Inflation and the rand: Why doing nothing is the best SA monetary policy can do

An unfortunate history of exchange volatility

The SA economy is once more challenged by an exchange rate shock. As we show below, such exchange rate weakness – of the order of a 15% or more move lower in the trade weighted exchange rate, compared to a year before is hardly unknown. In fact the latest shock is the fourth since 2000. As we also show below, the rand had lost as much as 26% of its foreign trading value by May 2002. By early 2007 the rand was down by about 15% on its value a year before and then 20 months later had lost 19% of its value.

The rand on 31 May 2013 was about 14% weaker than 12 months ago on a trade weighted basis. It will also be appreciated that while the long term trend in the value of the rand since 2000 has been one of rand weakness, the direction is by no means one way. Weakness can be followed by strength of similar magnitude. These unpredictable shocks, in the form of large sustained movements in the value of the rand in both directions, can be of similar magnitude and can complicate business decision making and monetary policy. They are a most undesirable feature of the SA economic landscape.

The sources of exchange rate volatility have very little to do with monetary policy

These large exchange rate movements are a response to interruptions or disruptions in the flow of capital to and from South Africa. Increased demands for rands push the rand higher and less demand moves the price of the rand higher or lower when valued in other currencies. It is very much a market-determined and flexible – very flexible in both directions – rate of exchange. The SA Reserve Bank does not typically use its own stock of foreign exchange to intervene in the market for rands.

This market, a deep one at that, regularly transacts over US$15bn worth of rands every trading day, according to the Reserve Bank on the basis of information provided by the trading banks. Three quarters of the trade is conducted between third parties without a direct connection to SA trade or finance. They presumably trade and hedge the rand so actively as a proxy for currencies that are less liquid. As we show below there is no obvious relationship between the trade weighted value of the rand and turnover in the currency market.

The one highly predictable impact of an exchange rate shock- more or less inflation

The one highly predictable influence of an exchange rate shock is that more or less inflation will follow in the opposite direction. More inflation when the rand weakens – less when it strengthens. It is most important to recognise that for SA the exchange rate leads and the inflation rate follows. In conventional monetary theory it is faster domestic inflation (caused by easy monetary policy) that leads to a weaker exchange rate. The weaker exchange rate then should help to maintain the international competitiveness of exporters and firms that compete with more expensive imports priced in the weaker domestic currency. In the figure below we identify the timing of the shocks that have sent the rand weaker and show how the trend in the inflation rate has followed these shocks consistently.

In the figure below we show the results of a very simple model. The trend in inflation is very simply explained in a single regression equation by the annual movement in the trade weighted exchange rate, lagged by six months. The model does well in predicting the direction of inflation in SA and also its level. The explanatory power of the model is rather good – explaining over 60% of the inflation trend. As the chart also shows, there is somewhat more to inflation than the exchange value of the rand. The model significantly underestimated inflation in 2008-09 and has less significantly underestimated it recently.

Among other forces moving SA prices and inflation are trends in global prices, particularly in the prices of grains and other soft commodities in US dollars that influence the domestic price of food when translated at import price parity into rands. The global price of oil is also very important in this regard. Clearly independent of the value of the rand, global inflation or deflation (including oil price increases or decreases) will influence prices in SA and their rate of change. The pace of administered prices increases in SA (taxes by another name) will also have an influence on the CPI. So will the strength or otherwise of domestic spending, supported more or less by the growth in money supply and credit and interest rates, that is by monetary policy.

Monetary policy is largely impotent in the face of exchange rate shocks of this order of magnitude

It should be very obvious from the recent history of inflation in SA that there is little the Reserve Bank or monetary policy can do about inflation because it cannot influence the variable exchange value of the rand in any predictable way. The same monetary history tells us that raising or lowering interest rates have simply no predictable impact on the exchange rate. Monetary policy is largely impotent in the circumstances of exchange rate shocks of the order of magnitude suffered by SA. Inflation targeting, to which SA subscribed in the early 2000s with all the sincerity of the newly converted, had as its justification the conventional wisdom of monetary policy of that period. The presumption of inflation targeting was that a politically independent central bank would target inflation with its interest rate settings in a sound way and inflation and the exchange rate would behave itself in a predictable way.

The unpredictable nature of exchange rate shocks – global or domestic in origin

That presumption has proved to be a false one. The exchange rate has not behaved itself and so measured inflation has remained largely outside the influence of monetary policy. Monetary policy and interest rate settings can clearly influence domestic spending. But maintaining the balance of domestic demand and potential supply does not at all necessarily secure exchange rate stability as we observe.

The exchange rate can have an unhealthy life all of its own, responding as it does to global forces, as it did during the Global Financial Crisis of 2008-09. This crisis increased the global demands for safe havens and reduced the demand for riskier emerging market assets and their currencies, including the weaker rand, and led to more inflation in SA.

The other shocks to the rand we have identified are much more SA specific in their origins. We can identify such SA specific risks driving the rand by comparing the behaviour of the rand to other emerging market or commodity currencies over a period of rand weakness or strength. The forces driving the rand in 2001-02 and in 2006-7 were largely SA specific in their origins. The rand has weakened by significantly more than its peers over these periods of weakness.

The only time the Reserve Bank may be held responsible for rand weakness was in 2006-7. Then the bank adopted interest rate settings that were too severe, that threatened the growth prospects for the SA economy and frightened capital away. The 2001-2002 weakness was an unintended consequence of partial exchange control reform – that led to panic demands for foreign currency by local wealth owners and fund managers. The latest burst of rand weakness that began in August 2012 is associated clearly with labour relations on the mines and elsewhere that threaten mining output and exports that are so important to the trade balance of the rand. Foreign and local investors have been discouraged by the political responses to this crisis.

Nothing for the Reserve Bank to do but watch the economy ride out the storm

As clear as are the political origins of the latest exchange rate shock is that the Reserve Bank and its interest rate settings can do nothing now to meaningfully assist the rand. It is out of their hands. Raising interest rates would further weaken domestic spending, that cannot be regarded as excessive. Still slower growth in domestic spending following any imposition of higher interest rates would if anything further undermine the case for investing in SA and could lead to a still weaker rand. Indeed, were it not for rand weakness, interest rates would have been reduced to encourage domestic demand. But such action might well be regarded as less than responsible in the circumstances.

The best the Reserve Bank can do in these difficult circumstances is to do very little. The economy must be left to rise out the exchange rate shock and the temporary increase in inflation that is likely to follow. The weaker rand will encourage production for export and for the domestic market as prices and profit margins for exporters and those competing with imports have improved. Hopefully the mining sector will be allowed to benefit from these price and profit trends. Hopefully too, the politicians can help the industry. Higher prices, especially for goods or services with high import content, will discourage consumption. There is nothing the Reserve Bank can usefully do to slow these inflation and relative price effects down. Raising interest rates would damage the economy further. The best monetary policy can do in response to an exchange rate shock (that is not of its making) is to do nothing at all – but also to explain why doing nothing is the best policy.