ZA Economist

It seems clear that new Reserve Bank governor Gill Marcus has not yet brought anything of a different point of view to the
Monetary Policy Committee (MPC). The style was much more inclusive and open but the substance was largely the same as
before. She has deferred to the established positions of the MPC of which she is the only new member.

Therefore the sense held by the previous MPC that the economy is at a turning point and therefore needs no further
encouragement for fear of being too procyclical with interest rates (which have declined by 500bp has been maintained). Also
maintained is the concern with second round effects on inflation of electricity price increases – absent of which inflation would not
be regarded as a problem at all by the MPC.

The inflation problem is Eskom and interest rates remain where they are largely because of the Eskom effect on inflation. This
Eskom effect is creating great uncertainty and therefore is affecting inflationary expectations which are presumed to make ever
higher inflation inevitable, unless the Reserve Bank remains vigilant in setting interest rates accordingly.

Had I been at the Media Conference I would have asked this question. Does not the prospect of further electricity price increases
justify lower rather than higher interest rates given the impact of such price increases on domestic spending and therefore on
output and employment?

The answer that would have been provided would unfortunately probably have been something like as follows: no, because higher
inflation following such electricity price increases might lead to even more inflation – because of possible second round effects on
inflation.

That the MPC could still concern itself with second round inflation when the economy is as weak as it is and when the rand is as
strong as it is and when in the Reserve Bank’s view global inflation is not a threat at all to domestic inflation, speaks volumes about
the MPC’s lack of grasp of the causes and effects of supply side shocks on prices. But here nothing has yet changed with Ms
Marcus in the chair – which is the pity.

The right answer would have been yes – because Eskom’s price increase is a tax on consumers and tax increases lead to higher
prices and less spending and in the circumstances, while inflation will go up – profit margins will come down and employment
growth will remain subdued and so the economy will need some encouragement from monetary policy. Or in other words the
distinction between supply side shocks that drive inflation higher and demand led inflation should be emphasised by the
Governor. The Governor should make it clear that Monetary Policy can only be effective against demand led inflation and
monetary policy should not add to the demand reducing influence of higher levels of taxation.

Ms Marcus was also complacent about the negative growth in money supply and credit which other central banks have been very
active in trying, though not yet succeeding in combating. Again the MPC still does not wish to do anything to encourage SA banks
to ease up for the sake of the economy.

But this lack of action by the MPC was surely encouraged by a belief that the domestic economy is recovering. However such
predictions by the Reserve Bank were highly qualified as the quote from the MPC statement below indicates very clearly:

There are signs that the domestic economy will continue on its recovery path but economic growth is expected to remain below
potential for some time; and dependent to some extent on the pace of the global recovery, which still appears to be fragile and
uneven across regions. Economic growth is also expected to be constrained by subdued domestic consumption expenditure. The
domestic outlook for inflation remains favourable as a result of weak demand pressures and the main threat to the inflation outlook
emanates from possible electricity price increases.

We however see no signs of any meaningful revival in domestic spending. Reference was made to the particular unpredictability of
GDP growth this past quarter- of which preliminary estimates will be released next week. However marginally positive quarter-on-
quarter GDP growth may be recorded even as final consumption and investment demands decline. Improvements in net exports
and a reversal in inventory accumulation may yet allow GDP to grow even as final demand remains very weak. Even a modest
recovery in GDP growth would therefore not indicate the likelihood of the SA economy operating even close to its potential over
the next year – something that should concern the MPC greatly.

Should the Reserve Bank be surprised by the lack of economic recovery, it now only has its next meeting in January 2010 to
respond to it. We should not expect any emergency meeting before then and we should expect interest rates to remain on hold for
much of 2010. We can anticipate that a broader mandate for the Reserve Bank is in the offing that would allow it to concern itself
more with the growth outlook and less with the inflation outlook, especially when the inflation is supply side driven, as is clearly the
case now. We would welcome such a development as we would continue to support the independence of the Reserve Bank to act
as it judges – an independence that Governor Marcus will uphold determinedly.

A poisoned chalice

This is not an easy time to be taking over the reins at the Reserve Bank. Spending by households and privately owned firms (which account for a very large part of the economy – up to 80% of GDP) remains in the grip of a very severe recession. More important for Gill Marcus to take into account is that there seems little sign of any imminent recovery in this spending upon which the economy depends for its growth.

For technical reasons the third quarter GDP numbers might look better because exports declined less than imports and the run down in inventories was at a slower pace than it was in the second quarter when an extraordinary reduction in inventories took as much as 10% off the GDP growth rate. But such numbers will indicate just how weak the economy is and there will be little consolation to be found in the trends in spending by the private sector.

The case for a fresh dialogue

The case for the Reserve Bank in these circumstances doing all it can to help the economy by lowering interest rates and pumping in cash to encourage the banks to lend more, might appear unassailable. However the Monetary Policy Committee found reasons at its last two meetings not to lower interest rates or to ease quantitatively.

The arguments that would have supported such inaction would presumably have included the notions that real interest rates in SA were already very low. The argument would also have been made that inflation in SA remains unsatisfactorily high and that elevated inflationary expectations could continue to have an unwelcome self fulfilling impact on inflation itself.

Ms Marcus would do well to question the validity of such arguments. It was such arguments that helped raise interest rates to recession producing levels in the first place and restrained their reversal long after it was clear that the growth in spending by households, particularly on interest sensitive durable goods was falling sharply. The damage caused to the economy is there to be seen. As we have argued before the weakness in the SA economy was of our own making. The global credit crisis made it more difficult to escape from recession.

What exactly are real interest rates?

Firstly let us raise the issue of real interest rates that may be defined as the difference between borrowing costs and inflation. By reference to CPI inflation real money market interest rates in SA may indeed appear very low. However if prices realised by producers, represented by the Producer Price Index (PPI), are taken as the point of reference real interest rates have increased to exceptionally high levels as we show below. The reason for this difference is that while consumers in SA still face inflation, producers have to deal with significant and dramatic deflation.

CPI and PPI Inflation

Source: StatsSA and Investec Private Client Securities

The Consumer and Producer Price Indexes

Source: StatsSA and Investec Private Client Securities

SA Real short term interest rates

Source: StatsSA and Investec Private Client Securities

Real interest rates are very high – not very low

The simple idea behind the importance attached to real interest rates is that higher prices charged for goods sold offset the interest costs of borrowing. In an extreme case, if the prices firms can charge for their goods or services rise faster than the interest rates then doing no more than borrowing (cheap) money to fill up a warehouse with stuff that is bound to increase in value becomes a highly profitable business. For a household taking a loan to buy goods (a car or a house), the prices of which will rise as fast as the interest rates they are charged, may also seem like a good idea.

However as is very apparent SA households are not responding to the prospect of more inflation by borrowing more, even when banks or retailers remain willing to lend. They are borrowing less because the prices of the homes and cars and furniture they might in normal circumstances be in the market for are not expected to rise at anything like their cost of borrowing. They may even be expecting prices to fall. They will know that the rising prices they are forced to pay are for goods and services they cannot store – electricity and other municipal services that could better be described as higher taxes.

The firms that might ordinarily be encouraged to borrow funds to add to stocks and work in progress and to their complement of workers, or to add more plant and equipment, are facing and expecting deflation rather than inflation. For them the idea that their real costs of borrowing have declined is risible. Their real cost of borrowing, that is to say the real interest rates they are paying, has risen dramatically. This is why they are running down inventories, working capital and (most regrettably) workers employed.

The reality is that for producers in SA prices are falling, not rising. The further reality is that higher prices/taxes paid by their customers and themselves for electricity and other services and the higher wages they have been forced to pay their unionised workers have made it harder rather than easier for them to raise prices. The strong rand has most importantly made it more difficult for them to compete on the local or export markets. They have less, not more, pricing power because of the rising trend in CPI and wages. Their operating profits have come under such pressure and this has led them to invest less and employ fewer workers and managers.

Inflation is not a self fulfilling expectation

The notion that in these circumstances producers will not only expect more inflation but that such expectations could be self fulfilling in the absence of support from the demand side of the economy, is surely a damagingly false notion. It means damagingly high interest rates. In the absence of accommodating demands for goods and services inflationary expectations (that is to say in current circumstances, expectations of more supply side shocks for the economy in the form of higher electricity prices) will not lead to still more inflation. Supply side driven inflation expected will however lead to less output and employment. All the Reserve Bank can hope to do in such circumstances is to ease rather than add to the punishment.

The Reserve Bank needs to make the firm distinction between the inflation it does have influence over (demand led inflation) and supply side shocks that cause inflation and even expected inflation to rise – over which it has no direct influence.

Judging the right level of interest rates for SA without full regard to this distinction can prove very damaging to the economy. Interest rates influence the spending decisions of SA households and firms without necessarily having a predictable influence on the supply side of the economy and therefore on prices. The unpredictable link between interest rate changes and the exchange rate makes it even more difficult to know how interest rates will influence the inflation rate in SA.

Ms Marcus would do well to recognise these difficulties for the practice of monetary policy in SA. She should also be under no illusions that the only problem for the Reserve Bank to focus its attention upon for now is the very weak state of demand, not the rate of inflation.