Month: October 2017

An expensive Budget failure – for extra-budget reasons

The Budget statement and speech on Wednesday badly disappointed the market in the rand and in RSA bonds. Since the Budget statement, the rand has lost about 3.3% of its US dollar value and was nearly 4% weaker against other emerging market exchange rates. This indicates that rand weakness and additional SA specific risks are at work.

The government’s cost of raising funds for 10 years has risen by about 22 basis points (0.22 percentage points), while five year money has since become a quarter of a percent more expensive for the SA tax payer. The spread investors receive as compensation for the risk that SA may default on its US dollar-denominated debt has increased by approximately 13 basis points.

Given that SA, to the 2020/21 fiscal year, will have to raise about R1 trillion to fund the growing deficit and to roll over maturing debt, the Budget statement has been a very expensive failure for the SA taxpayer. Furthermore, by weakening the rand, widening the risks to our credit ratings and to the rand and by adding to the inflation rate, the prospects for faster economic growth have deteriorated.

Yet one has difficulty in understanding why the statement was so poorly received. The statement continues to commit the government to fiscal conservatism. That taxes collected were a very large R50bn less than estimated in the February Budget, was widely signaled, as was the breach of the spending ceilings incurred to keep SAA alive. Furthermore, the decision to increase the Budget deficit and the borrowing requirement, rather than raise tax rates, makes good sense in such dire circumstances.

The Treasury may be implicitly conceding that raising the income tax rates in February proved counterproductive. Higher tax rates have not increased revenues and have in all probability discouraged growth. Raising income tax rates in the near future may well have become less likely.

Strictly controlling government spending while selling government assets is the only way out of the debt and interest trap. But privatisation on any scale appears as unlikely after the Budget statement as it was before.

What then are the steps the SA government could immediately take that might raise confidence in the prospects for the economy, enough to encourage households to spend more of their incomes and for firms to add jobs and capacity to meet their extra demands? Confidence enough to lift growth rates closer to a highly feasible 3% rather than 1% a year?

What is essential is no less than a confidence boosting conviction that the SA government is capable of ridding the economy of those individuals who have gained destructive control of the commanding heights of the SA economy. It therefore takes more than a statement to improve the outlook for the SA economy and to escape the stagnation that makes sound budgeting so difficult. 27 October 2017

 

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My Differences with the Reserve Bank – Redux

The Monetary Policy Committee of the Reserve Bank decided not to offer relief to our hard pressed economy.

This window of opportunity to lower interest rates was provided by declining rates of inflation and less inflation expected. The conclusion is that if cutting rates was not opportune last Thursday 21st September, when would circumstances ever allow the Bank to lower interest rates?

Indeed circumstances have since have made lower interest rates less likely. They came this week in the form of a stronger USD and a weaker ZAR, implying more inflation to come.

The MPC referred to the deteriorating assessment of the balance of risks.   However risks to the inflation rate will always be present and remain difficult to anticipate. What should be expected from a central bank is not accurate risk assessments but that it will react appropriately to the new realities. Especially to the impact of any exchange rate on prices to which the SA economy has proved particularly vulnerable.

Such events are described as supply side shocks to prices,  to be distinguished from the extra demands that might be forcing prices higher.  These supply side forces reverse as the exchange rate recovers or stabilizes or the harvest normalizes or tax rates do not increase any further. Thus these temporary supply side shocks should be left to their own devices – to work themselves out of the system without help or hindrance from higher interest rates.  The Reserve Bank however tends to react to inflation whatever its underlying causes

It often refers to so called second round effects of inflation.  The presumed danger that when inflation rises, for whatever reason, firms with pricing powers will plan for more inflation and set prices accordingly. And so inflation can become a self-fulfilling process.

That is unless corrected by higher interest rates to cause enough of a reduction in demand to prevent firms charging much more. Slack – that is an economy operating below its potential – is therefore the price that might have to be paid to achieve low rates of inflation as the economy is now paying up for.

The problem with this theory of self-fulfilling inflationary expectations in South Africa is that there is little evidence of it. Inflation and inflation expected mostly run closely together. Moreover inflation expected has been much more stable than realized inflation. This strongly suggests that inflation expected would have been a constant rather than a variable influence on actual inflation.

Inflation expected is surely not a simple extrapolation of past inflation. Inflation expectations will take account of the forces that are known to have cause inflation in the past, including the impacyt of reversible supply side shoks on prices. They will be informed by models very similar to the Bank’s own model that forecasts inflation. This Reserve Bank model currently forecasts inflation of about 5% in eighteen months, close to the inflation expected by the bond market.

The Reserve Bank and the market’s ability to forecast inflation is highly vulnerable to error given the unpredictability of the exchange rate and all the other supply side shocks that may send inflation temporarily higher or lower.

The inflationary forces that the Reserve Bank can influence consistently are only those that emerge on the demand side of the economy- not the supply side. The current problem for the economy is now one of much too little demand. A case of too much slack and too little growth.

The Reserve Bank therefore should adopt a very different approach to supply side shocks and to alter its narrative accordingly. One that will convince the market place that interest rate reactions to supply side shocks do not make economic sense. And that by not reacting to them when the economy is performing well below its potential does not mean that the Bank is soft on inflation.

Learning by doing – the next phase for monetary policy – reversing QE

The success of Quantitative Easing (QE) in promoting a global economic recovery calls for its reversal and the resumption of more normal in monetary affairs. The scale of QE, that is the creation of cash by central banks since 2008, has been extraordinary and unprecedented. Why this injection of cash has not led to more spending, much more inflation and a much greater expansion of the banking systems and in bank deposits than has occurred has been the big surprise. Providing an explanation for these highly muted reactions can explain why the reversal of QE may also be less eventful than might ordinarily be predicted.

The total assets of the major central banks, US, Europe and Japan grew from just over 3 trillion dollars in 2007 to their current levels of over 13 trillion USD, an amount that is still increasing The Fed balance sheet grew from less than one trillion dollars in 2008 to over 4 trillion by 2014.

The key fact to recognize is that almost all of the trillions of cash created by the Fed and other central banks buying the bonds and other securities that so bulked up their balance sheets, came back in the form of extra bank deposits. Commercial member banks before 2008 held minimal cash reserves in excess of what regulations said that were required to hold. They exploded thereafter. These excess reserves in the US peaked at 2.5 trillion dollars in 2014 remain above 2 trillion dollars worth of potential lending power.

The banks holding cash rather than making loans or buying assets has not only led to less spending than might have been predicted, it has also led to a much slower growth in bank deposits. It has shrunk the dramatically the ratio of total US bank deposits to the cash base of the system. This money multiplier has declined from nine times in 2008 to the current 3.5 times. Therefore the size of the banking system relative to the GDP has declined and made the US economy less dependent on bank credit. The US commercial banks on September 27th cash assets were equal to an extraordinary 20% of their deposit liabilities.

Extra bank lending requires that banks attract not only extra cash but also extra capital. Banks were undercapitalized before 2007 and have had to add to their capital to loan ratios. This has restrained bank lending as has a reluctance of potential clients to borrow more. Holding extra cash rather than making additional loans was an understandable choice. The extra cash held by US banks also earns interest, a further incentive to hoarding rather than lending cash. Low inflation – more so deflation – falling prices – can make holding deposits with the Fed, a good investment decision. The Fed minutes released yesterday reveal a concern that currently very low inflation may be “more than transitory”

Coming reductions in the supply of cash to the banking system are very likely to be offset by reductions in the excess cash reserves banks hold. Given the volume of excess cash reserves held by banks the danger is still of too much rather than too little bank lending to come. Were excess cash reserves to be exchanged on a significantly larger scale for bank loans the FED would have to accelerate its bond sales and raise interest rates at a faster pace.

This would all be a sign of faster growth and welcome for it. But there is possibility of a slip twixt central bank cup and lip and that markets will misinterpret the signals coming from central banks. So adding volatility and risks to markets before or as a new normal is established. Past performance will not be a guide to what will be another  unique event in monetary history- first was QE- then its reversal.