My Differences with the Reserve Bank – Redux

October 13th, 2017 by Brian Kantor

The Monetary Policy Committee of the Reserve Bank decided not to offer relief to our hard pressed economy.

This window of opportunity to lower interest rates was provided by declining rates of inflation and less inflation expected. The conclusion is that if cutting rates was not opportune last Thursday 21st September, when would circumstances ever allow the Bank to lower interest rates?

Indeed circumstances have since have made lower interest rates less likely. They came this week in the form of a stronger USD and a weaker ZAR, implying more inflation to come.

The MPC referred to the deteriorating assessment of the balance of risks.   However risks to the inflation rate will always be present and remain difficult to anticipate. What should be expected from a central bank is not accurate risk assessments but that it will react appropriately to the new realities. Especially to the impact of any exchange rate on prices to which the SA economy has proved particularly vulnerable.

Such events are described as supply side shocks to prices,  to be distinguished from the extra demands that might be forcing prices higher.  These supply side forces reverse as the exchange rate recovers or stabilizes or the harvest normalizes or tax rates do not increase any further. Thus these temporary supply side shocks should be left to their own devices – to work themselves out of the system without help or hindrance from higher interest rates.  The Reserve Bank however tends to react to inflation whatever its underlying causes

It often refers to so called second round effects of inflation.  The presumed danger that when inflation rises, for whatever reason, firms with pricing powers will plan for more inflation and set prices accordingly. And so inflation can become a self-fulfilling process.

That is unless corrected by higher interest rates to cause enough of a reduction in demand to prevent firms charging much more. Slack – that is an economy operating below its potential – is therefore the price that might have to be paid to achieve low rates of inflation as the economy is now paying up for.

The problem with this theory of self-fulfilling inflationary expectations in South Africa is that there is little evidence of it. Inflation and inflation expected mostly run closely together. Moreover inflation expected has been much more stable than realized inflation. This strongly suggests that inflation expected would have been a constant rather than a variable influence on actual inflation.

Inflation expected is surely not a simple extrapolation of past inflation. Inflation expectations will take account of the forces that are known to have cause inflation in the past, including the impacyt of reversible supply side shoks on prices. They will be informed by models very similar to the Bank’s own model that forecasts inflation. This Reserve Bank model currently forecasts inflation of about 5% in eighteen months, close to the inflation expected by the bond market.

The Reserve Bank and the market’s ability to forecast inflation is highly vulnerable to error given the unpredictability of the exchange rate and all the other supply side shocks that may send inflation temporarily higher or lower.

The inflationary forces that the Reserve Bank can influence consistently are only those that emerge on the demand side of the economy- not the supply side. The current problem for the economy is now one of much too little demand. A case of too much slack and too little growth.

The Reserve Bank therefore should adopt a very different approach to supply side shocks and to alter its narrative accordingly. One that will convince the market place that interest rate reactions to supply side shocks do not make economic sense. And that by not reacting to them when the economy is performing well below its potential does not mean that the Bank is soft on inflation.