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.