Tag: Monetary Policy

The rand: Foundations still to be laid

This past month has not been a particularly good one for the rand. The rand lost about 7% against the Aussie dollar in May 2011 to date, while losing less about three per cent Vs the Brazilian real and the US dollar.

We have long watched the relationship between the rand and the Aussie dollar for signs of South African specific risks influencing the value of the rand rather than commodity prices that are common to both currencies. A combination of commodity price strength and rand weakness is a heady one for investors in Resource companies, quoted in rands, on the JSE.

However the current modest rand weakness would appear to have more to do with favourable Australian, rather than less favourable South African specifics. This view is supported by the better performance of the rand against the US dollar and the Brazilian currency.

The rand is more than a commodity currency. It is also very much an emerging market currency and actively traded as a proxy for other less liquid emerging market currencies. The beat to which the rand is moving this month has been day to day volatility on emerging equity markets. The rand has been getting weaker or stronger as emerging equity markets have been going down or up in a highly synchronised way. And the JSE remains a highly representative emerging equity market.

It would appear that it is very much emerging market business as usual in the market for rands. If we run a model that uses the EM equity market Index to explain the rand/US dollar exchange rate using daily data since January 2008, the rand is trading almost exactly as the model predicts.

In the large market for the rand, with daily turnover of about US$20bn making it about the tenth largest foreign exchange market, three quarters of the transactions reported to the SA Reserve Bank are conducted between third parties with no direct link to SA foreign trade or capital movements. They trade the rand because they can trade the rand to hedge emerging market exposures.

The notion that the SA Reserve Bank could intervene effectively in such a market to move the exchange value of the rand in some preferred direction would seem a false premise. The Reserve Bank can buy foreign currency in this market to add to its reserves, as it has been doing, but such interventions could not easily be seen as market moving. The value of the rand continues to be dominated by global forces, particularly those that influence the outlook for the global economy and so emerging equity and bond markets. South African specifics seem to have had little influence on the exchange value of the rand in recent years and we expect global forces to continue to dominate the rand exchange rates.

The rand began the year at R6.61 per US dollar. It lost about 10% of this value by early February 2011 and then reclaimed its beginning of the year value in late April 2011. It has by now lost about 4% of its January 2011 value against the US dollar this year, while the Aussie and the real are about three percent stronger than they were at the beginning of the year.

While the volatility in the market for rands this year may be regarded as moderate by its own standards, the still unusual volatility in the rand must remain of concern to the authorities in SA. Without rand stability, predicting inflation and interest rates more than six months ahead with any degree of accuracy or confidence, remains a near impossible task. The foundations for genuinely stabilising monetary policy and interest rate settings in the form of a stable and predictable rand have still to be laid.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View:
Daily View 27 May: The rand: Foundations still to be laid

After the MPC: Interest rate expectations and the rand

The money market has raised the probability of an early increase in short term interest rates (in three months’ time) following the meeting of the Reserve Bank’s Monetary Policy Committee (MPC) on Thursday that maintained the repo rate at 5.5%. The short term three month Forward Rate Agreement curve (FRA) of the banks moved higher by between 10 and 30bps across the range of forward rates beyond the next three months late last week.

Interest rates expected over the longer term, beyond four years, have remained unaffected. The zero coupon yield curve implies that the one year government bond rate, currently around 6% per annum, will rise consistently to a level of about 9% in four years’ time and then stabilise at this level.

These expectations remain consistent with inflation compensation priced into the bond market in the form of the yield gap between conventional RSA bond yields and their inflation linked alternatives. This gap remains consistently above 6% regardless of the rate of inflation.

Our own interpretation of the MPC statement and the press conference is that the Governor and the MPC would be extremely reluctant to take any interest rate action before the economy has regained its potential growth, which it is still some way from attaining. However further increases in fuel and food prices and the headline inflation rate might force them in this direction for fear of second round effects on inflation itself. In other words, more inflation expected would lead in turn to still more inflation.

We have found comprehensive evidence that inflation in SA does to a small degree influence inflation expected, as measured for the Reserve Bank by surveys conducted by the Stellenbosch Bureau of Economic Research for business, trade unions and financial institutions. However, the reverse has not been true, although the Reserve Bank seems to believe otherwise.

Moreover it is clearly concerned to preserve its inflation fighting credentials even if this should mean having to raise rates. This is so even when it is clear that the inflation it is attacking is not under its control and when higher interest rates might lead to slower growth and a wider gap between actual and potential output and employment. The striking feature of inflation expectations in SA is just how stable they have been and how they remain above the inflation target band of 3% to 6%.

As we indicated in our first reactions to the MPC statement, the outlook for interest rates in SA will depend primarily (and unfortunately) on the rand price of oil and the continued upward direction of administered prices and not on the state of the economy that might be intolerant of higher interest rates. There should be a better way of running monetary policy in SA with more sensitivity to the state of the domestic economy and with the media and the financial markets well able to understand that a shock to the inflation rate does not imply permanently higher inflation. Keeping interest rates on hold in such circumstances when demand pressures are subdued does not mean being soft on inflation. This better way is indicated by the inflation targeting mandate itself, which does not demand adherence to inflation targets regardless of the causes of inflation and the consequences of higher interest rates for the economy, as is indicated explicitly and clearly in Paragraph 4 of the Mandate.

The rand has however weakened in recent days despite an earlier expected increase in interest rates. This again confirms that the influence of movements in interest rates on the value of the rand is not easily predicted. As we show below the rand lost about 4% of its trade weighted value last week.

Perhaps the market is being influenced to a degree by the unknown outcomes of the municipal elections in SA on Wednesday, which have become a test of the national government and its competence to govern. A small additional protest vote would probably be welcome as an incentive for the government to improve its delivery. An unexpectedly large vote for the opposition might be regarded as a serious longer term threat to the powers that be, and would perhaps have unpredictable outcomes for the ruling party, its leadership and its policies. As we know markets do not appreciate uncertainty.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 16 May: After the MPC: Interest rate expectations and the rand

Study on Inflation and Inflation Expectations in South Africa

Our study strongly supports the view that supply side shocks on inflation in SA are best ignored by monetary policy. The analysis infers that raising interest rates in the face of a supply side shock that pushes prices temporarily higher will reduce demand in the economy without affecting inflation in the short term or inflation expected in the short or longer term. We show very clearly that realised inflation has affected inflation expected to a modest degree in South Africa. But the reverse does not hold at all – inflation expected does not affect inflation. Thus in response to supply side shocks, especially those that emanate from net foreign capital flows and the exchange rate, a much better way should be sought to anchor longer term inflationary expectations in SA than raising short term interest rates. It would seem that raising interest rates to fight inflationary expectations or so called second round effects on inflation can impose large costs on the economy in the form of lost output to no useful purpose.

A preliminary draft of our study is available here: Study on Inflation and Inflation Expectations in South Africa

Other recent research on monetary policy:
Lessons from the Global Financial Crisis

The global forces that drive SA’s Financial markets from day to day – an analysis with the implications drawn for monetary policy

A full directory of my research on monetary policy is can be found here: Research Papers – Monetary and Financial Economics

Vehicle sales: Why a strong rand is good

It was another big month for unit vehicle sales in February. On a seasonally adjusted basis sales were ahead of the January numbers, which in turn were well up on December.
 
Year on year growth in unit sales has remained in the plus 20% range. However the quarter to quarter growth rates, which are not dependent on base effects, have surged ahead and are now running well above a 40% per annum rate.
  Continue reading Vehicle sales: Why a strong rand is good

The global forces that drive SA’s Financial markets from day to day

This study demonstrates with the aid of single equation regression analysis the role global capital markets play in determining the behaviour of the Johannesburg Stock Exchange(JSE ALSI) the Rand/ US dollar exchange rate (ZAR) and long term interest rates in South Africa on a daily basis represented by the All Bond Index (ALBI) or long term government bond yields represented by the R157. It will be shown that since 2005 the state of global equity markets, represented in the study bythe MSCI Emerging Market Index (EM) has had a very powerful influence on the JSE. The EM Index is shown to have had a less powerful yet statistically significant influence on the ZAR while it is also demonstrated and that conditions in global capital markets, and the ZAR have had some weak but statistically significant influence on the direction of long term interest rates in South Africa. It will be demonstrated that movements in  policy influenced short term interest rates, have had very little predictable influence on share prices, the ZAR or long termbond yields. The causes as well as the consequences of the ineffectiveness of policy determined interest rates for monetarypolicy are further analysed.

Minding the Gap

The Monetary Policy Committee (MPC) of the Reserve Bank opted to keep the repo rate unchanged at 5.5% yesterday, in a move entirely in line with market expectations. Perhaps of more interest was the MPC’s outlook for inflation, which it upped to 4.6% for 2011 (from 4.3%) and 5.3% for 2012 (from 5.8%). We discuss the monetary stance of the MPC elsewhere in Daily View, but there has certainly been more talk in recent weeks of higher inflation later this year, as a weaker rand and rising commodity prices take their toll.

Continue reading the Daily View here: Daily View 21 January 2011