The Reserve Bank, thankfully and understandably, given the near recession state of the economy, decided not to raise its repo rate at its meeting last week. The Monetary Policy Committee (MPC) statement concluded that:
“The increase in the repo rate at the previous MPC meeting contributed to the improvement in the longer-term inflation forecast, and that move should be seen in conjunction with previous actions in the cycle and the lagged effects of monetary policy. The MPC felt that there is some room to pause in this tightening cycle and accordingly decided to keep the repurchase rate unchanged for now at 7,0 per cent per annum. Five members preferred no change, while one member preferred a 25 basis point increase.
“The MPC remains focused on its inflation mandate, but sensitive to the extent possible to the state of the economy. The MPC will not hesitate to act appropriately should the inflation dynamics require a response, within a flexible inflation targeting framework. Future moves, as before, will continue to be highly data dependent.”
The MPC, as indicated, continues to regard itself as in a tightening cycle. Why further likely interest rate increases will be helpful in reducing the inflation rate any more, than past increases have done, is much less obvious. As we show below, short-term interest rates in SA have risen by 2% since the first 50bp increase in the repo rate was imposed in January 2014. Inflation, having fallen in early 2015, has recently risen sharply above 6%. A very good proxy for expected inflation – inflation compensation in the bond market, being the difference between the yield on a vanilla RSA 10-year bond and its inflation-protected equivalent – also rose sharply in late 2015, as did the difference between RSA 10-year bond yields and US Treasuries of the same duration. This difference may be regarded as the average annual rate at which the rand is expected to depreciate against the US dollar over the next 10 years.
These unfortunate trends have occurred despite higher interest rates and despite a weaker economy, to which higher interest rates have undoubtedly contributed. According to the Reserve Bank forecasting model, every one percentage point increase in the repo rate reduces the GDP growth rates by 0.4% p.a. and the inflation rate by 0.3% over the subsequent 12 months. To put such predicted reactions in some perspective, this means that to reduce the inflation rate by one and a half percent from 6.5% (above the target range of 3% to 6%) to 5%, it would take a five percentage point increase in short term interest rates. Interest rate increases that would be predicted to reduce GDP growth rates by two percentage points, say from plus one to minus one. This is a high price to pay in foregone output and incomes it must be agreed for still high inflation.
The increases in short rates to date will have reduced already anemic GDP growth rates by close to one percentage point. But such outcomes presume that all other influences on the inflation rate and on GDP growth included in the forecasting model will have remained as predicted by the assumptions and feedback loops of the model – a very unlikely outcome indeed, as recent experience will have demonstrated.
The recent increase in the inflation rate owes a great deal to rising food prices- the delayed impact of the drought that so reduced the maize, wheat and other harvests. The much weaker rand and higher administered prices, especially electricity charges, would have added to the pressures on costs and prices. But the pass through effect of a weaker rand on imported inflation and so the CPI, was unusually muted in 2015 given lower oil and commodity prices. Weakness in emerging markets and emerging market (EM) currencies in response to weaker EM growth and less risk tolerance in global capital markets however meant a weaker rand that depreciated against a stronger USD, broadly in line with the other EM currencies. But the events that moved the rand and inflationary expectations higher and added materially to SA risk, and to a still weaker rand expected over the next 10 years, were very South African in origin. President Jacob Zuma’s intervention in SA’s financial affairs was unprecedented and unpredictable. It did much damage to the annual inflation and exchange rate outlook – adding about 2% p.a more to both – such that increases in interest rates, even very significant increases, would not have countered and cannot be expected to counter. Yet they would have damaged the real economy in the predicted way.
The outlook for inflation will continue to be dominated by forces well beyond the influence of Reserve Bank interest rates, making inflation forecasts an unreliable exercise. Politics, the weather and global forces, including degrees of risk aversion accompanying commodity price trends, will be as decisive as they have been to date. Raising interest rates in such circumstances can have only one fairly predictable outcome: to slow down the economy further so making a credit ratings downgrade more likely.
The only justification for ever raising interest rates aggressively in SA would be when aggregate demand is rising strongly enough to put upward pressure on prices. Such pressure on prices will however then be accompanied by strong growth, not the weak growth now experienced. If the economy were growing well, say at a 5% rate and inflation was rising at above target rates, say at 6.5% p.a, then raising interest rates by say 300bp over a 24 month period could make every sense. Inflation could then be expected to come down to below six per cent and growth could slow down to a still satisfactory 4% or so rate.
The distinction between demand side forces acting on inflation that would justify higher interest rates and supply side shocks that drive the inflation rate temporarily higher and simultaneously but reduce demand and growth rates, is an essential one to make. Supply side shocks on prices should be ignored by monetary policy: this is the conventional wisdom. It is a distinction between supply side and demand side-driven higher prices that the Reserve Bank refuses to make. It has cost the economy dearly, while inflation and inflation expected have accelerated for reasons that have had little to do with the Reserve Bank. As I have said before, monetary policy in SA needs a better narrative, one that will preserve the credibility of the Reserve Bank without it having to play King Canute.
Incidentally, if the most recent forecasts of the Reserve Bank for inflation (below target in 2018) and GDP growth (no more than 1.7% in 2018) turn out to be accurate, the case for raising interest rates and any extension of a tightening cycle will remain as weak as it is now. Here’s hoping for better weather, conservative fiscal policy settings and a credible Minister of Finance, and a stable or stronger rand, enough to reverse inflation trends and lead interest rates lower- an essential condition for a cyclical recovery.
