Monetary Policy after the Budget

The announcement by Finance Minister Pravin Gordhan in his budget speech that inflation targeting is to be retained as the framework within which monetary policy is conducted has brought the debate about the future of inflation targeting to an abrupt end – some critics will say even before it had properly started.

Together with the decision to keep the target range of 3-6% based on headline consumer price inflation unchanged, it implies perfect continuity on the face of it. But is it really so simple?

Flexible inflation targeting

The letter the Minister sent to the Governor of the Reserve Bank (SARB) to inform the Bank of Government’s decision has lead to much speculation. My own view is that it amounts to nothing more than a reiteration of the Bank’s role as a flexible inflation targeter, something about which the current leadership at the Bank will be perfectly happy.

In the early period after the adoption of inflation targeting in February 2000, the SARB was very explicit in presenting itself as a flexible inflation targeter. One only needs to glance at the early editions of the Monetary Policy Review to find ample evidence of this.

For example, in April 2003 the SARB stated with regard to flexible inflation-targeting by central banks such as itself that “this does not necessarily mean that they have dual or multiple objectives, but rather that they are mindful of the costs of attaining the target or getting back to the target when they are knocked off course”, viz. they are very much aware of the “sacrifice ratio”.

However, over time the SARB’s rhetoric has changed, especially after the upper end of the target range was first breached in April 2007 and inflation persistently remained outside this range. The message of flexibility got lost and the SARB started to appear increasingly oblivious to the costs of fighting inflation. (It nevertheless cannot be accused of being draconian in its endeavour to bring inflation back into the target range.) Its standard response to criticism that it was not paying enough attention to issues of growth and employment was that the best contribution monetary policy could make to economic growth was to maintain price stability over the long run, thus avoiding the time-inconsistency problem.

Although this is essentially correct, it created the impression that the SARB does not care – a problem it shares with many other central banks. (According to Frederic Mishkin, a renowned authority on inflation targeting and current member of the Board of the US Federal Reserve, “the reality is that central bankers, whether they target inflation or not, are extremely reluctant to discuss concerns about output fluctuations even though their actions show that they do care about them.”)
 
The least one can say about the future conduct of monetary policy in South Africa is that the SARB’s rhetoric will revert to its earlier emphasis on flexibility, viz. to demonstrate that it does indeed care. The statement released after the meeting of the Monetary Policy Committee in January 2010 already provides the first evidence of a change in tone. In addition, on taking office the new Governor immediately created a function for Stakeholder Relations and entrusted it to the SARB’s chief economist, Dr Monde Mnyande, pre-empting the promise accompanying the Budget announcement that the SARB would improve on its communication with interested parties to better explain the reasoning behind its policy decisions.

A new approach to monetary policy?

But is it really only the rhetoric that will change? Or will there also be a subtle shift in the MPC’s assessment of the information in front of them to take more cognisance of the short-term trade-offs between inflation and growth and employment? The idea of flexibility after all introduces an element of discretion into the decision making process.
Even if it is not a principled shift, have the doves in the MPC perhaps not gained the ascendancy with the appointment of the new governor?

I am inclined to think that this is indeed the case, and that it will become clearer as we move along. Although the Governor indicated at the media conference after the recent MPC meeting that the possibility of a further cut in the repo rate had been seriously debated, it is unlikely that the rate will be cut at this point in the cycle. Perhaps the repo rate could have been reduced more aggressively in 2009 (negative real interest rates would temporarily have been perfectly in order given the recession), but it is now too late to cut further in view of the convincing evidence that the economy has turned the corner. A more likely outcome is that the SARB will wait till the economic recovery is well entrenched before it starts raising the repo rate, and then only slowly.

The real repo rate

Perhaps more important is the question of whether the repo rate (in particular the real rate) will in future be pitched at a lower level on average than in the past.  Up to the time inflation breached the upper end of the target range and started to play havoc with monetary policy, the SARB managed to keep the real repo rate fairly steady at approximately 3%, implying an average real prime lending rate of 6,5%.

However, it is quite conceivable that the real repo rate could be lower in future. In fact, one could argue that the tightening in banks’ lending standards caused by the financial crisis will be reinforced by a new regulatory regime that will include higher capital requirements, resulting in a permanent increase in effective lending rates. Such an increase would affect the monetary policy transmission mechanism in that a lower repo rate will then have the same impact as the previous higher level, and this should be incorporated into the SARB’s thinking.

In my opinion a fundamental reconsideration of the operation of the monetary policy transmission mechanism is in any case overdue. For example, the introduction of the National Credit Act has had a profound influence on the way credit is granted, while the relationship between monetary policy and movements in the exchange rate of the rand remains decidedly murky.
 

Caveats

However, there are some important caveats, e.g. the retention of the 3-6% target range in the face of expected higher future inflation, inter alia as a result of the economy’s adjustment to the new electricity tariff regime. The consensus view according to Reuters is that inflation will average 5,9% in the next three years, which is perilously close to the upper end of the target range. It will take very little to push inflation above 6%, e.g. only a moderate depreciation in the exchange rate of the rand, and the SARB will constantly have to deal with this risk to protect its credibility.

The unfortunate truth is that the credibility of the inflation target has already been tainted by the fact that the upper end has been breached for almost three years now. Although inflation is expected to return to within the target range soon and remain there, even if it is at the upper end of the range, the SARB cannot afford to be seen to tolerate another spell of persistently above-target inflation if it wants to fulfil its mandate of anchoring inflation expectations.
In addition, monetary policy cannot ignore the fact that it will receive less support from fiscal policy in future – in fact, a prolonged expansionary fiscal stance, as well as an increase in the size of government, points to additional inflationary pressures from this source.  The budget balance is set to average -5,1% of GDP in the next three years, compared with +0,1% in the three years up to 2008/09. Furthermore, government expenditure is expected to amount to 33% of GDP in the next three years, which is considerably higher than the average of 29,5% in the three years up to 2008/09. Any attempt to reign in the budget deficit by increasing taxes will create additional inflationary pressures if these taxes are passed on in higher prices (as is bound to happen – higher indirect taxes in particular feed directly into higher administered price inflation).

Should the target have been adjusted or not?

Which brings me to the question of whether the decision to retain the target unchanged was the optimal one under the circumstances.

I have argued in the past that any tinkering with the inflation target should take place only when inflation is well within the target range so as to avoid the perception that South Africa is becoming tolerant of high inflation. However, I have also pointed out that the choice of the 3-6% target range was a rather arbitrary decision, with inflation at that point in time well above the upper end. The 3-6% target was seen as the first step in a process of disinflation, and once inflation moved to within the target range in August 2001, the upper end was almost immediately lowered to 5% to set the next benchmark. (Of course the collapse in the exchange rate of the rand late in 2001 compelled Government to revert to the 6% upper end.)

I therefore suggested that the top end of the target range could be raised to 7% without having to fear a hugely negative response from financial markets. This would give the SARB more leeway in coming to grips with the sharp increase in electricity tariffs at a time when the economy is struggling. Alternatively, the definition of the targeted inflation rate could be changed to a version of core inflation that also excludes the first-round effects of the electricity tariff hikes.

South Africa would not have been alone in adjusting its inflation target; it would have been following in the footsteps of e.g. Turkey and South Korea, which both raised their inflation targets in 2009 without being blown out of the water by financial markets. Korea in particular was explicit in its motivation for this step as necessary to give it more room in dealing with short-term growth challenges.
 
The empirical evidence seems to indicate that such a move would still comply with the aim of supporting long-term growth by pursuing price stability. In their study of the relationship between inflation and growth, Mohsin Kahn and Abdelhak Senhadji of the IMF conclude that “the threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries”. In another study by Robert Pollin and Andong Zhu, they found that “higher inflation is associated with moderate gains in GDP growth up to a roughly 15-18 percent inflation threshold”.

Even Olivier Blanchard, the chief economist of the IMF, recently went so far as to suggest in an article co-authored by him that developed economies should raise their inflation targets from 2% to 4% (although he was heavily criticised for this statement!)

Raising the upper end of the inflation target range temporarily is therefore unlikely to result in disaster. The question is what would do the most damage to the SARB’s credibility and inflation expectations: raising the upper end of the target range to 7% or keeping it at 6%, only to miss it regularly?

To summarise: Although the SARB will probably like to reaffirm its credentials as a flexible inflation targeter, the fact that it will be living on the edge with the target range remaining unchanged may yet prevent it from acting any differently from the past. It is vital that the SARB retains its credibility to avoid an increase in inflation expectations, with its negative consequences for the cost of capital and therefore long-term growth.

Let me conclude by giving the last word to Prof. Lars E O Svensson, Deputy Governor of the Sveriges Riksbank: “Flexible inflation targeting, applied in the right way and using all the information that is relevant for the forecast of inflation and resource utilization at any horizon, remains the best-practice monetary policy before, during, and after the financial crisis.”

References

1. Monetary Policy Review. South African Reserve Bank. April 2003.

2. Frederic Mishkin:  “Can Central Bank Transparency go too Far”? National Bureau of Economic Research. Working Paper No.10829. October 2004.

3. Olivier Blanchard, Giovanni Del’Aricca and Paulo Pauro: “Rethinking Macro-Economic Policy”. IMF Staff Position Note. February 2010.

4. Mohsin S Kahn and Abdelhak S. Senhadji: “Threshold Effects in the Relationship between Inflation  and Growth”. IMF Staff Papers. 2001.

5. Robert Pollin and Andong Zhu: “Inflation and economic growth: a cross-country non-linear analysis”. In Gerald A. Epstein and A. Erinc Yeldan: “Beyond Inflation Targeting. Assessing the Impacts and Policy Alternatives”. Edward Elgar. 2009.

6. Lars E O Svensson: “Inflation targeting after the financial crisis.” Speech at the International Research Conference on “Challenges to Central Banking in the Context of the Financial Crisis”. Mumbai. 12 February 2010.