Monetary Policy – Page 6

The Reserve Bank has no more to offer

The Reserve Bank has indicated very clearly that it does not intend to provide any further relief for the hard pressed SA economy. Neither lower interest rates, nor quantitative easing, is on offer for the foreseeable future.

The Reserve Bank is relying on waiting to quote its release:

“….There are however signs that the downturn, both globally and domestically, may be nearing the lower turning point, but the recovery is expected to be slow and protracted…”

It added later that:

“….The composite leading indicator as compiled by the staff of the South African Reserve Bank increased slightly in April. The indicator suggests that the lower turning point in the cycle could be reached later in the year.”

We would agree that while the global economy may well have reached its lower turning point, we are not at all sure that the SA economy has done so. We do not share confidence in the predictive powers of a leading indicator much influenced by the stock market. The housing market is probably more important than the stock market in influencing the wealth and confidence of the SA consumer and trends there are not at all helpful.

The economy is very dependent on global trends

The reluctance to lower interest rates further or to engage in quantitative easing
(linked to attempts to restrain rand strength) has made the recovery of the SA economy dependent on global trends. The outlook for domestic spending remains bleak as the Reserve Bank has confirmed.

Unintended consequences

In response to the decision the rand responded favourably to the prospect of higher short term rates while higher long term rates followed short rates higher.

The compensation for inflation offered in the bond market, being the difference between the yields on the inflation linked government bonds and the vanilla variety (to which the Bank gives attention in its focus on inflationary expectations) rose yesterday. The yields on the inflation linkers declined reflecting the poorer growth outlook while the nominal yields rose.

A stronger rand and higher interest rates are surely not desirable outcomes of monetary policy settings. The stock market and also the exchange value of the rand however are responding to forces beyond the influence of SA monetary policy. The stock market is largely ignoring the deteriorating outlook for the earnings of SA economy dependent companies.

Global forces dominate the rand and the JSE

The dominant forces acting on the JSE and the rand are the direction of Emerging Equity Markets and commodity prices – they are running together in response to the outlook for the global economy. This outlook has improved significantly over the past few days in response to OECD economic forecasts that were revised higher rather lower.

The Reserve Bank is fighting inflationary expectations

The focus of the MPC statement was on inflation and inflationary expectations. The Reserve Bank argument against lowering interest rates is a familiar one. That is to contain inflationary expectations – even while recognising that the weak state of the economy – may well lead inflation lower. They also make reference to producer prices that are falling sharply and that unlike consumer prices, do decisively reveal the weak state of domestic demand as well as the influence of the strong rand on the competition for domestic producers. That producer prices might better reflect the thrust of monetary policy and that if they do, deflation may be a greater threat to the economy, does not receive consideration.

Are inflationary expectations self fulfilling?

The Reserve Bank is of the view that inflationary expectations are self fulfilling, even if the economy is suffering form excess supply rather than excess demand. The long run benefits of less inflation expected and therefore less inflation – as it is assumed – is thought to be the worth the short term sacrifices the economy has to make.

How the Reserve Bank could hold to this view now given producer prices, is very hard to appreciate. Our view is that inflationary expectations, when applying some naïve cost plus view of price determination, can only lead to permanently higher inflation when supported by a willingness of consumers to spend more.

The current unwillingness of SA consumers to pay more is obvious. The Bank also is well aware that the pressures on consumer prices are coming from prices that are regulated rather than market determined – and therefore well beyond the direct influence of monetary policy. Such price increases however act as a tax on expenditure and depress demands for less dispensable goods and service. Tax increases provide reason for lower rather than higher interest rates.

An alternative explanation for more inflation expected

The Reserve Bank might however consider another reason for the unhelpful trends in inflation expected, other than inflation trends themselves. That is a single minded focus on fighting inflation- in rhetoric perhaps more than in practice – is politically unsustainable. If so this is expected to damage the independence of the Reserve Bank to continue its fight against inflation over the long run. Apres moi le deluge is not an unrealistic conclusion, one leading to more inflation expected over the long run.

We share the view that low rates of inflation are helpful for economic growth in the long run. But to regard inflation as the end rather than the means of economic policy regardless of the state of the economy, is neither necessary or helpful to the cause. The decision of the Reserve Bank not to lower interest rates now will add doubts as to the usefulness of low rates of inflation when the sacrifices for it seem so heavy and do not make obvious sense. The political consequences of Reserve Bank inaction are not necessarily encouraging for the inflation outlook.

Monetary policy: How much room for manoeuvre?

Asking the right questions

The Monetary Policy Committee of the Reserve Bank will be asking this question of the economy today and tomorrow. They will be well aware that despite a severe decline in household spending (household spending declined at a real 4.9% rate in Q1 2009) net flows of capital to SA continued at near record rates, equivalent to 7% of GDP. All other things remaining the same, had spending growth been anything like normal, the flows of capital from abroad would have to have been even greater.

Avoiding the wrong answers

Perhaps it will be suggested by committee members that it would be unrealistic to expect capital flows of larger orders of magnitude – so limiting severely the scope for more household spending – and by implication the scope for lower interest rates that are urgently called for to encourage households to spend more and banks to lend more. We will argue that this would be the conclusion to draw from what is an inappropriate line of enquiry. Such thinking has caused the economy unnecessary distress in the recent past.

These are not normal times

Normally such a severe reduction in spending as occurred in Q1 2009, would have led to fewer goods and services imported, an improvement in the balance of trade and so less capital imported. The problem however was that the volume of exports declined at an even faster rate than real imports in Q1 – the result obviously of the global recession that reduced in particular demands for metals, minerals and motor cars from SA. The weaker trade balance dragged down GDP, which declined at a very depressing 6.4% rate in the quarter.

Spending in general held up in Q1 2009

However not all categories of domestic spending were in retreat in Q1. Surprisingly and somewhat anomalously, household spending on services actually grew at a brisk 7.5% rate amidst the consumer gloom – implying that spending on consumer goods will have declined at an over 12% annual rate. Gross fixed capital formation continued to increase, though at a very sedate pace compared to a year before, and government consumption spending also rose marginally.

Final demands, being the sum of household and government consumption spending and fixed capital formation, declined at only a net 1.5% rate. The disinvestment in Inventories of -R10.2bn, half the decline estimated for Q4 2008, meant that Gross Domestic Expenditure actually grew at a 2.2% annual rate in Q1 2009. (See the tables below sourced from the Quarterly Bulletin of the SA Reserve Bank June 2009)

Spending held up as did capital inflows and prices came down

Thus aggregate demand in general held up much better than aggregate output and this was made possible by robust capital flows. These capital flows also helped to strengthen the rand and by so doing lowered the rand prices of imported goods and services including capital goods. Without these more favourable trends in the prices of goods, particularly at the ports and the factory and farm gates, spending presumably would have been even weaker.

Guesses about the pace of capital flows have been wrong and may continue to be wrong

Trying to second guess the ability of the SA economy to attract capital and to set monetary and fiscal policy accordingly is in our view quite the wrong way to steer the SA economy. Yet such concerns have been an important and unhelpful influence on monetary policy in the recent past. They led to a much weaker rand in 2006-7 as higher interest rates came to threaten the growth outlook for the economy.

The guesses about the attractions of the SA economy to foreign capital are very likely to be wrong ones. Such guestimates have almost certainly underestimated actual capital flows to SA in recent years. They have not taken into full account the favourable feedback loop from faster growth to increased flows of capital into account. If growth can be kept going with sympathetic monetary policy settings, that emphasise the objective of sustaining growth, more capital can flow in to make that growth possible. And more capital means a stronger rand and less rather more inflation to accompany faster growth. That the SA economy could attract net foreign capital flows, at the rate equivalent to 7% of GDP in a recession as it did last quarter, would have been inconceivable to balance of payments model builders.

The conclusion the MPC should come to

The conclusion we believe the MPC should come to about its room for manoeuvre is to do all it can to revive household spending. Lower interest rates combined with quantitative easing is called for. If this should however mean a weaker rand because the extra foreign capital is not forthcoming this would mean a weaker rand and so be it. This would unfortunately mean higher prices and counter the stimulatory influence of lower interest rates.

Do not second guess the rand

The rand however should not be the objective of policy either directly, when the Reserve Bank intervenes in the currency market, or indirectly when it makes judgments about the sustainability of capital flows and sets interest rates accordingly. The rand should be allowed to find a value that is consistent with achieving a good balance between potential and actual domestic output. This is the only proper goal for fiscal and monetary policy with low inflation seen as a means to this end rather than an objective of policy itself.

The rand as we have indicated may well stand up well if faster growth were achieved and so more capital is attracted. The Reserve Bank should never feel constrained by fear of capital flows when encouraging domestic spending providing such spending is insufficient to the purpose of maintaining potential output and employment.

Realism called for

Yet the MPC will have to be realistic about how much influence it can have today on the economy. Any immediate revival in domestic spending growth is unlikely even with lower interest rates and quantitative easing. The confidence and wealth of SA households have suffered too much recent damage to expect any immediate response. Paradoxically even if the MPC does not share our view of the world the thought that spending is unlikely to revive soon will encourage the Committee to lower interest rates.

Therefore the relief for GDP growth is much more likely to come from exporting into a reviving global economy than from household spending. We expect the MPC to cut its repo rate by 50bps and by another 50bps in July. Any deeper cut now would be very welcome to us and the markets.

Explaining quantitative easing and the case for its application in SA

Introduction

In this report we explain why quantitative easing has been called for in the US because the demand by banks to hoard cash has increased so dramatically despite lower interest rates. This demand for cash has meant less bank lending and a weaker economy. In South Africa the unwillingness of banks to lend has also to be countered for the sake of the economy. However the monetary problem locally, unlike the US, is the slow growth in the supply of cash rather than the increase in cash hoarded at he Fed. We call for a combination of lower interest rates and quantitative easing to revive bank lending and the SA economy

Lower interest rates may not work if banks prefer to hoard than lend cash

It is clear that reducing interest rates cannot on their own always revive an economy in recession. Central banks in the US and Europe have become ever more ready to freely assist their member banks with cash at close to zero rates of interest. But the private banks have remained unwilling to borrow the cash. They have preferred to lend more to their central banks rather than borrow from them.

As we show the US banks have come to hold cash reserves far in excess of their legal requirements to do so and this demand for cash has greatly inflated the supply of central bank money in the US being the sum of the notes issued by the Federal Reserve Banks plus the deposits of the bans with the Fed less the cash held to meet compulsory reserve requirements.

US central bank money and excess cash reserves of the banking system

Source; Federal Reserve Bank of St Louis and Investec Securities

The banking system is powering down rather than up

This sum of central bank money is sometimes described as the money base of the system or more evocatively as its high powered money. This description indicates that increases in central bank money usually power up the supply of bank deposits in the system that are included in the broader definitions of the money supply (M1, M2, M3) But this can only happen when the banks lend out the cash. When the banks hoard the cash the system powers down rather than up as it is now doing.

Thus quantitative easing

Hence the call for quantitative easing to get the cash on the balance sheets of the central banks back into circulation so that it can help stimulate more spending as extra money normally does. The central banks eases quantitatively by utilising the cash it has on deposit to buy assets in the money and credit markets. This exchange of cash for assets, usually for securities issued by the government itself or government supported agencies, gets cash in the hands of those – unlike the banks – who are more likely to spend or lend rather than hoard cash. Judged by the recently improved ability of US and European companies to raise capital in the money, bond and lately also again in the equity markets, it does appear as if the global credit system is easing up in a most welcome way.

Both the supply of and demand for money matters

Recent developments in the money markets helps to remind us that what matters is not so much the supply of money but the excess supply of money, that is the excess of the supply of money over the demand to hold money. When the supply of money grows faster than the demand to hold more money the extra spending then pushes up prices at a faster rate. And when the supply of money lags behind the demand to hold money you get the opposite – less spending and deflation. This is the problem for the developed world- the demand to hoard money has grown even more rapidly than the supply of money. The challenge central bankers will face in due course will be to reign in the supply of cash when the banks become more willing to lend and less anxious to hoard their cash.

In South Africa the supply of money is growing far too slowly

While the SA economy is also performing well below its potential completely opposite conditions prevail in the money market. Unlike the case abroad, the growth in the supply of SA Reserve Bank money has been growing very slowly and far too slowly for the health of the economy. (See below) As we also show the growth in the supply of more broadly defined money, to include deposits issued by the commercial banks, has been decelerating sharply, as has the growth in the supply of bank credit to the private sector. The growth in M3 that was over 25%

in mid 2007 is now running at about 10% pa as may be seen in the figure below. However this growth rate understates the recent sharply decelerating trend in the growth in money and credit. The March 2009 quarter to quarter seasonally adjusted rate of growth in M3 was but 6% and the growth in bank credit supplied to the private sector was but 2%. Clearly these growth rates are far to slow to help revive the SA economy.

Growth in SA Reserve Bank Cash Supply

Source; SA Reserve Bank and Investec Securities

South Africa; Growth in M3 and Bank Credit supplied to Private Sector

No banking crisis in SA – merely an economic crisis not helped by nervous banks. Quantitative easing called for

South Africa has not suffered from a credit or banking crisis. Banks in South Africa, unlike their US peers have therefore not increased their demand for cash reserves. The ratio of excess reserves to the supply of central bank money remains very close to zero as we show below.

USA and South Africa- ratio of excess to required cash reserves of Banking System

Source; SA Reserve Bank Federal Reserve Bank of St Louis and Investec Securities

But the SA economy is growing far below its potential. SA banks too are suffering from higher write offs for bad debts though nothing like the scale infecting the banks in the US. Yet much more important they too have become more reluctant to lend and this is adding to the weakness of the economy. Something therefore needs to be done to accelerate the growth in the supply of money and credit in SA . Lower repo rates, still far higher than levels in the developed world, may not be sufficient to the purpose. Quantitative easing in fact is as much called for in South Africa as it is the US to encourage the banks to lend more.

How best to ease quantitatively

The method to do so is at hand. That is for the Reserve Bank to counter unwanted rand strength with purchases of foreign currency. However the additional rands, used to pay for the foreign currency, should be allowed to a greater degree to find their way into the market rather than be sterilised by the Treasury. Such sterilisation operations have taken place on a large scale in recent years to counter the growth in the foreign exchange and gold assets of the Reserve Bank. The Treasury has borrowed large sums, some R66b at year end to this purpose. The funds raised are then kept idle at the Reserve Bank and these idle balances then reduce the cash available to the private sector and prevent the money supply from increasing.

SA Reserve Bank

Given the increase in the fiscal deficit and the ordinary borrowing requirements of the Treasury the idea of selling fewer interest bearing government bills and bonds for the purpose of restraining the growth in the cash supply should have additional appeal. The case for encouraging the supply of cash to grow faster in SA has become a very strong one. The SA economy needs both lower interest rates and quantitative easing to recover its growth momentum.

The US dollar as a reserve currency – the jury is out on this one

Reserve currencies – what they are

A much discussed topic lately is the role of the US dollar as a reserve currency. The US dollar is held as a reserve of international purchasing power or liquidity by governments, banks and firms. The US dollar is mostly nominated as the basis of contracts, as the unit for transacting and accounting purposes, across borders between parties outside the US. It was because of the large role played by US firms in global trade and finance that the US dollar became the reserve currency of choice in the twentieth century increasingly replacing the pound sterling as the predominant unit of account in international transactions. The pound sterling had gained this role because of the earlier dominance of the UK in nineteenth century global trade and financial flows.

Until the early seventies the US dollars held by foreign central banks could be exchanged for gold at the rate of 35 dollars per Troy ounce of gold. Since many other central banks also kept their gold at Fort Knox in Kentucky such transactions would take the convenient form of moving gold from one part of the fort to another. The US unilaterally went off the gold standard in 1971. The UK gave up its willingness to exchange gold for pounds finally in 1932 after earlier phases of inconvertibility during the Napoleonic and First World Wars and their aftermaths. Gold is still held as a minor source of international purchasing power by governments and their central banks – still often safely stored for them in Fort Knox.

Reserve currencies emerge in response to market forces

Reserve currencies are not declared by some international agency – they emerge in response to the global needs of trade and finance. The possibility of one reserve currency increasingly replacing another is clearly always possible given the freedom contracting parties have to nominate a convenient unit of account in which to conclude a contract. Governments and banks also have the freedom to choose the most helpful currency or currencies in which to hold their reserves of international purchasing power. These reserves are mostly kept in the form of US dollar deposits in foreign banks including other central banks. Reserves of liquidity are also kept by in the bills and bonds issued by the US government that pay higher rates of interest tan bank deposits.

The advantages to the issuer of a reserve currency

The advantage to the issuer of a currency or bonds or bills held as reserves by others is that these demands reduce their costs of funding government expenditure. The notes issued by a central bank are the non-interest bearing liabilities of the issuing central bank. That foreign holders of these notes, in addition to their domestic holders, are prepared to forgo interest on the their cash – for the convenience it offers – including the ability to evade surveillance by tax authorities – makes issuing notes a particularly cheap source of finance for the government. A large proportion of the actual greenbacks are in fact held outside of the US so helping to fund US government spending.

The costs of issuing notes

Not that issuing the notes is without its costs – the costs are incurred in the protections the issuing government that have to take against counterfeiters as well as highjackers of cash in transit. Government have to insure the safety of the notes issue if economic actors are to be willing to hold them. The difference between the interest governments save by issuing notes rather than bills and bonds and their costs – including the costs of staffing their central banks – is called seignorage and is implicit in the dividends central banks declare to their governments. In South Africa unusually, this central banks income from issuing non interest bearing notes, is still shared in small part with some private owners of Reserve Bank debt in the form of a fixed coupon payment.

The essence of a well respected unit of account and reserve currency

Domestic currencies serve perfectly usefully as the unit of account for the many contracts entered into between domestic parties. Both domestic parties will be well aware of the real value of the contract when fulfilled. Clearly for a foreign currency to be nominated as the unit of account in a contract indicates that something must be considered unsuitable in the domestic currency by one or other of the parties involved. This unsuitability presumably arises out of the relative unpredictability of the exchange value of the domestic currency. Presumably reserve currencies must offer predictability in the rate they can be exchanged for domestic currencies.

Does the US dollar meet the criteria – does any other currency?

An essential quality of a reserve currency must be the predictability of its rate of exchange for all other currencies. It is surely this lack of predictability of the exchange value of the US dollar that calls into question its continued role as the predominant reserve currency. Clearly if a reserve currency strengthens this will be highly acceptable to its holders and vice versa will be uncomfortable when it generally weakens against other currencies. However even unpredictable strength will make the currency less useful for purposes of trade or finance. The requirement is rather predictability of value though predictable strength rather than predictable weakness will clearly to be preferred by holders of a reserve currency.

The US dollar has not been very predictable – not that it has been a one way bet

We show the exchange value of the US dollar against the other major currencies in recent years. Higher numbers indicate strength. As may be seen the US dollar was very strong in the mid eighties. It weakened sharply in the late eighties and traded at these weaker levels more or less stably until the mid nineties when a further period of pronounced strength emerged that was reversed over much of the past decade.

The US is extremely reluctant to commit itself to policies that would stabilise the US dollar at the possible expense of the US economy. But unless its attempts to stabilise the US economy help co-incidentally to stabilise the US dollar far better than has been the case over the past 30 years, the suitability of the US dollar or other US government liabilities as a reserve will remain a live issue. But no other currency has presented itself as suitable as is the US dollar for the purposes of undertaking global trade and finance.

Gold is still making a case as a reserve

No other country, or in the case of the euro, the European governments collectively, seem willing to commit to currency stability while also allowing currency convertibility. The Chinese may offer predictability in the yuan – but not easy convertibility. They fear how such a commitment could qualify them for reserve currency status. They are aware that such a commitment, even when believed, may constrain their freedom to manage their domestic economies. The contest for global currency supremacy can however never be regarded as decided as over. It remains up to the market place and government policies to decide the outcome. While the outcomes remain particularly uncertain as they now are gold is likely to retain its appeal as a contingency against the unpredictability s of other stores of value

FRED Graph

The SA Business Cycle: Hard numbers still pointing to lower levels of activity

Our Hard Number Index (HNI) can now be updated for May 2009 with the release of two hard numbers, vehicle sales and the notes issued by the Reserve Bank at May month end. As we show below there is no sign of any improving trend in the SA economy to be derived from the HNI. The Index attempts to replicate the pace of growth – higher numbers indicate that growth is picking up momentum that is accelerating while lower numbers indicate that growth is slowing down.

The HNI peaked in late 2006 at a value of over 165 indicating that the economy was then moving ahead at a very rapid rate. The latest reading for May 2009 is 106.06 and down from its 109.06 reading in April. This indicates that not only has the economy slowed down but that it is in now in reverse and probably going backward more rapidly than earlier in the year.

The HNI may be regarded as representing the first derivative of the economy. The second derivative, that is the rate of change of the rate of change in economic activity, is still pointing lower indicating little sign of a bottoming out in the pace of economic activity.

The Hard Number Index May 2009

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Source: Investec Securities

The SA Business Cycle – The second derivative

Cont_2.jpe

Source: Investec Securities

New vehicle sales are still in decline

Vehicle sales in May provide very little cause for comfort that interest rate sensitive spending is responding to lower interest rates. The growth measured as the change in vehicles sold in May 2009 over May 2008 showed a further decline compared to April growth. More discouraging is that the underlying trend in vehicle sales is still pointing down rather than up. We calculate this trend by smoothing vehicle sales and then annualising the monthly growth in this smoothed measure.

Growth in New Vehicle Sales

Cont_3.jpe

Source: NAAMSA, Investec Securities

Not all bad news – the money cycle is pointing up

It is fortunately not all bad news. There is some consolation to be derived from the latest trends in the cash, that is Reserve Bank money supplied to the SA economy. Adjusted for the inflation trend, we can now observe an improving trend as may be seen below. Annual growth has turned marginally positive and the underlying trend has improved suggesting that a sustainable recovery in the supply of cash is under way. The driver of this series is lower inflation rather than any pick up in the cash supply itself as we also show. The growth in the actual cash supply (not adjusted for inflation) has been trending marginally lower as may be seen.

The real money supply cycle

Cont_4.jpe

Source: Investec Securities

The cash cycle

Cont_5.jpe

Source: Investec Securities

Is the Bank undertaking quantitative easing?

In this regard it is to be noted that the gross foreign exchange reserves of the Reserve Bank increased by a large US$1.724bn in May 2009. This indicates that the bank was very active resisting rand strength last month, notwithstanding the recent remarks from the Governor about intervention in the currency market. Of greater interest is that these purchases to not appear to have been sterilised by treasury open market sales of government securities.

The government deposits at the Reserve Bank that would indicate such operations actually fell in May to R66.153bn from R66.402bn in April. This may indicate that the bank and the treasury agree with us that quantitative easing, that is supplying the banks with more cash via operations in the currency market, to encourage them to lend more freely, is a good idea, given the weak state of the economy. A recovery in the supply of money and bank credit is essential to the purpose of reviving the SA economy.

No room for complacency about the state of the SA economy – aggressive policy action is called for

Grim news from the shop keepers

Retail sales statistics were updated yesterday 13 May. The state of the retail sector in March 2009 provides no comfort at all about the state of the SA economy. The statistics indicate that sales adjusted for inflation are still falling at an accelerating rate. Interpreting retail activity is always complicated by the Easter holidays that may come in March or April, as they did this year. We will need to wait for the April numbers to fully adjust for Easter.

Continue reading No room for complacency about the state of the SA economy – aggressive policy action is called for