By Jac Laubscher, 1 June 2016
This time around they opted for growth, while at the same time making it clear that the decision to keep the repo rate unchanged should be viewed as a mere pause in a continuing tightening cycle that has yet to come to an end.
To resolve the inflation vs. growth dilemma facing monetary policy one needs to see it in a structured framework to unpack its different aspects. Such a framework should include the identification of the forces driving inflation, an understanding of how inflation expectations are formed, and a clear picture of how the monetary policy transmission mechanism would work for monetary policy to achieve a lowering of inflation and the stabilisation of inflation expectations at a level that is consistent with the Reserve Bank’s inflation target.
In the first place one therefore needs clarity on the causes of high and rising inflation. As the MPC has indicated on more than one occasion there is no evidence of inflationary pressures originating in excess demand. It is also unlikely that we will enter such a phase in the foreseeable future.
Growth in household consumption expenditure is subdued as is growth in household credit, mostly because households’ existing debt burden and debt service costs are hardly affordable. Consumer confidence is at a low ebb. Job creation remains restricted. Disposable income faces downward pressure from personal taxes that are likely to rise in future years. The support household disposable income has received from a sharp increase in the government’s wage bill in recent years has come to an end. Household spending patterns have had to adapt to municipal services and electricity bills taking up an increasing share of expenditure.
Business investment spending is lacklustre, as is business confidence. It will take a decisive improvement in future prospects for the economy to break this impasse. Growth in government consumption and capital expenditure will remain under pressure because of the need to consolidate public finances and stabilise (and eventually reduce) the government’s debt burden.
In short, excess demand is highly unlikely to put upward pressure on prices for an extended period of time. However, it is possible that weak demand may constrain the pricing power of business, forcing them to absorb cost pressures or find ways to reduce costs if profit margins are to be maintained.
So it is all about cost pressures coming through from the supply side of the economy ̶ higher food prices because of the severe drought, higher imported inflation as a result of rand weakness, and sustained increases in administered prices over a long period, electricity prices in particular, in excess of general inflation. Although one could legitimately ask whether all of these are to be regarded as contributing to a rise in the general price level and whether at least some of the price changes do not rather reflect changes in relative prices that are an inherent part of the signalling function of the pricing mechanism. Suppressing the latter would in fact undermine the information content of prices that is necessary for market participants to efficiently adjust their behaviour to changed market conditions. For example, higher fresh produce prices as a result of the severe drought are necessary to balance demand with reduced supply and to encourage increased production by those who can.
In the second place, as for the matter of managing inflation expectations, the question is whether expectations are not predominantly adaptive, in other words they adjust to the ups and downs in the inflation rate as they occur. The methodology of the inflation expectations survey actually encourages expectations to be adaptive. Thus it is questionable whether measured inflation expectations reflect strong convictions about future price movements that will be factored into decision-making processes.
Although it is plausible that economic and market analysts forecast future inflation taking their expectations regarding the future path of interest rates into account, it is highly unlikely that business and labour would do so.I In any case, there are indications that business pays little attention to inflation data as it is not regarded as a strategic input into business decision making. It is just not realistic to think that business people will be alert to how their individual pricing decisions feed into general inflation data and that it could trigger a response from the MPC, resulting in their refraining from raising prices.
The third element of our framework of understanding, once we have determined the causes of inflationary pressures, is our understanding of the monetary policy transmission mechanism. In exactly what way do we expect a change in the repo rate to affect the general price level, or more specifically, how do we see an increase in the repo rate addressing the inflationary pressures coming from our identified causes?
Will suppressing already weak domestic demand even further by increasing debtors’ debt service burden and upping the cost of credit do the trick? Will it weaken business’s pricing power to the point of profits taking the knock? Or will business, faced with even lower prospective demand, in any case hike prices in an attempt to try to support nominal turnover? Does the prospect of ongoing fiscal tightening for the next few years not relieve the burden of monetary policy?
The price pressures resulting from the drought and administered prices cannot be addressed by monetary policy. Food prices will normalise once supply normalises, while administered prices are a matter of policy.
The futility of trying to protect the exchange rate of the rand by increasing interest rates has been proved time and again. It is implausible to expect interest rate differentials to encourage market participants to take an uncovered position in a currency that is as volatile as the rand, where any benefit from a favourable interest rate differential can be wiped out overnight by an adverse movement in the exchange rate.
What will support the exchange rate is higher economic growth, resulting in the seemingly unrealistic conclusion that lower interest rates could in fact cause the currency to strengthen by encouraging capital inflows, for example increased foreign purchases of domestic equities. Resolving the political impasse will also be helpful.
My conclusion is therefore that the MPC should be very circumspect in raising the repo rate further. In any case, the cumulative increase of 200 basis points over the tightening cycle is probably the equivalent of 300 basis points in the previous tightening taking into account the effects of higher capital requirements and more stringent lending standards in the aftermath of the financial crisis.
Although the MPC might believe that its credibility could be on the line if it does not tighten policy further, it should start signalling that the end of the tightening cycle is close. In any event, at some point the normal lag of 12 to 18 months with which monetary policy works will mean that it will take us past the upper turning point in inflation, viz. the interest cycle should peak before the inflation cycle.