By Jac Laubscher, 3 February 2015
But what should we understand by normalisation? Does it imply a return to monetary policy as it was conducted prior to the financial crisis that commenced in 2007? Is this at all possible or has the crisis left a fundamentally different world in its aftermath?
A Staff Discussion Note published by the IMF in April 2014, reviewing the debate within the institution on this topic, refers to “Monetary Policy in the New Normal”. This seems to indicate that the IMF envisages a different future scenario rather than a mere return to previous practice. The international financial crisis has certainly led to the view that price stability should be central banks’ only objective and short-term policy interest rates their only policy instrument being challenged.
So what should we understand by the “new normal” when it comes to monetary policy? A range of issues need to be addressed in answering this question.
Although these issues are still in the process of being resolved, important principles of the pre-crisis monetary policy consensus remain as valid as before. These include central bank independence, policy transparency, a clear mandate and accountability. There has also been no suggestion that central banks should discard low and stable inflation as their primary objective in order to anchor inflation expectations.
But what does this debate mean for South Africa?
According to the Monetary Policy Statement of 29 January 2015 the Committee remains of the view that interest rates will have to normalise over time. On the face of it therefore appears as if the SARB has been caught up in the quest for a “new normal” in monetary policy.
However, the complete MPC statement, as well as the December 2014 Monetary Policy Review, positions the SARB very much as the conventional flexible inflation targeter it has always claimed to be. The normalisation it envisages apparently applies only to interest rates and rightly so. After all, the SARB did not go down the abnormal policy route to the extent that e.g. the US Federal Reserve did because it was not faced with the same abnormal challenges. At most it also adopted a mild form of forward guidance in communicating its policy stance.
Many of the issues raised as part of the normalisation debate are peripheral to South Africa (e.g. quantitative easing as a policy instrument), while others (e.g. the organisation of macroprudential and microprudential oversight) have already been resolved.
Flexible inflation targeting with a sufficiently long time horizon as already practised by the SARB is seen as part of the solution to dealing with the trade-offs between price stability and other objectives when they arise. Having an inflation target of 3%+ has suddenly become a vir-tue because of the increased awareness of the difficulties central banks face on reaching the zero lower bound on interest rates.
The most important question is therefore what the SARB regards as the normal level for interest rates. Prior to the financial crisis it kept the real repo rate fairly steady at 3%, but it has already acknowledged that higher capital and liquidity requirements for banks and a tightening in lend-ing standards warrants a lower real repo rate.
On the other hand the decline in South Africa’s potential growth rate implies a narrowing of the output gap and therefore greater inflation risk should demand start growing more rapidly ̶ although for the moment there are no indications of excess demand in the economy and credit growth remains benign.
One will also still have to see how medium-term inflation expectations respond to the sharp drop in oil prices ̶ after all core inflation has hardly budged and remains at 5,7%. Although inflation expectations will probably to some extent adapt to the current declining trend in inflation in response to lower oil prices, one should bear in mind that the inflation numbers will be influenced by a lower base in the first half of 2016.
If one therefore assumes a 2% real repo rate as the “new normal” with inflation expectations possibly settling at between 5% and 5,5%, one arrives at a nominal repo rate of around 7,25%, compared with the current level of 5,75%. That leaves another 1,5 percentage points in potential repo rate increases, the pace of which will be determined by the economic cycle.