past day the rand has strengthened improving the inflation outlook and so helping to keep the Reserve Bank on the fence where it should stay. If the rand stabilizes – better still strengthens further in response to global forces or SA reasons – for example better labour relations – one may hope for lower interest rates. These will help growth and by improving the incentives for foreign investors to buy South Africa may well strengthen the rand and improve the inflation outlook.

Talking about the strong Rand today it was highly instructive that the stronger rand was accompanied by higher Rand values attached to almost all financial assets. Almost all equities appreciated – global plays for example NPN or BTI or SAB became more valuable in rands – despite the stronger rand – as did the SA plays – banks and retailers – as did almost all Resource companies, especially the gold miners that might ordinarily be expected to suffer from rand strength and benefit from rand weakness. In other words there were no rand hedges on the JSE on the 18th September (.i.e. companies that benefit in rand terms from rand weakness or are harmed in rand terms by rand strength).

There is in fact very little recent evidence of rand hedge qualities in JSE listed companies. This is because rand strength reflects good news about the global and the SA economy – for example lower interest rates in the US – absent tapering – that is good economic news. The good news effect on the dollar value of JSE stocks outweighs the effect of translating higher dollar values into stronger rands. Hence no rand hedge characteristics are consistently to be observed. The opposite is mostly true when the rand weakens on bad news. A weaker rand does not usually compensate for the lower dollar prices of globally traded shares when the outlook for the global and or SA economy deteriorates. Therefore investors should hope for a strong rather than a weak rand. But is remains true that the SA economy plays- businesses that benefit from lower interest rates that may well follow a stronger rand and the lower inflation that follows-  stand to benefit even more than the global companies listed on the JSE that generate a much smaller proportion of their revenues and profits from the SA economy.

Takeaways from the SA Reserve Bank Quarterly Bulletin, September 2013

The Reserve Bank has filled in the picture of the SA economy in Q2 2013 adding expenditure, balance of payments accounts as well as money, credit and financial statistics to numbers released earlier by Stats SA for domestic output (GDP). Growth in GDP at a seasonally adjusted rate of 3% in Q2, picked up momentum from the 0.9% rate recorded in Q1 2013. GDP grew by a pedestrian 2.5% in 2012. The modest acceleration in output (GDP) growth in Q2 was attributable almost entirely to a strong recovery in manufacturing output, that grew at an annual equivalent rate 11.5%, having declined the quarter before at a 7.9% p.a. rate. Mining output, by contrast, having grown by a robust 14.8% in Q1, declined at a 5.6% rate in Q2. Agricultural output declined further in Q2 at a 3.7% rate. Growth rates of the tertiary sector measuring activity in services, retail government and financial services, for example, are far more stable than those of manufacturing, mining and agriculture. But growth in service activity has been disappointingly slow of late growing by a mere 2.4% p.a. in Q1 and 2.3% p.a. in Q2 2013, having grown by an only slightly higher rate of 3% in 2012. (see below)

It should be appreciated that the SA economy is dominated by the supply of and demand for services that now accounts for 69% of all value added (the primary sector, mining and agriculture delivers but 11.85% of the economy while and manufacturing has a 12.5% share when measured in current prices. Outcomes in both the trade sector (wholesale and retail and catering activity) with a 16% share of the economy and financial services with a 21.5% share are far more significant for GDP and its growth than trends in manufacturing and mining

 

It could be said that the currently depressed growth rates are the result of a lack of demand for goods and especially services rather than a lack of potential supply of them. Final demands for goods and services from households firms and the government grew by only 2.5% in Q2 2013, well down from the 4% pace of 2012. Gross Domestic Expenditure that adds changes in inventories to final demands grew at a marginally faster rate of 2.7% in Q2 also well down on the 4.1% increase recorded in 2012. (See below)

Real gross domestic expenditure

Clearly the growth in aggregate spending is slowing down markedly though not all categories of spending were so negatively affected. Household spending on durable goods (cars, appliances etc) grew at a remarkable 11.8% annual rate in Q2 while growth in demand for semi-durables (shoes and clothes) also grew very strongly in Q2 at an 8.2% rate, sustaining the extraordinary growth rates of the past few years. By contrast a decline in the demand for the all important service sectors was recorded in Q2 – again continuing the very weak growth trends of the past few years. (see below)

The explanation for such dramatically divergent trends is in the very different prices being charged. The prices of services(largely influenced by administrative action and regulation) have risen much faster than the prices of clothing and durable goods the services of which are consumed by households. The table below makes this very clear. In the year to date the prices of consumer goods on average rose by 6.3% – the prices of clothing by 3.3% and that described as (durable household content and equipment at an even lower 2.9% while the prices of ‘communication” – telephones and calls rose by a well below average by 1.8%. Clearly prices, relative prices matter for these demand trends.

The weaker rand threatens the relative price trends that have been so favorable for the consumers and retailers of durables and semi -durables. A strong rand is good for consumption generally because it helps makes consumption goods cheaper and lowers the costs of finance, though some forms of consumption benefit more than others. Vice versa a weak rand drives consumption growth lower prices and interest rates higher. Indeed lower levels of consumption and higher levels of production for export and as competition with imports is a necessary part of the adjustment process to a weaker real rand.

The rand weakened because supplies of foreign capital so essential to fund even sub-par 3% growth in SA were made available on less favorable terms. Partly for SA specific reasons- especially the strike action on the mines and partly in recent weeks for global reasons- higher interest rates in the US.

In recent days the SA specifics in the form of a threatened disruption of mining output- so important in the export basket- have seemed less threatening. The threat and reality of higher interest rates in the US has also become less damaging to EM currencies including the ZAR. The recovery in the ZAR especially Vs emerging and commodity currencies reflects some of this. The hope must be that a stronger rand – the result of more favorable global investor sentiment towards SA- will allow lower interest rates that are so badly needed to stimulate domestic demand. Without stronger demands for services, supported as it would have to be by more favorable terms on which foreign capital is made available to SA borrowers, that in turn leads to lower interest rates and more freely available credit, the economy cannot hope to escape any time soon from its current slow growth phase.

All tables and figures included are taken from the SA Reserve Bank Quarterly Bulletin, September 2013

The SA economy needs lower not higher short term interest rates. Will it get them?

The SA economy, according to our Hard Number Indicator (HNI) continued to move ahead in August 2013. Growth in economic activity remained positive in August. However the forward motion of the economy appears to be losing rather than gaining speed. Our very up to date business cycle indicator is based on two equally weighted hard numbers that are released very soon after the end of the previous month, unit vehicle sales and the note issue.

This Indicator, the HNI, has proved to be very relaible in recognising the turning points in the offcial business cycle, the coinciding business cycle indicator published by the S.A Reserve Bank, that is based on a larger number of economic indicators derived mostly based on sample surveys, not hard numbers, and therefore is only published at best two or three months later than the HNI.

As we show the HNI appears to have reached a plateau suggesting that the forward momentum of the economy that has picked up speed strongly since the recession of 2008-09 has now stabilised. The forecast also suggests that the economy may not grow any faster over the next twelve months. (See below)

The Hard Number Indicator of the Current State of the SA economy.

The components of the HNI are shown below. As may be seen the supply of and demand for cash continued to grow at a rapid rate in August 2013 in both nominal and inflation adjusted terms. The trend in the extra cash supplied by the Reserve Bank to the economy remains above a 10% p.a. rate though the trend appears to be declining. Adjusted for rising inflation the real growth rates remain above 4% p.a as may be seen. This growth must be attributed in good measure to underestimated informal economic activity that is cash intensive.

The cash cycle- rowth in the supply of Reserve Bank Notes

New unit vehicle sales, that have been such a source of strength for the economy over the past two years, appears to be losing momentum, as we show below. On a seasonally adjusted basis August unit vehicle sales on the domestic market were well down on July sales and suggest that new vehicle sales are unlikely to increase over the next twelve months. Yet if sales volumes can be maintained at current seasonally adjusted levels, such outcomes, in the light of the history of the sector would be regarded as satisfactory. Significant increases in exports of new vehicles, labour relations permitting, could add to motor manufacturing activity.

Growth in new unit vehicle sales to the SA market.

SA Unit Vehicle Sales. Annualised and Forecast.

The National Income Accounts released on August 27th estimated that GDP grew at an improved seasonally adjusted 3% rate in Q2 2013. However GDP in Q2 2013 was only 2% higher than year before. These growth rates must be regarded as highly unsatisfactory given the potential for faster growth. Such GDP outcomes would ordinarily call for lower interest rates. Unfortunately the times cannot be regarded as ordinary with the foreign exchange value of the rand, in company with other foreign capital dependent economies, under so much pressure form higher long term interest rates in the US.

The inflationary implications of a weaker rand therefore make lower short term interest rates less likely. Lower rates would be very helpful for not only vehicle sales but housing prices and employment creating residential construction activity. Were mortgage rates closer to five per cent than ten per cent a lively housing market and many more new houses would surrely follow.

Higher short term interest rates, incluinding the rates charged for mortgage or car loans would further slow down the SA economy and hopefully will be avoided. The weaker rand and the higher prices to be charged domestuic consumers will anayway be taking their toll of domestic spending. Already subdued domestic spending will be under enough additional downward from higher prices, particularly from higher petrol and diesel prices. Spending does not need further discouragement from still higher interest rates.

Higher rand prices for exported goods should however encourage the mining and agricultural sectors to produce more. Manufacturing activity should also benefit from incentives to export more and also as domestic producers compete with now more expensive imported goods for space on the shelves of retailers. But extra output and incomes can only be realised if the mines and factories stay open for business.

The rand is not only a play on US interest rates. It is a play on SA labour relations that deteriorated so badly a year and more ago at the Marikana platinum mine that saw the ZAR perform so poorly not only against the USD but also against other Emerging Market currencies.

An unexpected recent degree of realism about wage demands appears now to be influencing the SA labour market. The outlook for mining and manufacturing output has improved accordingly and the rand has benefitted to a degree from this. In recent weeks and days the ZAR has been a relatively strong EM currency and the Indian Rupee particularly weak, as we show below.

The foreign currency cost of a rand

This small degree of rand strength has been accompanied by some relief for long term interest rates in South Africa. These rates as they did throughout the EM world followed higher yields in the US higher after warnings of the tapering of Quantitative Easing entered the global financial markets in late May 2013. In recent days the gap between RSA and USA yields has also narrowed indicating a lower cost of forward cover and somewhat less rand depreciation expected over the next ten years. (See below)

Long term interest rates; RSA and USA

The interest rate yield premium. (RSA-USA ten year bond yields)

More of the same – that is SA specific reasons for a stronger rand linked to more production on the mines and in the factories –especially if accompanied by lower rather than higher US bond yields – would be especially welcome news for the SA economy. It would improve the outlook for inflation and perhaps allow for lower rather than higher short term interest.

But in the absence of such favourable forces the right monetary policy response to higher US rates and a stronger dollar would be to continue to leave the adjustment process to a fully market determined ZAR and to keep short term interest rates where they are .