By Jac Laubscher, 11 February 2014
The change in policy has brought five years of accommodative monetary policy nearer to a close and it is fitting to review the motives behind the MPC’s decisions during this period.
The past five to six years were challenging for central banks, especially in the developed countries that found themselves at the centre of the financial crisis. Central banks in emerging-market countries, including the South African Reserve Bank, were compelled to respond to the impact of the global crisis on their national economies.
They were also involved in the international coordination of the policy response to the crisis through the G-20, of which South Africa forms part. Countries with a current account surplus and/or room on the fiscal side were expected to stimulate domestic demand with a view to limiting the depth of the global recession.
It is therefore not surprising that international events and risks started to play a bigger role in the Reserve Bank’s decision making. The question, however, is whether the MPC did not go too far at times – for example, there was a time when the Bank put great emphasis (too much, in my opinion) on the risks to the European economy. The Reserve Bank’s policy decisions naturally make no difference to the outcome of these risks, while it can be difficult to correct policy if it is positioned for a risk that never materialises.
Excessive emphasis on foreign risks can also result in a loss of focus, in other words too little attention being paid to the underlying trend in inflation and the domestic drivers thereof.
To my mind, along with this there was a shift in the balance maintained by the Reserve Bank between combating inflation and promoting economic growth and employment in favour of the latter. Although the Reserve Bank was already following a flexible approach to its inflation target, the 2009 recession understandably made such a shift unavoidable. The sluggish economic recovery after the recession prevented the pendulum from readily swinging back.
As a result the Reserve Bank has applied its inflation target range of 3% to 6% asymmetrically. Instead of the midpoint of the target range (4,5%), the effective target was set in the top half of the target range. Nir Klein, a senior economist at the IMF, came to the same conclusion in an IMF Working Paper published in 2012. He found that the implicit inflation target fluctuated over time and moved to the upper end of the target range in recent years. He then comes to the conclusion that since the start of the financial crisis the Reserve Bank has been more tolerant of high inflation in order to be able to better support economic activity.
The accompanying graph shows that core inflation (i.e. consumer price inflation excluding food, fuel and energy), which often serves as anchor for the MPC’s decisions, reached its lower turning point early in 2011 and has since shown a virtually uninterrupted upward trend, although it has remained within the target range, i.e. below 6%. To my mind, however, monetary policy should focus not only on the level of inflation, but also on the momentum.
The course of the repo rate compared to core inflation does give the impression that the MPC lost focus at one stage. In fact, the repo rate was decreased in July 2012 in spite of the continued upward momentum in core inflation. The accompanying MPC Statement indicates that this decision was motivated mainly by international events, with the MPC expressing its concern about the risk developments in the global economy (especially in the Euro area) held for the local economy. The aim of the rate cut was to bring relief to some (unspecified) sectors of the economy.
In short, in my opinion it is unwise to conduct monetary policy on a basis whereby action is taken only if there is a real possibility that the inflation rate could breach the 6% upper end of the target range for a prolonged period of time. What happens inside the target range cannot be ignored – this would imply an effective inflation target of 6% and would also mean that when policy is eventually tightened, policymakers will already be behind the curve, putting them under pressure to make up leeway.
There is also another respect in which the MPC Statements of the past few years are somewhat puzzling – not for what they said, but for what they did not say.
In recent years the Reserve Bank has not shied away from making critical pronouncements on other policy issues affecting its mandate to a greater or lesser extent. It is therefore remarkable how little the MPC had to say about fiscal policy and how uncritical it was of the management of government finance, and this while there is a close relationship between fiscal policy and monetary policy and they supplement each other in the pursuit of macro-economic stability.
Usually statements on fiscal policy have been nothing more than a reiteration of the salient points of budget documents and the Reserve Bank has rather been supportive of fiscal policy as it has been applied over the past five years. For example, it has been stated repeatedly that the projected rise in the government debt-GDP ratio to approximately 45% is well within the international benchmark of 60%, whereas the benchmark for emerging-market countries is 40% (60% is the benchmark for developed countries).
At no stage has the justification for the sharp increase in the government’s wage bill as anticyclical policy been criticised. The inflationary implications of large wage increases in the private sector have received regular attention, whereas the demonstration effect of the government’s generous wage and salary increases on the rest of the labour market has never been mentioned.
Therefore it is not surprising that the MPC Statement announcing the interest rate hike did not make any reference to fiscal policy. I believe this is a serious omission, as it does not address the question of whether the problem lies with monetary policy or fiscal policy.
Would a tightening of fiscal policy, i.e. an accelerated consolidation of government finances, not have been a better option than an interest rate hike? To my mind the argument that this is not possible in an election year does not hold water – it is about time sound economic principles are given priority over party-political considerations when it comes to economic policy.
Estimating the Implicit Inflation Target of the South African Reserve Bank. Working Paper no. WP/12/177. International Monetary Fund. July 2012.