Category: Monetary Policy

The Reserve Bank raises rates modestly and falls into the trap set by other central banks. Too little by half to impress the markets – more than enough to damage the economy.

The Reserve Bank fell into the trap set for it by its central bank peers in Turkey and India (and Brazil and Indonesia which are already in a tightening mode) who raised short rates to defend their weaker exchange rates.

That this strong armed defence (including direct intervention in the foreign exchange markets) has failed to support the likes of the Turkish lira or the Brazilian real, might have given  pause to the Monetary Policy Committee (MPC). A minority of members voted against the increase, presumably because they know that higher interest rates have an unpredictable influence on exchange rates – particularly when global capital markets are under strain – while having a predictably negative influence on already weak domestic spending and therefore economic growth.

The Governor or the members of the MPC cannot explain how higher interest rates will reduce inflation rates, unless the exchange rate strengthens in response to higher rates, which it may or may not do. The immediate response to the 50bps increase has been a weaker rather than stronger rand. It may however be argued that the market expected a more hawkish response of at least a 100bp increase and sold the rand accordingly. In other words, so the argument goes, the MPC surprised the market not because it raised rates but because it did not raise them much further.

What the SA economy needed and did not get from the Reserve Bank was a vigorous analysis of the uselessness in current circumstances of capital market volatility of raising short term interest rates. A full explanation should have been provided, and would have explained why a 50bp increase would be irrelevant for the exchange rate and harmful to the economy and why any larger hike in interest rates, perhaps expected in the market place, was unthinkable given the weak domestic economy. Nor, it might have been pointed out, would an even larger increase in short rates have helped the rand anymore than it has helped the Turkish lira.

Such an argument will be as imperative the next time the MPC meets, should the rand not have gained strength by then and should the inflation outlook remain as unsatisfactory as it is now and the economy become even less well placed to tolerate a further increase in rates. Without such an argument the economy may well set off on a 1998 Chris Stals-like spiral of higher interest rates in response to a weaker currency and the more inflation that follows that leads to still slower economic growth.

We have been here before and we should remember how much better the Australians coped at that time with Aussie dollar weakness – by sitting on their interest rate hands and not reacting to the essentially temporary inflation danger presented by a (temporarily?) weaker exchange rate. The comparison between the success the Aussies had by doing nothing and the pain suffered for example by the SA, New Zealand and Chilean economies in the late nineties, where interest rates were increased aggressively in response to emerging and commodity market crisis-driven exchange rate weakness, makes  a most instructive case study.

The right response to a weaker exchange rate driven by forces beyond the control of the Reserve Bank is not to react at all. It should ride out the exchange rate weakness as best it can and focus on the requirements of the domestic economy. The MPC did not have the wisdom to do this and unfortunately made a modest concession, a mere 50bp concession, to poorly considered market expectations and poorly executed monetary policy reactions in other emerging markets.

We can only hope it does a much better job before and during the next MPC meeting of defending the SA economy against ill considered and unhelpful interest rate increases. Monetary policy needs to be not only data dependent, as the Governor has indicated following the Fed mantra, but accompanied by appropriate guidance for the market that makes good economic sense. That is why we will not be embarking on an interest rate spiral unless the domestic economy can justify it – which it is very unlikely to do anytime soon.

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.

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.

Ben Bernanke fired his Bazooka yesterday. He pledged the Fed to further purchases of securities in the market without effective limit and for as long as it takes. The Federal Open Market Committee (FOMC) indicated net injections of cash of the order of US$85bn a month for as long as it takes. The indication from the FOMC is that

“…exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015”.

The asset markets were pleasantly surprised by the scale of the intended interventions in the asset market as well as their unlimited nature.

The key paragraph of the OMC statement read as follows:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative. The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Will these additional actions (QE3) work to revive the US economy and reduce the unemployment rate to a natural 5% or so within the next few years? The answer must be not necessarily so, given that highly accommodative monetary policies to date have not worked very obviously to reduce the unemployment rate below a stubborn 8%, with many more potential workers discouraged from looking for jobs (though how poorly the US economy would have looked without the accommodative actions to date can only be speculated about).

Persistently low interest rates and continuous injections of cash into the securities markets cannot do any harm to employment prospects. Nor can very low interest rates (as far as the eye can see) do anything but support the property market generally and related construction activity (unless these exceptional monetary measures were considered dangerous to the long term health of the economy and so undermine business and household confidence. This does not seem to be the present danger at all).

QE3 is likely to be very positively received by US business. However the boost to confidence necessary to strongly revive the spending plans of US business will have to be taken by the politicians after the elections. Better economic news from Europe and Asia would also be confidence boosting, but clarity on the outlook for Europe and China may not be imminent.

Monetary stimulus is helpful to asset markets. Higher asset prices support pension plans and encourage households to spend more. Low interest rates )that are expected to stay low) add to the argument for equities – especially those that come with dividend yield.

What sectors benefit?

The further question then is what sectors of the equity markets stand to benefit most in a still more friendly monetary policy environment? The case for the defensive stocks, that is those that pay dividends and have the balance sheets to maintain dividends, is most obviously improved.

The cyclical stocks, while not prejudiced at all by easy monetary policy and low interest rates would benefit most from a cyclical recovery itself. This, as we have suggested, is not a certainty in the short term: until a cyclical recovery clearly manifests itself, the outlook for commodity prices appears uncertain.

For undemandingly valued JSE listed cyclicals that would ordinarily benefit from of higher operating margins from SA specific rand weakness, this takes some of the wind out of their sails. The stronger rand in a world of persistently low interest rates (likely to extend to SA) is helpful for the interest rate sensitive stocks on the JSE.

The conclusion one comes to is that Bernanke, while helping equity markets, has in our opinion not yet improved the case for cyclical over defensives. The time for the cyclicals will come when the outllook for a global cyclical recovery appears more certain. Brian Kantor

Mario Draghi asserted the independence of the European Central Bank (ECB) to act as the independent central bank of Europe and to be the responsible guardian of the “irreversible” euro. This declaration of independence was supported by all but one of the governors of the ECB.

The bank’s government bond buying campaign is to be concentrated on maturities of less than three years to maturity. These purchases, now called the Outright Monetary Transactions (OMTs) will be conducted without any limit other than constrained by the judgment of Draghi and his colleagues. These purchases of all government bonds linked to the euro will not be inhibited by inferior credit ratings, nor would the ECB claim any seniority of its claims against borrowing governments ahead of private lenders. This is an important principle designed to draw private sector support for the bond market. ECB support for the market in distressed government bonds is conditional, that is on the condition that those governments seeking aid from Europe, the ECB and the IMF abide by the conditions set for such support. The “conditionality’ of ECB was strongly emphasised, no doubt to address likely criticism that the programme represented a soft option for hard pressed European states unable (so far) to convince the market place that they can continue to meet their obligations to creditors.

Predictably, the plan did draw criticism from the Bundesbank as representing fiscal assistance to governments and therefore was not within the mandate of the ECB. No doubt it was this German viewpoint that has so delayed the assertion of ECB independence and its ability to do, in practice, what it takes to protect a financial system in times of crisis. What it takes to solve a financial and banking crisis, as the Fed has proved recently, is quite simply the exercise of a central bank’s power to print money without limits, other than those set by its own judgment as to how much extra cash it will takes to solve a crisis. Once the crisis is resolved (hopefully, with excellent timing), it will then take back the cash from the banking system that could otherwise become inflationary (as excess supplies of money over the demand to hold money, inevitably become).

Sterilisation

Draghi did say that the automatic money supply effects of its bond purchases – crediting the banks with extra deposits at the central bank – would be “sterilised”. In other words, they would be countered by simultaneous ECB bond sales. Presumably, if the banks choose to hold excess cash reserves(as they have been doing to a very large extent in the US and Europe) sterilisation would not be called for.

Draghi was firm and forthright that his plan fully confirmed to the mandate of the ECB that charges the Bank with achieving monetary stability for Europe. Monetary stability, according to Draghi, demands the survival of the euro and the integration of the currently “fragmented” European monetary system. These are essential components of monetary stability and his ability to enter the bond markets without restraint is essential to this purpose, according to Draghi.

An integrated Eurpean monetary system would mean similar interest rates and costs and availability of credit in all the European centres of finance. It would also have to mean well co-ordinated fiscal policies and banking regulations and a unified European banking system. Europe will work towards this – monetary stability and the irreversibility of the euro to which the ECB is committed allows time for the European project – the European Union – to be completed.

It will take time, maybe lots of time, to be realised, but Draghi has acted to reduce what he described as “tail risk”, that is to reduce the perhaps small but catastrophic possibility of a banking and financial collapse in Europe.

It has taken a long time for the ECB to assert itself as a fully independent central bank. The almost immediate reactions to the Draghi plan were highly favourable. Risks came off, to the advantage of the bond, equity and currency markets, including the rand. If the market is convinced that the ECB could do what it would have to do in a time of crisis then maybe the markets in euro debt and interbank loans will calm down enough to avoid the ECB from actually exercising its powers. The bazooka is loaded: it may not have to be fired.

Fired or not, the markets can return to the still difficult task of forecasting the state of the global economy (Europe included) without the same fear about the tail risk of a European financial break down that the ECB has addressed. Brian Kantor

Headline CPI inflation declined to 4.9% for the 12 months to July. This welcome lower rate of inflation does not tell the full story of the direction of prices. A year can be a long time in economic life and what happens to prices in between can be much more revealing about inflation trends. Over the past three months prices have increased very slowly – more slowly than they did a year ago, as we show below. Prices rose by 0.08% in May, 0.24% in June and 0.32% in July.

These relatively small monthly increases compared to a year before have brought down the three month rate of inflation, seasonally adjusted and annualised, sharply lower to well below 4%. ( See below)

If current trends in the CPI persist, the outlook is for an inflation rate of no more than 3.5% this time next year, as we show in the chart below. It should be noticed that monthly increases in the CPI were particularly rapid early this year, thus offering the possibility of seeing year on year inflation come down further in early 2013 (that is, if monthly increases then turn out to be below the rather high monthly increases of early 2012).

These trends could be damaged by a combination of a weaker rand and supply side disruption (drought and war) which might drive global grain and oil prices higher. If global growth gathered enough momentum to drive up metal and commodity prices generally, for demand side reasons, the rand might well strengthen to moderate such influences on the prices of imported and exported goods. Faster growth in export markets would be very helpful to the SA economy. It could bring faster growth without more inflation, because the rand will strengthen.

Slower global growth would be very likely to weaken the rand and cause the inflation numbers and outlook to deteriorate. The domestic economy will also be harmed by such trends. It would mean slower growth and higher inflation. The case for raising interest rates under such adverse circumstances is a poor one. It would mean still slower growth without any predictable impact on the inflation rate.

The Reserve Bank, under present leadership, seems unlikely to raise rates should this adverse scenario materialise. If the economy stays its present course (less inflation and growth that remains below potential growth), the case for lowering rates improves. The more hopeful scenario – the SA economy to benefit from a reviving global economy and higher commodity prices and a more valuable rand meaning no more inflation – the case for lower interest rates also improves.

And so in the light of currently lower inflation, the case for lower interest rates has improved. Furthermore it is hard to contemplate more favourable or less favourable economic circumstances that would drive short rates higher. We might describe the outlook for (lower) interest rates in SA as the Marcus Put. Brian Kantor

(From 23 December 2011)
The ECB has finally acted as a lender of last resort (without limit) to the European banks, who had been threatened by the weakness in the European Government bonds they hold. These bonds are now being used as collateral by the banks for three year money from the ECB at 1% per annum.

Click here for the full report:
Talking Point A New Year Wish

(From 14 December 2011)
The big new story in the currency markets is not the weakness of the rand or the strength of the dollar – but the weakness of the euro. The euro, which was worth as much as 1.417 US dollars on 27 October, is now trading at close to 1.30

Click here for the full report:
Currencies Structurally weaker euro

Published in Sunday Independent November 20th 2011

Brian Kantor
15th November 2011

It is surely clear that the SA economy can do with all the help it might get from lower interest rates. It is not getting that help from the Reserve Bank because the inflation outlook has deteriorated. The inflation outlook however has deteriorated because of a weaker rand. And the rand is weaker for reasons completely out of the influence of the MPC – that is the Euro debt crisis.

The MPC should know but seems not to recognize that interest rate settings in SA have no predictable influence at all on the exchange value of the rand. The correlation between changes in interest rates and the changes in the value of the rand is close to zero- that is there is no observable influence of changes in interest rates on the exchange value of the rand. And therefore interest rates have no predictable influence on the prices paid for imported and exported goods that have such a strong direct bearing on consumer prices in South Africa. Moreover over the past twelve months, since the MPC last cut interest rates, the rand has been all over the place, driving inflation in one and then the other direction.

The evidence is overwhelming, no doubt awful to contemplate for those with a text book view of monetary policy in South Africa is that interest rates and therefore monetary policy settings have not had any meaningful influence on inflation outcomes in SA. And moreover they cannot be expected to have any predictably anti inflationary purpose until the rand responds to SA, rather than global forces. This surely cannot be predicted to happen any time soon.

Like it or not monetary policy can only influence aggregate demand in South Africa. Its impact on the price level has been and will be overwhelmed by moves in the rand. Thus higher interest rates, especially when accompanied by a weaker rand and the higher prices that follow, can only mean less spending and less output and employment in South Africa- without having any helpful influence on inflation or the outlook for inflation that will be dominated by the outlook for the rand. By not lowering rates or even, heaven forbid at this stage of the business cycle, contemplating raising them, because the inflation rate might breach the inflation targets, the MPC has burdened the SA economy with less growth and no more or less inflation.

And should the Reserve Bank response to this critique take the form that monetary policy must fight not just inflation but inflationary expectations, it should also be recognized that there is also no evidence of this in South Africa. Inflation may have affected inflation expected in South Africa, even though inflation expected has been remarkably stable, suggesting that such effects have been of small magnitude. But there is no evidence of any feedback or so called second round effects effects. That is more inflation expected leading to more inflation. This has not happened perhaps because the theory is faulty but much more obviously, because inflation in SA follows the exchange rate and does not lead it. ( See Below)

South Africans have been called upon to make sacrifices in the form of slower growth for lower inflation or at least inflation in line with inflation targets that in the light of our recent monetary history make no sense at all. A new narrative for SA monetary policy is long overdue. This does not have to mean more inflation or more inflation expected. This would neither be desirable or inevitable. If the narrative explains the facts of the matter that inflation is dominated by exchange rate movements, over which SA has little predictable influence, and monetary policy was set accordingly, it would mean faster and more sustainable rates of growth. This faster more sustainable and predictable growth would attract more capital to South Africa to fund this growth. This would mean a stronger rather than weaker rand over the long run- and so less rather than more inflation over the long run.

But this narrative would mean recognizing that inflation targeting for South Africa- given the openness of its financial and currency markets to unpredictable global forces – has not been a sound basis for monetary policy.

Retail inflation- led by import prices – a mix of global prices and exchange rates – heading higher

Our markets have been dominated by global events – with the JSE, the rand and to a lesser extent the SA bond market gyrating closely in tune with global markets, especially emerging markets, in response to degrees of global risk aversion.

Friday 11 November however was an unusual day in the SA bond and equity markets. Market moves were dominated by an SA specific event: the meeting and outcome of the Monetary Policy Committee (MPC) of the Reserve Bank that reported back on Thursday afternoon. The market by Friday had significantly revised its view on the interest rate outlook. The market had attached only a small probability of a cut in rates on the Thursday before, but had been pricing in an above 50% probability of a cut within three months.

As we show below the market, in the light of what was said rather than what was decided at the MPC meeting, now regards the chance of a cut in rates anytime soon as highly remote. The yield curve that was upward sloping, indicating the likelihood of higher interest rates a year out, has shifted up and become steeper indicating higher rates to come, and sooner.

Clearly such expected interest rate moves are not helpful to the growth outlook for SA, which has if anything deteriorated in recent months, with the risks attached to Europe and its implications for global growth, as was confirmed by the Reserve Bank. Also indicated by the Reserve Bank was the weakness in domestic demand.

Hence the failure on Friday of the equity market to respond to better news about Europe or to the strength in offshore equity markets. The rand was similarly unmoved by stronger equity markets, perhaps also because the SA growth outlook had deteriorated.

It is surely clear to all on the MPC that the SA economy can do with all the help it might get from lower interest rates. It is not getting that help because the inflation outlook has deteriorated. The inflation outlook however has deteriorated because of a weaker rand; the rand is weaker for reasons completely out of the influence of the MPC, namely the Eurozone debt crisis.

The MPC should know but seems not to recognise that interest rate settings in SA have no predictable influence at all on the exchange value of the rand. As we show below the correlation between changes in interest rates and the changes in the value of the rand is close to zero – there is no observable influence of changes in interests rates on the exchange value of the rand and therefore on the prices paid for imported and exported goods that in turn have such a strong direct bearing on price setting behaviour in SA. The correlation co-efficient is close to zero. Moreover, since the MPC last cut interest rates in November last year, the rand has been all over the place driving inflation in one and then the other direction.

The evidence is overwhelming that interest rates have not had any meaningful influence on inflation outcomes in SA. Moreover they cannot be expected to have any predictably anti-inflationary purpose until the rand responds to SA, rather than global forces. This surely cannot be predicted to happen any time soon.

Like it or not monetary policy can only influence aggregate demand in SA. Its impact on the price level has been and will be overwhelmed by moves in the rand. Thus higher interest rates, especially when accompanied by a weaker rand and the higher prices that follow, can only mean less spending and less output and employment – without perhaps having any helpful influence on inflation or the outlook for inflation. By not lowering rates or even, heaven forbid, contemplating raising them, the MPC has consistently burdened the SA economy with less growth without any predictable influence on inflation.

And should the response to this critique take the form that monetary policy must fight not just inflation but inflationary expectations, it should also be recognised that there is also no evidence of this in South Africa. Inflation may have affected inflation expected in SA (even though inflation expected has been remarkably stable, suggesting that such effects have been of small magnitude). But there is no evidence of any feedback effects (ie more inflation expected leading to more inflation). It has not happened perhaps because the theory is faulty but much more obviously, because inflation in SA follows the exchange rate and does not lead it.

South Africans have been called upon to make sacrifices in the form of slower growth for lower inflation or at least inflation in line with inflation targets, which make no sense at all. A new narrative for SA monetary policy is long overdue. This does not have to mean more inflation or more inflation expected. If the narrative recognises and explains the facts of the matter and monetary policy were set accordingly it would mean faster and more sustainable rates of growth. By attracting more capital to SA to fund growth could mean a stronger rather than weaker rand over the long run and so less rather than more inflation over the long run. But this would mean recognising that inflation targeting – given the openness of its financial and currency markets to unpredictable global forces – has not been a sound basis for monetary policy in SA. Brian Kantor

We have heard the same story before from the Reserve Bank MPC. With every reason to cut rates to improve the growth outlook and to alleviate the risks of slow growth (as highlighted recently by Moody’s), the MPC again stood pat as it has done since November 2010, when it last cut rates in surely very different and less propitious circumstances.

Yes, as we are constantly reminded, the inflation rate remains stubbornly high despite the recognised weakness of domestic demand. But what is not acknowledged is that the inflation rate is beyond any predictable influence of the Reserve Bank. This fact of economic life is simply ignored by the MPC which employs a highly flawed theory (that enjoys no empirical support whatsoever from the SA evidence) of the forces that have driven inflation in SA over the past 10 years. The MPC appears simply not up to the intellectually demanding task of adapting its highly conventional theory of inflation to recognise its anti-inflationary impotence or the seriousness of the slow growth outlook. Its responsibility is to do what it can for growth (which is all the Reserve Bank can realistically hope to do), that is, influence the domestic growth rate with its interest rate settings so that it may better fall in line with potential growth.

The fact is that the exchange rate drives inflation in SA and the exchange rate is dominated by highly unpredictable global forces beyond the influence of SA monetary policy. Inflationary expectations have remained highly stable in SA and only modestly influenced by inflation itself. Any possible feedback from more inflation expected to more inflation has clearly not been in evidence. Moreover there has been no predictable impact of changes in policy determined interest rates on the exchange value of the rand. Therefore it should be recognised that while interest rate settings influence the level of aggregate demand in SA, the links between changes in aggregate demand and inflation have been overwhelmed by exchange rate changes (and will continue to be so overwhelmed). In the same way, any possible influence on the inflation rate of inflationary expectations will be overwhelmed by unpredictable exchange rate developments and to a lesser extent by global food and commodity prices. The so called second round effects on inflation are but an article of faith for the members of the MPC. Good monetary policy takes more than faith in conventional and also flawed theories of inflation.

This is a disappointment. We had hoped for better from Governor Marcus – but we are inclined to the view that we should not now expect a more growth sensitive approach from her and her committee.

It is very hard to anticipate the change in circumstances that could lead to a rate cut anytime soon. If not now then when? The inflation outlook will remain unchanged (absent of any important reversal in the rand) that can only come with an improved global growth outlook that in itself would reduce the argument for lower rates. And so we can anticipate an extended period of sub-optimal growth, inflation at or about the upper band of the target range – and thus an extended period of interest rates at current levels. Brian Kantor

The MPC yesterday downplayed the risks to inflation correctly, while the risks to the domestic economy received full attention. Listening to the litany of economic problems facing the SA economy referred to by Governor Gill Marcus during her speech (quoted below*) I had a moment of near exhilaration that the MPC would in fact surprise the market by cutting rates. The economy is clearly screaming out for them as it has been doing for some time.

But then caution prevailed. We can blame global risk aversion and its impact on the rand for the predictable pusillanimity in Pretoria. But the case for an interest rate cut was debated and the Governor provided every indication that a cut next time round is now very much more likely (if the economy stays on its present sub-optimal course) and especially if the rand recovers some of its losses, which it will if the global risk appetite recovers to a degree. Brian Kantor

Extracts from the MPC statement that pointed to interest rate action, not inaction:

The depreciation of the rand poses a potential upside risk to the inflation outlook. However the degree of this risk will depend on the extent and persistence of the depreciation trend, which in turn will be influenced by the duration and intensity of global risk aversion. The rand tends to be more sensitive to changes in global risk perceptions than most of its emerging market peers. At this stage the MPC still considers the upside risk to the inflation outlook from this source to be relatively moderate, but rising.

Source: MPC statement, 22 September

How much would European Banks be required to write off of their loans to European governments? That is presuming a bad (not worst case) scenario of a 70% write down of Greek, Portuguese and Irish debt and losses of 30% on Spanish and Italian debt. The recent stress tests of 90 European banks and an IMF analysis of the CDS market provide some ball park numbers. The estimate is of the order of EUR260bn: a large amount but not nearly as much as the EUR700bn written off by European banks in the aftermath of the 2008-09 global financial collapse.

A consoling thought is that aside from the failures of their sovereigns, banks in Europe have little other additional exposure to private borrowers that they might have to write off. They have done very little additional lending lately, quite unlike the run up to the global financial crisis when lending growth was robust at close to a 10% annual growth rate.

Equity investors have made their own severe judgments as to the losses European Banks will incur. The Stoxx Europe 600 banks index is down just over 25% since1 August. Société Générale, France’s second-largest listed bank, has lost half of its market value since the beginning of August. Shares in Crédit Agricole, France’s number 3 bank, have dropped 35% while those of BNP Paribas, the largest French bank, are down 32% over the same period. More important perhaps than the absolute fall in the value of their shares, is that the market value of some of these banks is much diminished. This suggests very poor prospects for these banks and very little capacity to raise additional capital from their much damaged shareholders. Since 1 August the market value of Soc Gen has fallen from EUR25bn to its current value of EUR11.79bn while BNP is now worth EUR32.4bn compared to EUR52.4bn on 1 August. As far as shareholders are concerned they have already had to write off very large amounts of capital in their banks.

The question then becomes whether or not the European governments have the will and even perhaps the financial capacity to do what presumably the market place would be unwilling to do, and that is to recapitalize their banks. The alternative is a permanently impaired banking system unable to make the essential contribution to credit availability and economic growth that banks make. And a word of sympathy for banks – that is their shareholders – is in order. You can blame the lending officers of the banks for supporting US mortgage backed credit. You can hardly blame them for lending to their own governments – indeed they are obliged by regulation to do so because they are treated as being the safest of assets.

It can be expected that should some formal Eurozone governments’ defaults be acknowledged of the grave order indicated above (a possible but by no means certain event) governments will have to replenish the capital of their banks. Furthermore the liquidity strains of these banks will continue to be fully satisfied by the ECB – as they have to date. It is this support that has prevented a further melt down in Spanish and Italian debt as well as support for the banks using such debt as collateral for ECB support.

The responses of the US Fed and the US Treasury to the banking and financial crisis has very clearly pointed the way forward for European governments and the ECB. The very effective responses of the Swedish and Norwegian governments to their own banking crisis of the early 1990s are perhaps even better examples of crisis management closer to home.

The share markets may be pricing in not merely a bad case scenario of significant write offs of European government debt. They appear to be pricing a worst case scenario in which European governments and the ECB stand by and watch the European banking and financial collapse. This is a development that would not only harm its banks irreparably but would damage as irreparably the capacity of European governments to raise debt, a notion too ghastly to even contemplate. European leadership and technical central banking skills are surely capable of avoiding the worst case and be able to deal with what is a bad case fully discounted in the market place.

The money market is now pricing in a significant probability of a 50bps cut in the repo rate by early next year. The three month interest rates offered by the SA banks on forward rate agreements have been declining sharply since mid August and they declined further last week indicating a more than 50% chance of a 50bps cut within six months.

It seems clear that the focus of the Reserve Bank is now firmly on the state of the SA and the global economy rather than on any short term blips in the inflation rate, over which the Bank has little influence. Without a series of unexpectedly good news about the global economy (and the SA economy, especially about demands for credit), these lower interest rates (now factored into and expected by the financial markets) will become a very necessary reality.