Monetary policy: The limits to inflation targeting

Is SA monetary policy accommodative? It all depends on whose inflation and whose interest rates you have in mind

We are told by the Reserve Bank that monetary policy in SA is “accommodative” because interest rates are below the rate of inflation. That is because real interest rates are negative. But whose interest rates and whose inflation rates can the Reserve Bank be referring to? From the perspective of lenders the interest paid on savings accounts in the banks are not keeping up with inflation – and more so if tax has to be paid on interest income. Low real interest rates are tough on savers, but, for a good reason, borrowers may be unable to pay any more for the use of their savings.

But from the perspective of business borrowers, especially small businesses still able to borrow from their banks at prime plus something over 9%, finance may in reality be very expensive. The presumption of negative real interest rates is that businesses will be able to increase the prices they charge their customers at more than the 9% per annum they pay in interest. If this were the case, simply financing a warehouse of non-perishable goods that increase in value by more than the costs of finance (after taxes) becomes a no-brainer of a profitable business decision. This would presumably make monetary policy accommodative and encourage business.

But is this currently the case for many businesses serving the domestic market? Do they currently have the power to price their goods or services ahead of the rate of inflation that was 5.4% in December 2013?

The weakened state of demand for goods and services may prevent this as the more detailed inflation statistics bear out. The headline inflation rate is the weighted average of the prices of goods and services consumed by the mythical average SA household, some of which have risen by much more than the average and others by much less. It is administered prices, those charged by municipalities for water and electricity etc and those subject to additional excise duties, for example alcoholic beverages (up 7.2% on average with beer up 9.2% on December a year before), that have been making the inflation running . Administered prices were up nearly 8% on a year before in December 2013.

By contrast, the price of clothing and footwear is estimated to have increased by a mere 3.6% and 3% respectively. The food basket itself was also only 3% up, believe it or not. The farmers, food retailers and manufacturers will know all about their pricing power and the pressure on their sales volumes and profit margins.

It is clear that rising prices in SA have very little to do with any strong demands being registered by consumers. As is well recognized, SA households are under increasing budget pressures from higher prices and taxes imposed upon them. And, most relevant, they are suffering from a lack of pricing power in the most important market for their services, in the market for their labour services.

By recent accounts from Adcorp the rate of dismissal from private sector jobs is accelerating and workers are much less mobile than usual. They are therefore presumably somewhat fearfully holding onto the jobs they have, rather than moving to better paid ones. This is not an environment likely to encourage growth in spending, despite interest rates in the money market being below the headline inflation rate.

In fact monetary policy is doing very little to encourage domestic spending and, indeed, with the recent increase in benchmark short rates, has become less so. Even less demand side pressure on spending can be expected as prices continue to rise, driven especially by a weaker rand over which domestic interest rates have little or no influence.

The fact that the SA economy is as weak as it is, indicates quite clearly that interest rates should have been significantly lower than they have been, and that they should be falling, rather than rising, given the deteriorating state of the economy. Furthermore, targeting inflation when prices are rising for supply side (exchange rate shocks, drought and taxes) rather than demand side reasons makes little economic sense. Inflation targeting in SA can only makes good sense when the exchange rate itself responds predictably to interests rate settings. The rand over much of the past 12 years or so has not behaved anything like this.

Aiming for low inflation is good monetary policy. Trying to meet inflation targets is proving again to mean very poor monetary policy in S.A.