The new optimistic message from the Reserve Bank is welcome, but there are some reservations about the analysis and its implications for monetary policy and the SA economy.
The Monetary Policy Review recently published by the Reserve Bank (MPR) offers a full explanation of how the Bank thinks about its role and how it goes about realising the inflation target set for it. I offer a critique of the analysis that I hope can help prevent the errors of monetary policy that I believe have characterised monetary policy over the past few years.
The Reserve Bank Governor, Lesetja Kganyago, in introducing the MPR, sounded a clear call for a new, better future for the SA economy and the role of the Reserve Bank in helping realise this much more hopeful vision. To quote his introduction to the MPR:
“This Monetary Policy Review arrives at a moment economists would call ‘a structural break’ – a point where the behaviour of the numbers changes. In more everyday terms, we have witnessed the end of one chapter of South Africa’s history and we are starting a new one. This document represents an attempt to write the economic story of that chapter, or at least the first pages, in advance. Of course, this is a difficult enterprise, with a reasonable chance of substantial error. But monetary policy affects the economy with a lag of one to two years, so it must be forward-looking.”
(Introduction to Monetary Policy Review, South African Reserve Bank, March 2018. All figures presented below are sourced from the MPR.)
When you have repelled the very dangerous gang that threatened your existence – bravely and effectively as Reserve Bank Governor managed to do – you would be are fully justified in looking ahead with a renewed sense of hope and confidence. As he explains further in his introduction to the MPR:
“What keeps this situation sustainable is that much of the economy’s poor performance is due to other factors, which are now fading. In particular, business confidence is recovering from some of the lowest survey readings in our modern history. Exchange rate dynamics are absorbing most of the inflationary pressure from new taxes. There are abundant reform opportunities. With the right policies, we can grow out of our problems. This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it”
(Introduction to Monetary Policy Review, South African Reserve Bank, March 2018. All figures presented below are sourced from the MPR.)
When you have repelled the very dangerous gang that threatened your existence – bravely and effectively as Reserve Bank Governor managed to do – you would be are fully justified in looking ahead with a renewed sense of hope and confidence. As he explains further in his introduction to the MPR:
“What keeps this situation sustainable is that much of the economy’s poor performance is due to other factors, which are now fading. In particular, business confidence is recovering from some of the lowest survey readings in our modern history. Exchange rate dynamics are absorbing most of the inflationary pressure from new taxes. There are abundant reform opportunities. With the right policies, we can grow out of our problems. This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it”
This sense of economic opportunity is refreshing. I hope as much as the Governor that the next chapter in the monetary history of SA is a much happier one, characterised by less inflation and faster growth. The transparency of the MPR is admirable and demands a full response. But if faster growth with lower inflation is to be sustained for the long run, it will in my considered opinion take a different frame of mind at the Reserve Bank. I indicate how I believe the Reserve Bank could better realise its objectives for inflation, without having to sacrifice growth.
A successful monetary policy is one that delivers low inflation in a way that encourages rather than inhibits the growth of an economy. An inflation targeting monetary policy regime should recognise that unpredictable supply side shocks that lead prices and inflation higher call for lower, not higher interest rates to help the better economy absorb the shock to prices and to the demands for goods and services produced domestically.
Only demand led inflation, more demand than the economy can hope to satisfy without higher prices, calls for higher rates. Higher interest rates then can slow down spending. But higher interest rates will harm growth when spending is already under pressure from rising prices that follow what is in effect reduced supplies of goods and services. What is described as a supply side shock to the economy is one that drives up prices and discourages spending.
Higher interest rates at times like this simply reduce spending further and growth slows more than it should. Supply shocks can come in the form of a drought that reduces the supplies of staple foods and pushes up their prices. Another supply side shock on prices follows a sharp decline in the exchange rate described as an exchange rate shock. Then the supply of goods imported or in sold domestically in competition with exports comes with higher prices.
A decline in the exchange value of a currency may have nothing to do with the demand side of the economy – with demand running ahead of supply so forcing up the prices of goods and services and also the cost of foreign exchange. Currency weakness can have their cause in global events that influence the supply of foreign capital or local political events. To fears that worsen the outlook for the economy and lead to less capital flowing in and more out, enough to weaken the exchange rate that will then lead to subsequently higher prices.
Supply side shocks greatly disturbed the SA economy between 2014 and mid-2016. The drought and the weakness of the rand linked to the strength of the US dollar and weakened further by political developments in SA, were among the major shocks with which the economy had to cope. The Reserve Bank however between 2014 and 2016 resisted any distinction between supply side and demand side forces acting on prices in SA that should call for different interest rate reactions. It reacted to the increases in the CPI as if it was demand driven and so raised its repo rate to further inhibit spending and output growth that remained highly depressed over the period. The economy grew slower than it would have done had interest rates been lower and spending been more buoyant. My contention is that growth was sacrificed without any lower inflation than would have been the case with lower interest rates.
This MPR acknowledges correctly (see quote below) that the recent VAT increase is contractionary – not persistently inflationary – representing the equivalent of a supply side shock that will raise CPI inflation by about a half a per cent only over the next 12 months. After which, assuming no further VAT increase, it will fall out of the inflation numbers.
What is true of the temporary impact of a VAT increase was surely as true of the food price impact of a drought and of the exchange rate shocks that forced SA prices higher after 2014. These were temporary price shocks even reversible ones, that serve to contract spending and are best ignored by monetary policy settings. Indeed the more favourable inflation trends observed recently in SA represent the reversal of the price shocks – the rand and the drought – that raised the CPI between 2014 and mid-2016. The demand side of the economy still remains repressed though lower inflation would appear in late 2016 to have helped lift the growth rates in household spending, particularly on durable and semi durable goods (clothing etc) whose prices would have benefitted from the recovery in the exchange value of the rand.
A further objection is that the forward looking monetary policy recommended by the Governor is only helpful when forecasts of inflation, interest rates and real growth fall within a narrow range. The forecasts of the Reserve Bank as indicated in the MPR qualify very poorly in this regard.
The fan charts provided by the MPR (see the chart below) indicate very conspicuously the lack of confidence policy makers should attach to the most likely outcomes as forecast by the model. For example, as shown below, the point forecast for the Repo rate is 7.5% in three years’ time, 125 basis points higher than the current repo rate – but with considerable uncertainty around this 7.5%. For example the chart indicates a high probability (15%) of the forecast being between 8.7% and 10%. And a similarly high probability (15%) of being much lower, between 5% and 6.3% A case of having to take your pick for the repo rate as anywhere between 5% and 10%.
Similar conclusions could be reached about the forecasts of GDP or inflation. In the case of GDP you can take a pick between a forecast of minus 1.2% and a booming 7% real growth in 2020. As for inflation the forecasts offer a pick between a 1.8% and near 9% in 2020.
If the economy turns out very differently to the forecast, delayed responses to interest rate changes made in advance can be damaging to the economy. This ability to accurately forecast the SA economy has been undermined by the series of shocks the rand has suffered. The impact of the drought on food prices as well as shocks to commodity, metal and oil prices have been additional largely unpredictable events to disturb the accuracy of past forecasts. The quality of these forecasts will not improve unless the shocks that have so affected the SA economy are of much diminished scale and range.
One can only hope with the Governor that this indeed will be the case. But if not, the MPC will have no option to think on its feet and to react to events as they occur, hopefully with good judgments about the causes and effects of inflation and the difference between supply side and demand shocks that call for very different reactions. And differences in responses that need to be well communicated to and understood by the economic agents affected by interest rates and inflation and the rate of growth of the economy, that they too will be trying to anticipate in a forward looking way. A different narrative from the Reserve Bank is called for to explain why the different causes of higher prices can call for different policy responses, responses that do not mean tolerating inflation more than makes sense.
The MPR contends that its interest rate settings in recent years have been accommodative rather than restrictive and will likely remain so (see figure below).
As the MPR states:
“Viewed through the lens of the South African Reserve Bank’s (SARB) Quarterly Projection Model (QPM), the policy stance will be expansionary over most of the forecast period, helped by the recent rate cut. The projected rise in near-term inflation, which lowers the real interest rate, is largely due to the VAT increase. This will reduce disposable income and is in this respect actually contractionary. The recent rate cut mitigates this effect, making policy more clearly accommodative through the rest of 2018 and 2019.”
And so if in fact inflation turns out as expected- around 5%, a lower repo rate appears as unlikely.
The MPR defines these interest rate settings as accommodative because interest rates have stayed below inflation. But evidence of demand running well below potential levels is overwhelming enough to conclude that interest rates were too high rather than too low in the circumstances of such weak spending propensities. The persistence of an output gap, a gap between actual and potential output that is the longest on record, according to the MPR, is strong evidence of too little spending and thus to be inferred as the result of contractionary rather than accommodating monetary policy (see figure below). Ideally monetary policy should help eliminate slack in the economy (negative or positive). The persistence of slack is evidence that policies were too tight rather than too loose, that interest rates were too high not too low.
It is important for the supply side of the economy and the exchange rate that the Reserve Bank maintain its independence to conduct monetary policy as it sees fit. The Bank’s independence came under severe threat and it resisted this attack successfully to its eternal credit. But independence should ideally be accompanied by good judgments and not necessarily compromised by appropriate interest rates.
Further direct evidence of tight monetary policies comes with direction of the growth in money supply and bank credit. These growth rates have declined consistently over recent years but receive surprisingly little attention in the MPR.
I further question the notion, that inflationary expectations are self-fulfilling, much relied upon by the Reserve Bank over the years to justify its interest rate settings, that is the more inflation expected the more inflation realised, regardless of the slack in the economy. And that higher interest rates increases are required to prevent these so called second round effects from driving up prices whatever the initial cause of higher prices because higher prices mean more inflation expected and in turn more inflation realised.
The evidence for such persistent second round effects on inflation is very weak. Inflation in SA tends to lead and inflation expectations follow- with some regard for what are seen to be temporary forces that may have pushed up prices- for example a drought. If inflation comes down in South Africa- for good permanent reasons- inflation can be expected to decline. And if inflation rises because of supply side shocks these increases will be temporary and may even be reversed when the shock passes through. The recent decline in inflation in SA is mostly the result of the reversal of the forces that drove up inflation – the harvests have normalised and the rand has strengthened. Positive supply side shocks that have brought less inflation and stimulated a revival in household spending. The MPR appears to concede this point.
It remarks, in justification of reducing its repo rate recently, that:
“A second consideration was that lower inflation could be used to bring inflation expectations closer to the target midpoint of 4.5% over a shorter time frame. However, these factors do not preclude fine-tuning of the interest rate. The MPC is also not committing to a rate cutting cycle.”
Finally I would question the notion that deficits of the current account of the balance of payments represent danger rather than opportunity for the SA economy as the MPR appears to regard them. By definition the current account deficit is equivalent to the capital flows an economy is able to attract from abroad. Faster growth will mean larger current account deficits and larger capital inflows. Growth leads and foreign capital can follow the prospective faster growth and make it possible. I would argue that the opportunity to grow faster by attracting more capital should not be frustrated by higher interest rates for fear that capital flows can reverse when the news deteriorates.
Monetary policy should focus on stabilising the economy so to improve the case for investing in SA. Sustainably low inflation is helpful to that end. But monetary policy should not sacrifice growth when prices are rising for reasons beyond its control and beyond the influence of interest rates. The lessons from the history of recent monetary policy in South Africa is that such errors of policy that mean slower growth for no less inflation – can be avoided. 25 April 2018