The members of the Federal Open Markets Committee (FOMC), while contemplating an increase in their key Fed Funds rate from an abnormal zero per cent to a slightly less abnormal 0.25%, are at pains to emphasise that such decisions remain “data dependent”.
Most recently chair Janet Yellen indicated that if the data on the US economy confirm their forecasts of an economic recovery well under way, then interest rates in the US will rise this year – this after spending all the while since 2009 at about zero. One would hope that their counterparts on the Monetary Policy Committee (MPC) of the SA Reserve Bank remain equally data dependent.
The danger is that the MPC has become path dependent – it has signaled its firm intention to raise rates this year regardless of the state of the SA economy, the state of which (if anything) has deteriorated in recent months as household spending on goods and services has slowed down. The MPC might believe that not raising rates (independent of data) would be interpreted as being soft on inflation – a most unfortunate state of path dependence if that becomes the case. Travelling down this path to still higher short term rates would be a grave error of judgment, even if the market place regards such interest rate developments as inevitable. The MPC needs to step off this path it has mapped out for itself.
It has to be pointed out that any further increases in its repo rate have been postponed ever since June 2014, presumably because of the weak economic data. The SA inflation to date has had nothing to do with excess demand that would usually call for restraint in the form of higher borrowing costs. Spending by firms, households and recently by the government itself (practising a degree of austerity) have grown even more slowly than even energy-repressed supply. Higher observed prices have almost everything to do with higher taxes on expenditure – on petrol and diesel and on electricity charged by Eskom and municipalities – with the prospect of further increases to come. Absent of these tax events the inflation rate would have been about the three per cent rate it reached in February 2015 – between August 2014 and February 2015 the CPI itself hardly rose at all – indicating a very subdued underlying trend in inflation before higher taxes kicked in. The firm rand in a world of deflation was a very helpful contributor to these trends. Despite the strong US dollar and because of the weak euro, with the largest weight in our foreign trade, the trade weighted rand is little changed from its exchange value 12 months ago. See below, where strength is indicated by higher numbers:
These more favourable exchange rate and demand side influences on prices in general have been well reflected Producer Price Inflation, prices charged at the factory and mine gates, that was 3% in April 2015. The mines and factories are not exercising much pricing power- the markets they serve are not proving very accommodating to higher prices they are being charged for their inputs- for tax and trade union reasons. The notion that real interest rates in SA- measured conventionally and unhelpfully as the difference between overdraft rates and CPI inflation is not a burden on producers – is belied by the fact that producers are not achieving anything like average consumer price increases in the prices they are able to charge their customers. Costs may rise, including the costs of hiring labour, but profit margins may well have to give way to economic realities, as will employment opportunities- even as may be observed – in the public sector.
The Reserve Bank would have to argue that inflation in SA would have been higher and would be higher if it did not raise its rates. Their argument is that expected inflation drives prices and inflation. The evidence for such a feedback loop from inflation expected to inflation is very unconvincing. Indeed the rate of inflation expected by the bond market has remained remarkably stable around the 6% p.a rate, the upper end of the inflation target range, indicating very little change in observed inflation could have come from that constant quarter. If anything actual inflation leads inflation expected. Inflation comes down and less is expected – inflation goes up and more inflation is priced into long term interest rates- not the other way round. See below where we show inflation compensation- the difference yields on 10 year RSA’s and their inflation linked equivalentsyields over the past 12 months. Inflation compensation moved lower with less inflation and has since moved higher as it became apparent that he receiver of revenue would tax much of the gains from lower oil prices.
The Reserve Bank must argue that without its actions and narrative, inflation expected would now be higher and inflation even higher. It is impossible to refute such a counterfactual. To know what would have happened had interest rates not been raised last year and had the Reserve Bank not suggested that further rate increases were to be expected, remains an unknown. But we would argue that there is something very wrong with a narrative that suggests interest rates must rise regardless of the state of the economy, especially if it cannot be known with any degree of confidence, that higher interest rates can reliably influence the rate of inflation itself.
The link between higher interest rates and the exchange value of the rand and therefore on inflation to come, is particularly difficult to establish, given all the other influences on the rand. Especially the impact on emerging market currencies generally of a highly variable and unpredictable global taste for risk and so the flows into emerging market equities and bonds and their currencies. However it can be predicted, with a much higher degree of confidence, that higher rates will depress domestic demand and GDP growth rates. As the rating agencies constantly remind us, the biggest risk to SA and its credit rating is slow growth. Sacrificing growth for whatever reason is a risky strategy, especially if its impact on inflation is unpredictable. In fact stronger growth can lead to less inflation if growth attracts foreign capital and supports the rand. And vice versa when the prospect of slower growth drives capital away from SA and weakens the rand
The major uncertainty facing the markets in the near future will be the reaction to the Fed rate increase. The impact of this widely expected move on emerging market currencies will be very hard to predict with accuracy. In the past, rising US rates that accompanied faster US growth rates have usually had a favourable impact on emerging markets. This is because US growth implies faster global growth, from which emerging market economies and their financial markets and currencies stand to benefit. It makes little sense for the Reserve Bank to talk up local interest rates for fear that higher rates in the US will weaken the rand and cause inflation in SA to increase. Higher interest rates will do nothing to counter such a shock, should it occur.
The right policy response to any currency shock is to ignore it and allow exchange rate flexibility to help the economy recover from such a shock. Higher inflation that follows a supply side shock of the exchange rate or tax kind itself depresses domestic spending. Interest rate increases in such circumstances are not called for – despite higher inflation. This should be the Reserve Bank narrative, not its vain pursuit of inflation targets, regardless of the causes or consequences of inflation. Policy actions above all should be data dependent and not predetermined.