Inflation targets are proving to be a very unhelpful guide to monetary policy settings

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.