Category: Monetary Policy

Dealing with a financial and economic crisis – by creating money

This is the age of money creation. Money creation à outrance– to the limit – unsparingly[1] that began on a monumental scale in response to the Global Financial Crisis of 2008-9. (GFC) A new phase in money creation on an even greater scale has begun in response to the Corona Virus crisis. Or more precisely in response to the shutdowns of normal economic activity ordered by almost all governments. In the week ending April 10^th the US Federal Reserve Banks, as an outstanding example, expanded its assets and liabilities sheet by an extraordinary 2 trillion dollars. It increased its assets and liabilities from approximately 4 to 6 trillion dollars or by 50% in one week. With more money likely to follow in the weeks ahead.

The recipe for curing a banking crisis has long been known- create more and enough money until the panic rush for money abates. It has been done this way many times before in response to one or other financial crisis. But it had never been practiced on the scale adopted after the GFC and now.

Analysing the balance sheets of central banks to find the sources of extra money

On the asset side of the Federal System you will find mostly securities issued by the US government. Its liabilities are mostly incurred in the form of deposits placed by member banks of the Federal Reserve System. The size of the Fed balance sheet has increased more than six times since 2008 – and it is set to rise much further.

These deposits with any central bank are money – central bank money – cash, if you like. Money that can be exchanged without limit for goods and services, other currencies and financial and tangible assets of all kinds. The cash so acquired by banks or others may also be used to make additional loans – bank overdrafts for example- or used to subscribe for new issues of securities offered by governments and businesses of all kinds, including other banks. They are money, because as with notes and coins of the realm, they would not be refused when offered in exchange for goods, services or other assets.

Whenever a central bank on its own initiative buys a security (a US Treasury Bill or Bond for example) or makes a loan to a bank or business, it settles the obligation to pay by crediting (digitally) its very own deposit accounts. In other words a central bank pays for whatever it wishes to buy, by creating its own money, at no extra cost to itself or the government of which the central bank is an agent. It may be described as a wholly owned subsidiary  of the government.

A few additional observations are in order. When the central bank buys an asset directly from a bank, that bank will in the first instance deposit the receipts of the sale in its account at the central bank. The money supply increases accordingly. When the asset is sold to the central bank by another financial institution, other than a bank, the proceeds will first be deposited in its account at some private bank. The bank receiving an extra deposit from a client will in turn present the digital equivalent of a cheque to the central bank for settlement and will receive a credit to its deposit account with the central bank. Again the money supply increases in proportion to the value of the transaction.

When however the central bank lends directly to the government in exchange for a newly issued security or against an increased overdraft, as the UK government is now doing, the government deposit account with the central bank will be credited accordingly. This larger government deposit account is not immediately part of the money supply. It is only when the government account is drawn upon to pay for goods and services, and the transactions are banked by suppliers to the government does the money supply increase in the form of extra deposits of private banks banked with the central bank.

Modern money is only convertible into the self-same money

Modern so-called fiat currencies are however not convertible at any fixed rate of exchange into gold or other reserve currencies. Yet they are easily converted into goods, services, assets of all kinds including gold and other currencies at variable exchange values that are continuously determined in the various markets. The purchasing power of its money is therefore not at all certain. It may lose buying power if there is too much of it issued – that is when more is supplied than is willingly held as money. Money may gain value in exchange for other currencies if extra demands to hold the money press upon existing supplies.

Money is held very willingly for its convenience as a transactions balance or as part of some optimal portfolio of assets. It is the most liquid, most easily exchanged of assets, with a certain monetary value. Other assets are less certain in their future value, expressed in money of the day. Though fiat money does have not a certain real or purchasing power value when exchanged for goods or other currencies.

Money as an asset is especially desirable when the prices of other assets are expected to fall in value. That is when the risks of business failure or the prospect of higher interest rates, that may reduce the value of income earning assets, appear more likely. But the owners of money may at any time decide that they have too much money in their portfolios and too little of other assets that they might use their surplus money or cash to acquire. That switch in the composition of any portfolio of assets may be more likely when the supply of money is seen to be increasing rapidly. Money holders may well they fear that their money will lose value over time and accordingly reduce their holdings of it. And by so doing put more upward pressure on the prices of goods, services and assets.

Central bank money is mostly demanded and supplied to banks. Will they hold the extra money or use it to make loans?

The principle owners of central money are the banks. And while they hold notes and coins to meet the demands of their customers in their tills and ATM’s, their major holdings of central bank money will be in the form of deposits with the central bank. Deposits of banks with the central bank may exceed the supply of notes and coin that make up the money issued by a central bank. (see figure below on the composition of the Federal Reserve Balance Sheet)

The decisions the banks take with their holdings of additional central bank money supplied to and received automatically by them will be crucial to the outcomes for total lending and spending in the economy. Essentially the more of the extra cash received the banks prefer to hold as extra cash reserves, the less will be the repercussions for the wider economy. An increase in the supply of money accompanied by an increase in the demand to hold that money cannot lead to extra bank lending. That is to additional supplies of bank credit that can be used to fund additional expenditure. The buck stops there – literally.

But banks are in business to make money – that is profits – by keeping as little cash on their books – as is prudent – and putting their cash to work by making loans. They earn profits on the spread between the interest they pay on deposit and the interest they earn on their loan portfolio- their assets. These deposits, especially those used to make payments are a convenient substitute for the notes and coins issued by the central bank into which they can be converted on demand. They are also described as part of the wider money supply.

The banks therefore not only borrow and lend, they maintain the payments system the reliability of which is crucial for economic stability. They incur costs including wages and rents costs attracting deposits or other sources of funds and transferring them on instruction of their deposit holders. They incur losses should their loans go sour. But without taking some risk with their cash and capital in search of profits they could not hope to succeed in the banking business.

They are in the risky business of lending and borrowing. They are typically highly leveraged businesses in two important senses. The amount of cash they hold in reserve against their deposit liabilities that may be withdrawn without notice is a minimal one – the legal requirement may be as low as a 2.5% reserve of cash against deposits. Banks will also hold equity capital as a reserve to cover losses on their loan book. This reserve ratio is also regulated to be as much as a 15% capital to asset ratio.

After the GFC most of the banks of the world behaved very untypically. They held onto much of the cash and did relatively little extra lending. They held cash reserves far in excess of the regulated reserve requirements as may be seen of the US banks in the figure below. The supply of cash was increasing at enormous rate after the GFC. But so was the demand to hold those reserves. Perhaps because the banks had become very risk averse in the aftermath of the GFC and held much larger cash reserves to feel safer. They did moreover receive interest on these deposits from the Fed. Competitive with the low money market rates available. No doubt this was further encouragement to hold on to cash

Bank credit grew relatively slowly in the US after the GFC and despite the surge in central bank money. as did the deposit liabilities of the US banks which are registered on the other side of their balance sheets. Thus the increase in the supply of central bank money, sometimes known as the money base (MB) or M0, did not lead to any dramatic increase in bank lending and spending associated with such extra lending. It was not inflationary as it turned out.

Recent money supply trends

In the figure below it should be noted how the money base (M0) in the US peaked in 2014 and then declined rapidly in 2018 – as QE was reversed. In late 2019 it rose sharply again to support the banking system that was found unexpectedly short of cash that put unwanted pressure on inter-bank lending rates. The most recent Corona virus-inspired surge in the money base can also be seen. The supply of currency by contrast has increased at a very steady rate- in response to the demands for dollar bills- in and outside of the US.

Fig. 1; Liabilities of the US Federal Reserve System.

Source; Federal Reserve Bank of St Louis (Fred) Investec wealth and Investment

We show the asset side of the US Fed Balance sheet in the chart below. (figure 2)   As may be seen most of the growth in assets – and liabilities – was the result of the Fed purchase of US Treasury Bonds in the capital market. The other assets of the Fed include loans made to banks and mortgage backed securities issued by government agencies.

Fig.2; Total Assets of the Federal Reserve Bank System and Holdings of Treasury Bills and Bonds

Source; Federal Reserve Bank of St.Louis. Investec Wealth and Investment

These Fed holdings of securities issued by the US Treasury have gained  an important share of all the debt incurred by the Federal Government – currently the Fed share is around 12% of all US government debt – as we show in figure 3 below.

Fig.3; Federal Debt and US Government Debt held by Federal Reserve System

Source; Federal Reserve Bank of St.Louis. Investec Wealth and Investment

Increased Treasury Bond holdings of this magnitude have surely helped to reduce the interest rates paid on US Treasury Bonds. Since the Federal Reserve Bank of the US, while it keeps a separate set of accounts and balance sheet, is a wholly owned agency of the Federal Government. If we consolidated their balance sheets and set off the Reserve Bank’s holdings of Treasuries against the total Fed debt, we would reveal a reduction in outstanding Federal debt, replaced by the increased deposit liabilities of the Federal Reserve Banks. In other words cash – irredeemable non-interest bearing government debt – that is issued by the government or rather its central banks without interest – replacing interest bearing debt.  Though, when the interest paid on government debt, short and long dated, is very low- close to zero- as it is now in the US – the distinction between debt and money is largely irrelevant from the perspective of the issuer incurring the liability and not paying (much) interest

Explaining why bank deposits are a multiple of central bank money- but limited by it.

Central bank money, currency and cash reserves in the form of deposits with the central bank can be described more evocatively as “high powered money”. This is because the bulk of the money held and used to pay for goods and services is supplied by the private banking system in the form of transaction balances (deposits) held with them and exchanged on the instruction of depositors. The loans and advances banks make may flow from one bank to another. But the money loaned mostly stays with the banking system. They arrive as deposits with other banks or even as another  deposit of another customer of the bank making the loan. The funds lent, borrowed and spent do not drain away from the domestic banking system, except when withdrawn as notes or deposited in a foreign banking account.

It is the cash reserves held by banks  that sets the theoretical limit to the sum of the loans in one form or another that the banks may make. It therefore sets the limits to the so -called money multiplier – the multiple ratio of broadly defined money – known as M1 M2 or M3 made up of bank deposits of various kinds from transactions balances to longer term deposits- to  central bank money.

That ratio or multiplier as we show below was of the order of 14 times in SA M3/M0 or 8 times in the US M2/M0 before the GFC. It collapsed in the US to about 3 times as the demand of the banks to hold a much greater reserve of central bank money was exercised by the US banking system. It has increased recently to about four times the money base or M0. See figures 3 and 4 below.

South African banks by contrast with their US hold very little by way of excess cash reserves – cash reserves in excess of the regulated ratio- some 2.5% of deposit liabilities. Rather than holding excess reserves SA banks consistently borrow significant sums from the Reserve Bank to meet their demands for cash as we will demonstrate below. SA banks were not caught up short of cash in the GFC. They are now very much caught up in the crisis caused by the responses to the Corona virus. The loans they have made will not be easily serviced when their borrowers are not able to realise any revenue. Solvency and a lack of liquidity will threaten them as much in SA as it will do anywhere else.

Fig 4; South Africa Narrow and Broader definitions of the Money Supply and the money multiplier

Source; SA Reserve Bank and Investec Wealth and Investment

Fig.5; US Money Supply and the money multiplier

Source; Federal Reserve Bank of St.Louis. Investec Wealth and Investment

Private banks do not create money- they supply deposits that act as money at a cost – and not necessarily profitably

While these bank deposits can be measured as a multiple of the cash supplied to the system this does not mean that the banking system can “create deposits” in some magical, costless way. Supplying deposits to the system and maintaining the payments system to which a deposit account gives access, is a costly exercise. It takes computer systems and ATM machines and premises and people to manage the system and also equity capital that might be better employed in other businesses. And loans may not always be repaid. Banks may go broke if their bad loans exceed the value of their equity which may only be equivalent to 10-15 per cent of their loans and advances. And they may also go under if they cannot meet a run on the bank- a demand for cash in exchange for their deposits – which is their contractual obligation. Only the central bank can create money at will and without cost. The difference between private banks who supply deposits at a cost – and the central bank who can create money without cost is a fundamental one.

The limits to the size of a banking system- the aggregate value of its assets and liabilities -will be determined in any full analysis of the determinants of its size, by its profitability. Profitable banks grow their assets and their deposit liabilities – unprofitable banks shrink away. The profitability of a bank is enhanced by leverage – minimising as far as responsible its cash reserves and equity capital. Banks are typically highly leveraged businesses. But risk of failure in all enterprises comes with leverage and prudence may limit lending activity, and may have to mean larger cash and capital reserves, fewer loans and so reduced profitability and so a smaller money multiplier -as has been the case in the US since the GFC.

The habits of the customers of the banks, how much they prefer to use notes to make payments rather than accept bank deposits as payment, will also influence the cash reserve ratios of the banks and so the volume of their lending. The money habits of the community – a preference for money in the bank rather than in the pockets or purses or in offshore banks – may change only gradually over time- so limiting the growth over time in the banking system. The relative importance of a banking system might be measured as the ratio of bank assets and liabilities to GDP in money of the day prices. As may be seen in the figure below the real role of banking in the US and SA economies is not dissimilar- with M2 running at about 50 to 60 per cent of GDP. The SA ratio however increase markedly between 1980 and 2010. The US money to GDP ratio was stable even declining between 1990 and 2008, suggesting a relatively less important role for banks in the US economy, but has increased in since the GFC as may be seen in figure 6 below.

Fig.6; The Money (M2) to GDP ratios in SA and the US. Measuring the real importance of private banks.

Source; Reserve Bank of SA, the Federal Reserve Bank of St.Louis and Investec Wealth and Investment.

An economy depends on a thriving profitable banking system – able to support growing businesses with convenient credit and a payments system.  Zombie banks – undercapitalised banks -that survive only on government and central bank life support – are not helpful for economic growth. They are poorly capitalised because they have not earned enough income to retain cash with which to augment their reserves of equity capital.

Furthermore it should be appreciated that every deposit made with a private bank represents a real saving – of consumption spending  – however temporary. Banks pool these savings to make them available to borrowers. Money in the bank is as much a saving- a reduction in potential spending out of income or wealth – as a contribution to a pension fund. It is a more liquid form of saving, they are savings more easily cashed in for goods, services or other assets at a certain money value.  Cash is an important component of any wealth portfolio and part of the working capital of any business.

However what is true of the deposits of a private bank that act as money in competition with the notes issued by the central bank – that they are costly to produce- is not true of the cash issued by a central bank. Such cash is almost costless to produce and can be supplied in unlimited quantities. It is convertible only into the same government sanctioned cash.

Why not fund government spending with cheap money? Responses to QE as  the exception not the monetary rule.

Why then should any government restrain the amount of money it creates that costs so little to produce? Why do governments fund their deficits from the market place rather than via their own central banks? The value of a currency that can be issued without limit is based on a trust that it will retain to a least some degree,  or at least temporarily retain its purchasing power, that is its value in exchange. Otherwise it is not very useful.

The limits to issuing money, is that issuing too much of it – more than would be willingly held as a reserve of purchasing power – is that the money created would consistently and even rapidly lose its value in exchange. That is it would cause inflation – defined as a continuous increase in the price level – and a persistent decline in the foreign exchange value of the currency and its purchasing power. This is usually not a politically popular outcome and so it is to be avoided. Hyper inflation is moreover highly destructive of the real economy.

Economies may adapt to moderate inflation- say inflation that runs between five and fifteen per cent per annum- especially if the rate of inflation though high becomes predictable. But inflation trends may easily slip higher should government come to rely more permanently and heavily on printing money rather than raising taxes or borrowing in a genuine way in the capital market. Inflation and currency depreciation would follow should the supply of central bank money consistently exceeded the demand of the public and the banks to hold that central bank money as a reserve.

QE after 2008—09 representing an extraordinary increase in the global supply of central bank money did not cause inflation because much of the extra cash issued was willingly held by the banks. Had the banks used the extra cash to make additional loans the supply of deposits (money broadly defined)  and the supply of bank credit would have grown proportionately – say at the eight times multiple normal before the GFC. And spending would have grown much faster than it did with the aid of much more bank credit and prices would have risen much faster than they did. Thus it is not the supply of money that automatically leads to more spending and higher prices. It is the excess supply of money- central bank money- over the demand to hold that money that causes bank credit to increase and prices to rise.

Time will tell what use is made of the extra cash created to fight Corona Virus. Will it be held mostly as additional cash reserves by the banks? Or will it stimulate a burst of extra bank lending and a multiple creation of deposits and a rapid expansion of bank credit and the extra spending associated with freely available bank credit? That is prove more inflationary than QE was last time round- post the GFC? The reactions to QE in SA – the scale of it and the trends in money supply and bank credit will be of particular interest.

The case of SA – how much QE will and should be undertaken?

There is no doubt that a large gap will open up in South Africa between the output and incomes that might have been produced without the lockdowns and what will be produced. The output gap will be a very large one. Perhaps the equivalent of 25% of one years GDP will be sacrificed to the cause of defeating the Corona virus. It will be a very large loss to bear. And much like the losses to be incurred in all the economies subject to lock down.

How much income will actually be sacrificed will depend in part on how much the SA government spends on relief measures and how much the Reserve Bank supports the government and private sector with extra cash. The more support provided to the economy in one way and another by the government and the Reserve Bank, the more demand for goods and services can be exercised and the smaller will be the eventual loss of output as supply responds as best it can. Any reduction in economic damage of the large likely order expected is a clear gain to the economy. Given the size of the output gap and a general lack of demand for goods and services, inflation in SA is very likely to remain subdued. This surely a time to be concerned about the lack of output and incomes, not that prices may be rising faster at some time in the future.

Any additional utilization of what would otherwise be wasted capacity- human and material- comes without real economic cost. That extra demand can bring forth extra supplies would be pure gain to the economy, especially if funded with central bank money. The Keynesian argument for extra spending by government, funded as cheaply as possible, holds very strongly when supply and demand in the economy can be confidently predicted to decline significantly- as it will in SA during the lock down.

It is not clear that the Reserve Bank sees the SA predicament in this same urgent way. In the way central banks in the developed world are recognizing the role they can play and acting accordingly. The SA Reserve Bank  has every  opportunity to create more of its own money without any cost. In order to help borrowers, and to assist the banks and the government,  but also to support hard pressed private businesses through its lending programmes. Unlike its peers in the developed world it also has scope to significantly lower short-term interest rates. All the way close to zero would make sense to help make up some of the output sacrificed with the lock down.

The Reserve Bank should not be hesitating to act boldly. Any inflation that may come along later with a recovery in the economy will have to be dealt with in its own good time. Money created can be as easily removed from circulation when the economy has closed its output gap. And a wider fiscal deficit can be temporary rather than permanent when economic normality is regained. The case for the SA government to limit its spending and fiscal deficits over the long run remains as strong as ever. But not for now. It calls for calm wisdom and good judgment. Unusual times call for unusual responses. Let us hope the SA Reserve Bank is up to the challenge.

[1] As described by Keynes. John Maynard Keynes was the originator of depression economics. He provided the justification for governments to spend more to overcome a lack of spending that caused the great depression in the nineteen thirties. And for which there appeared no self-correction. He inspired a highly  influential school of economics known as Keynesians. His argument for stimulation through government spending rather than monetary policy was that interest rates could not fall far enough to encourage enough capital expenditure. But he never, as far as I am aware, advocated printing money to fund extra government spending. While logical enough to use money to fund government spending if the depression was a deep one, he knew such a proposal would be politically unacceptable. For fear of inflation of the Weimar republic that was not far from memories in the nineteen thirties when Keynes developed his ideas..

Published in Business Day 17. April 2020.

The SA government will double its fiscal deficit in response to the Coronavirus crisis and its impact on output and incomes. The losses in output and incomes from the lock downs may be of the order of one trillion rand of sacrificed output and incomes. They will certainly be large, perhaps as much as one trillion rand of lost output, or the equivalent of 25% of GDP in 2019. We can only hope the extra government spending is highly effective and well directed to minimize the damage caused. It will help close the output gap, the difference between much lower realized GDP, and what might have been GDP, without the lock downs.  Encouraging more demand for goods and service will helpfully also increase the supply of them and increase incomes accordingly.

A spirit of generosity rather than any niggardliness is the right way for the government to approach its responsibilities for the economic damage it has inflicted. It should however be made very clear that whatever relief it offers and how offered is temporary in its nature. It is an urgent response to a grave emergency. Policies for the long term remain to be determined in the usual considered way, subject to all the usual due process.  We are hostage to a crisis – not to the future.

The government should therefore hope to raise the emergency funds it intends to spend as cheaply as possible. This means borrowing at the short end of the bond market at very low rates of interest- as close to zero as we can get them. And we can get these short-term interest rates as low as we choose to set them. The shortest and cheapest way to fund the surge in spending would be to create money to the purpose. This is what every central bank in the developed world is doing enthusiastically and without shame. We should be doing the same as unapologetically.

The developed world faces much lower long-term interest rates than we do. They can issue long term date without paying much interest at all. And their borrowing costs are as low as they are because of the willingness of their central banks to buy vast amounts of government bonds in the market. This process now known as Quantitative Easing (QE) is money creation by another name. Their central banks are doing vastly more bond buying and additional lending to banks and businesses in response to the economic threat posed by Coronavirus. And they are creating much more money and holding down the interest their governments must pay for funds.

Addditional central bank money comes mostly in the form of bank deposits held with a central bank. The supply of money in SA increases every time the Reserve Bank makes a loan to a bank or buys foreign exchange or government securities in the market. Money in the form of additional bank deposits(cash) held with the Reserve Bank would also increase should the Treasury draw on its own considerable deposits with the Reserve Bank to make payments. It has over R160b in its deposit account with the Resbank and presumably does not need Reserve Bank permission to draw upon. If so it can do its own money creation.

The high cost of the RSA borrowing on a long term basis – 10% p.a. to borrow rands for ten years – is even more reason for us now to rely on the central bank to assist in a sensible funding plan for Corona virus relief. It means bringing down short rates further and sharply. And making enough extra cash available to the banks and other eligible borrowers on favourable terms, so that the banks can fully support the market in issues of short dated, low interest paying, Treasury Bills and Bonds. Supporting issues of short term debt that will and should be growing rapidly to fund the extra spending. We should fully eschew long term borrowing for now and replace maturing long term debt with short.

All the world including SA will be set for a post-Coronavirus battle over the future scope of government spending. On how much the government should intervene. The left will want more intervention – more spending – more regulation  – more taxation of the wealthy – and will fudge the dangers of relying on central banks to cover larger fiscal deficits. Monetising government is very likely to be inflationary if done permanently on a large scale. But it will not be inflationary in SA for now- not until after the crisis. When we can get back to a new normal- that will include sensible monetary and fiscal policy.

How are governments and their central banks responding to the damage from the lock downs forced upon their economies and their citizens? They are doing all they can to minimize the damage to incomes sacrificed during the lock downs. There is no reluctance to spend- the issue is not about how much but rather how best to spend.  Restraints on fiscal deficits and money creation have been abandoned – and rightly so in the circumstances.

When so much central bank lending is to the government, even via the secondary market replacing other lenders, the distinction between monetary and fiscal policy falls away. The British government made this clear when it exercised its right to a large overdraft on the Bank of England. The Bank could not and would not say no to such a demand for funding, giving the state of the Kingdom. The US Fed has added over 2 trillion dollars of cash to the US banking system over the week to April 10^th. That is increased its balance sheet by 50% over a very busy week. The federal government has budgeted for trillions of dollars of extra spending- including spending to cover possible losses on the Fed’s loan book.

Issuing money is usually the cheapest way for any government and its taxpayers to fund such emergency spending. Though when interest rates on long term government debt is close to zero – more so if interest rates are negative – as in the developed world- issuing debt is almost as cheap as issuing money. Though where would interest rates settle without the huge loans provided to governments and banks by their central banks?

This is not the case in South Africa and many other emerging economies. Issuing long term debt at around 10% p.a. is an expensive exercise. Issuing three-month Treasury Bills at 5% p.a is also expensive. For central banks to create money for their governments and tax-payers is a much cheaper option. Is there not the same good reason for them to support government credit in the same exceptional circumstances as vigorously as  is being done in the developed world to universal investor approval?

There is every reason for the SA government to rely heavily on its central bank at a time like this. With the same proviso as applies in the developed world. That is when the economy is again running close to its potential the stimulus should be withdrawn to avoid inflation. That test however will come later. There is an immediate challenge to be met now. And spending and lending without usual restraint is rising to the challenge.

How much economic output and income will be sacrificed over the period of the lock-down and the gradual recovery after that? A broad- brush comparison between what might have been without Corona and what may yet happen to the SA economy can be made. The loss in output as a result of the shut downs – the difference in what might have been produced and earned had GDP performed as normal in 2020 and 2021, and what now – post Corona- is likely to be produced has been estimated as follows.

We first estimate economic output and incomes (GDP at current prices measured quarterly)  had the economy continued on its recent path unaffected by Corona. To do this we use standard time series forecasting method. That is to extrapolate what might have transpired had GDP in money of the day continued to grow at its very pedestrian recent pace of about 4- 5 per cent per annum. GDP inflation in recent years has been of the order of four per cent per annum meaning indicating very little real growth was being realized as is well known. We then make a judgment about how much of this potential output will be lost due to the shutdowns. We estimate a GDP loss ratio for the quarters between Q1 2020 and Q4 2021 to calculate this difference between pre and post Corona GDP.

The cumulative difference – the lost output and incomes over the next two years we estimate as of the order of R1,071,486 millions – that is approximately R1 trillion of lost output will be sacrificed to contain the spread of the virus. This one trillion is equivalent to approximately 24% of what might have been the GDP in 2020. (See figures below)

GDP and GDP after Corona (Quarterly Data Current Prices)

Source; SA Reserve Bank and Investec Wealth and Investment

The loss ratio – the percentage of the economy that remains after the shutdown is the crucial judgment to be made. We have assumed that the economy operated at 95% of its pre-Corona potential in Q1 2020.  Then as the impact of the lock down intensifies through much of Q2, the economy it is estimated will utilize only 75% of capacity in Q2. This, it is assumed, will be followed by somewhat less damage in Q3 when the economy is assumed to be operating at 80% of potential capacity as the lockdown is gradually relieved. Conditions are then expected to continue to improve by the equivalent of 5% each quarter. That is until the economy gets back to where it might have been without the lock downs assumed to be in the second quarter of 2021.

This almost V shaped recovery might well be too optimistic an estimate. The losses in 2020 may well be greater and the recovery slower than estimated. But the output gap – the difference between what could have been produced and what will be produced, for want of demand as well as ability to supply, will be a very large one.

Loss of Output Ratio – GDP Adjusted/GDP Estimate (pre-Corona)

Source; SA Reserve Bank and Investec Wealth and Investment

Estimated Loss in GDP per Quarter (R millions) Sum of losses 2020-2021 = R107146m

Source; SA Reserve Bank and Investec Wealth and Investment

The pace of recovery will depend in part on how much the government spends and how much the Reserve Bank supports the government and private sector with extra cash. The more support provided to the economy in one way and another by the government and the Reserve Bank, the more demand will be exercised and the smaller will be the eventual loss of output. Any reduction in economic damage of the large likely order estimated is a clear gain to the economy. Any additional utilization of what would otherwise be wasted capacity- human and material- comes without real economic cost. That extra demand can bring forth extra supplies would be pure gain to the economy, especially if funded with central bank money.

It is not clear that the Reserve Bank sees the SA predicament in this same urgent way. In the way central banks in the developed world are seeing and acting. It has the opportunity to create more of its own money without any cost – to help borrowers –not only the banks and the government but also private businesses directly through its lending. Unlike its peers in the developed world it also has scope to significantly lower short-term interest rates. All the way close to zero would make sense. It should not be hesitating to act boldly. Any inflation that may come along later with a recovery in the economy will have to be dealt with in its own good time.

Post-Script on Growth Rates They will not mean what they usually do post the crisis.

GDP growth rates are most often presented as annual percentage growth from quarter to quarter when the GDP has been adjusted for seasonal influences and converted to an annual equivalent That is growth from one quarter in seasonally adjusted GDP to the next quarter raised to the power of 4. This is the growth rate that attracts headlines.  (Q1 is always a below average GDP quarter)

Two consecutive negative growth rates measured this way are regarded as indicating a ‘technical recession’. The implication of this measure is that  quarterly growth will continue at that pace for the next year. Clearly under the influence of lock downs growth measured this way is likely to become much more variable than it usually is.

This will be especially true in Q2 2020 when the impact of the lock down will be at its most severe- maybe reducing annual growth to an annual equivalent negative rate of growth of 50% or so. Estimating growth on this quarter to quarter basis over the next few years will be a very poor guide to the underlying growth trends. It may show a very sharp contraction in Q2 2020  to be followed by positive growth of 40% p.a. in Q3 and Q4, 10% in Q4 and then as much as 50% again in  Q2 2021. The recession will seemingly have been avoided and the economy will soon be recording boom time growth rates. A likely and highly misleading account of what will be going on with the economy it must be agreed.

If GDP is compared to the same quarter a year before we will get a much smoother series of growth rates. It is likely to  show negative growth throughout 2020, (down by as much as -20% p.a in Q2) with strongly positive growth of 30% only resuming in Q2 2021, off a highly depressed base of Q2 2020 when the lock down was at its most severe.

The better way to calculate the impact of the lock down in terms of growth rates would be to calculate the simple percentage change in GDP from quarter to quarter as the impact of the lock down unfolds and gradually, we hope, dissipates. The worst quarters measured this way will be Q2 and Q3 2020 after which quarter to quarter growth in percentage terms will become positive.

Estimated Quarterly Growth rates between 2020 and 2022 under alternative conventions.

Source; SA Reserve Bank and Investec Wealth and Investment

The upshot of this is that growth rates will not be able to tell what has happened to an economy subject to a severe supply side shock – that is temporary in nature. Measuring in absolute terms , in money of the day GDP sacrificed each quarter, as we have attempted to do will tell the full tale of economic destruction.

GDP Normal GDP Adjusted for Corona. R million Aggregate Losses R835b  GDP at Current Prices= 5888b in 2019 -Approximately 14% of one year’s GDP

Central Banks around the world are launching a new phase of accelerated money creation now known as Quantitative Easing or QE.  They are doing so in response to the economic contraction caused by the Corona Virus and the lock downs of economic activity intended to limit the spread of the virus. The scale of this QE and its consequences for economic activity asset prices and inflation are still to be revealed.

Click to read the full paper here.

Developed and emerging markets have very different expectations of inflation. The monetary authorities should think carefully about the consequences of austerity

The developed world is much agitated by very low interest rates. Rates are so low that it is hard to imagine them declining further, so emasculating monetary policy.

Interest rates reflect a relative abundance of global savings. Hence inflation (prices rise when demands exceed available supplies) is confidently expected to remain at these very low rates. Interest rates accordingly offer compensation for expected inflation. The US bond market only offers an extra 1.56% annually for bearing inflation risks over the next 10 years (see figure below).

The US Treasury bond market (10 year yields)

Deflation or generally falling prices, have rather become a threat to economic stability. When prices are expected to fall and interest rates offer no reward to lenders, cash (literally hoarding notes and coin) may be a desirable option. If prices are to be lower in six months than they are today, it may make sense for firms and households to postpone spending, including on hiring labour. Hence even less spent and more saved, compounding the slow growth issue.

An economy-wide unwillingness to demand more stuff is not a normal state of economic affairs. If demand is lacking, resources – land, labour and capital – become idle. In these unwelcome circumstances a government and its central bank can always stimulate more spending, including its own, without any real cost to taxpayers or economic trade-offs. More demand means no less supplied – therefore no output or income will be lost and more will be forthcoming, should demand catch up with potential supply.

Most simply, spending can be encouraged without limit by handing out money or jettisoning cash from the proverbial helicopter. For a government to be able to borrow for 30 years at very low interest rates is as inexpensive a funding method as printing money.

One can confidently expect unorthodox experiments in stimulating demand – should the developed economies continue to grow very slowly – and interest rates and inflation to remain at very low levels until growth and inflation picks up. Cutting taxes and funding a temporarily enlarged fiscal deficit with money or loans is another (better) option.

Quantitative easing (QE), the process whereby central banks create money to buy government bonds on a very large scale, mostly from banks, was highly unorthodox when first introduced to overcome the Global Financial Crisis of 2009. QE prevented the banks from running out of cash and defaulting on their deposit liabilities, thus preventing the destruction of the payments system that banks provide. But the banks, when selling bonds to their central banks, mostly substituted deposits at the central bank for previously held Treasury Bills and bonds. Bond holdings went down while deposits held by banks with  the central bank went up by similar amounts.

The banks did not (much) turn their extra cash into loans. It would have been more of a stimulus to spending had the central banks purchased assets from the customers of banks (retirement funds and their like) rather than the banks. Had they done more of this, the deposits of the banks as well as the cash of the banks would have increased immediately. The growth in bank credit and bank deposit liabilities has remained very modest, especially in Europe, though the recent pick-up in growth in bank loans is noteworthy. Hence the persistently slow growth in spending in Europe.

Growth in bank loans in the US and Europe

Source: Thomson-Reuters, Federal Reserve Bank of St Louis and Investec Wealth & Investment

While the developed world struggles with low interest rates and subdued inflation and expectations of inflation, the world of emerging markets present very differently. Interest rates remain persistently high, with elevated expectations of inflation (and exchange rate weakness) to come. Accordingly, interest rates, after adjusting for realised inflation, remain at high levels as do inflation protected interest rates.

South African financial markets have continued to perform very much in line with other emerging financial markets. The JSE All Share Index gained about 2.6% in US dollar terms in 2019 (to 11 October) while the MSCI Emerging Market Index was up by 4.7% – both distinct underperformers when compared to the S&P 500, which was up by over 18% over the same period. The rand and emerging market currency basket had both lost about the same 2% against the US dollar over the same period (see figures below).

The USD/ZAR and the USD/emerging market currency exchange rates in 2019

Source: Bloomberg and Investec Wealth & Investment

The JSE and the emerging market equity benchmark in US dollars

Source: Bloomberg and Investec Wealth & Investment

On the interest rate front, emerging market local currency bond yields remain elevated – above 6% per annum on average for 10 year bonds. While the average emerging market bond yield has edged lower in 2019, SA bond yields have moved higher this year (see figure below). The market in SA bonds is factoring in more rather inflation and a still weaker USD/ZAR exchange rate. Unlike in the developed world, the cost of capital, that is the required rates of real return to justify expenditure on additional plant and equipment, remains elevated in SA. This means a continued discouragement to such expenditure and is negative for the growth outlook.

SA and emerging market bond yields (10 year)

Source: Thomson-Reuters, Federal Reserve Bank of St Louis and Investec Wealth & Investment

Capital remains very expensive for SA borrowers and growth rates remain subdued.

Interest rates and spreads in the SA bond market

Source: Bloomberg and Investec Wealth & Investment

A combination of more inflation expected with less inflation realised, because demand has been so subdued, has been toxic medicine for the SA economy. As in the developed world, the slack in the SA economy calls for stimulation from lower interest rates. And, unlike the developed there is ample scope for traditional monetary policy – in the form of rate cuts.

The inflation expected of the SA economy reflects the well-understood dangers of a debt trap and that the SA economy will print sometime in the future print money to escape its consequences. Yet fighting these expectations, which have nothing to do with monetary policy, with austere monetary policy makes no sense at all. Rather it means more economic slack, less growth, a larger fiscal deficit and enhanced inflationary expectations. Eliminating slack with lower short-term interest rates would do the opposite.

Is the new block chained backed payments system (LIBRA) to be introduced by Facebook a pure and much lower cost payments system? Or a bank, or equivalently a money market fund, upon which transactions can be drawn conveniently for low or no fees.

The operating costs for a bank that provides a  payments facility are largely covered by the difference between the interest paid on deposits (perhaps zero) and the interest earned by the bank/payments provider making loans- of varying degrees of default risk.  Unlike a Visa that collects fees to cover its costs –and does not make loans.

The banks have cross-subsided the fees that might otherwise have to charge with the revenue earned from their lending activities. The profitability of banks depends in part on managing their cash reserves, keeping them as small as possible to meet demands for cash back. And  holding no more than prudent reserves of equity capital to cover non-performing loans. And provide shareholders with enough of a return to keep them in the banking business.

It is this leverage (banks holding fractional reserves of cash) that exposes the bank shareholders (and the broader economy that depends upon sound banks facilitating transactions) to the danger that non-performing loans may exceed the equity of the bank. However it is not only the deposits (liabilities of the banks and assets of depositors) that may be destroyed by the failure of a banking system. Of greater importance is that the payments system, can go down with the banks, with truly catastrophic effect for any modern, highly specialized economy that depends on its payments system.

Perfect safety for a payments system can only come with deposits fully backed by cash issued by the central bank with its power to create as much extra cash as the system might need. Block chain may well offer enormous savings in protecting the transactions they give effect to, against fraud. Savings that mean low enough fees that would cover the full costs and still provide a profitable return on capital. And avoid the dangers of leverage. SA banks lose as much as R800m a year to credit and debit card fraud. They likely spend even more on trying to prevent fraud.

Leaving banks to make the trade-off between risk and return, has worked well enough for most, but not all the time. The Global Financial Crisis of 2008 (GFC) demonstrated why it is very important to be able to deal with a banking crisis – should banks or more specifically-  the payments system delivered by banks, be threatened with failure. The solution to any run on the banking system is for the central bank to supply more than enough cash to the banking system to stop any run on the banks- as the GFC also proved.

Perhaps modern information technology will allow a 100 percent, central bank deposit backed (not private bank backed) fee collecting payment providers, to compete effectively with the deposit taking banks for our transaction balances. If so, deposit taking banks, supplying a bundled service of payments with the aid of leverage, may fade away to be replaced by other forms of financial intermediation. That is by other financial institutions that can provide essential credit and take on leverage profitably, but without accepting responsibility for effecting payments.

This new world (of fully backed transaction accounts) may be the next phase in the evolution of the modern financial system. One that would provide for the separation of the payments system from the dangers of leverage.  Wisdom would be to let a profit seeking, competitive financial system to evolve in response to the preferences of lenders and borrowers. And for regulators to stay out of the way so that a pure payments system could possibly evolve. However, if Libra is a bank- dressed up as a money market fund, carrying risks on its balance sheet, it should also be required to play by the same rules as its banking competitors. However these rules applied to vulnerable banks could be relaxed if the payments system were secure.

10^th June 2019

It was one of those interesting weeks that optimistic South Africans could have done without. Early in the week we were informed that the economy did even worse than we had expected – going backwards at a 3.2% annual rate in Q1. The news immediately weakened the rand -not only against the USD –  the ZAR also lost about 5% to a peer group of other EM exchange rates. EM currencies generally ended the week stronger against a weaker USD that fell back against the Euro and other developed economy currencies as Fed interest rate cuts loomed.

The spread between declining US bond yields and rising RSA yields widened, indicating that the rand was now expected to weaken further at a 7% p.a average annual rate over the next ten years. Consistently with this rand weakness and all that it implies for the higher prices of imported goods in weaker rands, still more inflation to come was priced into the RSA bond market. Inflationary expectations, as measured by the spread between long dated vanilla RSA bonds and their inflation protected alternatives, widened to about 6.5% p.a for 10 year money. The debt trap that might follow slow growth, less tax revenue, wider deficits and printing money to get out of it – seemed a little closer than it was (See charts below)

Fig.1; The ZAR and the EM Basket (2019=100) Daily Data

Source; Bloomberg and Investec Wealth and Investment

Fig.2; The USD/ZAR compared to the USD/EM currency basket. Daily Data (2019=1)

Source; Bloomberg and Investec Wealth and Investment

Fig.3: Long dated RSA and USA Government Bond Yield and Risk Spread (RSA-USA 10 year yield) Daily Data 2019

Source; Bloomberg and Investec Wealth and Investment

And then to compound the weakness in the ZAR and RSA’s markets the surviving Zuma factions in the ANC later in the week mounted a further diversionary attack on the independence of the Reserve Bank and its anti-inflationary zeal. Further rand weakness and higher interest rates followed.

There was however some consolation for investors on the JSE- including everyone with a SA pension plan. The global plays on the JSE – those companies with  major interests outside SA – acted as they could be expected to do given rand weakness absent emerging market weakness as was the case. They helped meaningfully to diversify SA specific risks (up over 5% in the week as did Resource companies that were up 6.5% – enough to lift the All Share Index by 3.3% by the week-end. (see below)

Fig. 4; Weekly Performance on the JSE (2^nd– 7^th June)

Source; Bloomberg and Investec Wealth and Investment

One hopes the Reserve Bank was watching these developments very closely. That is slower growth is associated with more not less inflation expected. Not perhaps what you might find in the macro texts. And more important that the reverse is also likely to be true. That is faster growth will be associated with a stronger rand and so less inflation expected and lower bond yields and less spent paying interest. Even our good friends at Moody’s now expect and would appear to welcome a cut in the repo rate to boost growth. As does the money market that now expects short rates in SA to decline by 50 b.p. over the next twelve months.

The Reserve Bank would be well advised to do what is now expected of them and do what they can to stimulate faster growth in SA. Faster growth leading to less inflation expected and as likely, no more actual inflation, should be very welcome. And also help resist those with ulterior  motives when they attack the Bank.

The Reserve Bank attempts to control inflation and inflationary expectations that, in large measure, are beyond its influence. As recent events in the currency and bond markets surely confirm. Supply side shocks (the rand, the weather, the oil price, Eskom and expenditure taxes) dominate the direction of prices and all serve to inhibit disposable incomes and consumption spending. And inflation expected has a political course of its own that can add to upward pressure on prices.

Interest rates set by the Bank do influence the demand for goods and services. Demand has been consistently weak in South Africa for a number of years. Weak enough to counter to some degree the supply side pressures on the price level. But weak enough to inhibit any cyclical recovery. The trade off – less growth for marginally less inflation – has been much too severe for the economy. A more nuanced approach to interest rate settings and a more nuanced narrative to support it would better have served the economy and the Reserve Bank’s independence.

The immediate challenge for the newly appointed SA cabinet is to do what it takes to stimulate faster growth in output incomes and employment over the next few years. And to instill a strongly held belief that they will succeed in doing so.

The benefits of any more optimistic belief that growth will accelerate would be immediate. The interest rate on longer dated RSA bonds would come down as the danger of a debt trap for SA receded. As it does with faster growth in tax and other revenues for the Republic.

Governments cannot formally default on the loans they issue in the local currency. But they may be tempted to pay down such debt by issuing more currency – should the interest burden on the debt become politically intolerable. Printing more money than economic actors are willing to hold, leads inevitably to more inflation as they get rid of their excess money holdings. Investors are very well aware of the process of inflation- led as it always is by governments unwilling to accept harsh economic realities.

Such inflationary dangers call for compensation for lenders in the form of higher interest rates. There is a lot of inflation priced into long term interest rates in SA that makes borrowing particularly burdensome for SA taxpayers. Very low interest rates of the kind now demanded of European and the Japanese governments, practically eliminates any possibility of a debt trap, even when the Debt to GDP ratios are more than double the ratio in SA, as they are. South Africa would look so much healthier were interest rates a lot lower.

The running yields provided to match supply and demand for RSA bonds provides a very clear and continuous measure of how well the government is rated by investors for its ability to avoid inflation- and stimulate growth. The difference between the yield on a vanilla RSA bond and an inflation protected bond of the same period to maturity indicates how much inflation is expected by investors. It is a risk that the owner of an inflation linked bond largely avoids. Hence the difference between the yield on a five year vanilla RSA bond (currently around 8% p.a) and the lower yield on an inflation protected bond  (currently 2.4% p.a) reveals that inflation in SA is expected to average 5.6% p.a. over the next five years and about 6.5% p.a. over the next ten years. Headline inflation is now significantly lower at 4.4% p.a.

Fig.1: RSA Bond yields and compensation for expected inflation (5 year bonds)

Source; Thompson Reuters, Bloomberg and Investec Wealth and Investment.

Another important signal comes from the difference between RSA rand bond yields and those on US Treasury Bonds of the same maturity. This spread indicates how much the rand is expected to depreciate over the years. The difference between 10 year RSA yields and US 10 year Treasury bonds is of the order of 6.6% p.a. That is the rand is expected to depreciate against the US dollar at an average over 6% p.a. over the next ten years. This clearly implies much more inflation in SA compared to the US- hence a further reason for much higher interest rates.

Fig. 2; RSA and USA Treasury Bond Yields (10 Year) Daily Data 2019

Source; Thompson Reuters, Bloomberg and Investec Wealth and Investment.

The very latest news from the RSA bond market has not been encouraging about the prospects for growth enhancing reforms. If anything these  interest rates spreads have widened rather than narrowed  – indicating more not less inflation expected and no more growth expected. Hopefully the selection of the cabinet members and better knowledge of their good intentions will raise expected growth and lower long-term interest rates.  Unfortunately SA has not benefitted from the global decline in government bond yields as have other emerging market borrowers.

Fig.3 Global Bond Yields. Movement in May 2019.

The level of short-term interest rates will be set by the Reserve Bank. We can hope that the Bank will recognize that inflationary expectations are largely beyond their influence. More inflation expected can add upward pressure to prices as firms with price setting powers attempt to recover the higher costs of production they may expect. But such attempts to raise prices can be thwarted by an absence of demand for their goods and services.

Very weak demand for goods and services over which Reserve Bank’s interest rates have had a direct influence has contributed to very slow growth -and lower inflation. But without reducing inflation expected.

The Reserve Bank should recognize that lower inflation- achieved by deeply depressing spending and growth rates to counter more inflation expected- will not bring less inflation expected over the longer run. That is a task for the cabinet. The role for the Reserve Bank is to do what it can to stimulate more growth by lowering short term interest rates.

A post-script on debt management in SA

The SA Treasury has long adopted a policy to lengthen the maturity of RSA debt. The policy appears to have been reversed somewhat recently in response to the pressure on the budget placed by more debt funded at higher interest rates. We show the maturity structure of RSA debt issues in recent years below. We also show how debt service costs have risen as a share of tax revenues. [1]By international standards the duration of RSA debt is exceptionally high.

Borrowing long has been more expensive for the RSA than borrowing short. The term structure of rand denominated bond yields has been consistently upward sloping since 2008. The average monthly difference in these yields has been 2% p.a. between 2010 and 2019. See the figure below that charts the difference between 10 year and 1 year RSA yields.

Fig.4: The slope of the RSA yield curve RSA 10 year – RSA 1 year bond yields

The case the Treasury makes for extending maturities is to avoid the danger of so described roll over risk. The longer the maturity structure of the debt incurred, the less often has debt to be refinanced. Though surely the breadth and depth of the market for RSA bonds is surely enough protection against not being able to refinance debt when it comes due, or before it comes due.  As are the large cash reserves the Treasury keeps with the Reserve Bank. Paying so much more to borrow long rather than short seems a very expensive way to avoid the unknown danger that it may be difficult to place debt at some unknown point in time.

But there is more than roll over risk to be considered. The Treasury preference for borrowing long- when inflationary expectations are elevated (over six per cent per annum as they have been for much of the period since 2010) – indicates little confidence in the ability of monetary policy to meet its inflation target of between 3 and 6 per cent p.a.

Borrowing long – extending the maturity structure of national debt -adds to the temptation to inflate away the real value of debt incurred. Investors are surely aware of their vulnerability to the consequences of a debt trap- the danger that a country will print money to retire expensive debt that will then lead to inflation and much reduce the real value of their loans.

Such reliance on borrowing long that brings with it inflationary temptation must show up in higher long term interest rates – relative to shorter rates- to compensate for the extra risks incurred in lending long. Having to roll over short term debt at market related interest rates that will rise with inflation makes lenders less hostage to the danger of unexpectedly high inflation. It may even act to discipline government spending and borrowing because inflating away the debt burden is not an option. Accordingly it reduces the danger of inflation and by doing so may improve a credit rating. Borrowing long is an opportunity that a government treasury should best resist- as proof of its anti-inflationary credentials.

When you have bravely repelled a dangerous gang that threatened your existence — as has Reserve Bank governor Lesetja Kganyago — you are fully justified in looking ahead with a renewed sense of hope and confidence in the future of SA. As he does in his introduction to the Monetary Policy Review: “This is a good time for South Africans to be ambitious. For the first time in years, I suspect our forecasts lean towards being too pessimistic rather than too optimistic. A better future is within our reach, if we choose it.”

We must hope with the governor that the next chapter in the monetary history of SA brings less inflation and faster growth. But it may take a different frame of mind than revealed by the review. Only more demand for goods and services than the economy can hope to satisfy without the help of higher prices calls for higher interest rates. But higher interest rates harm growth when spending is already under pressure from rising prices that follow effectively reduced supplies of goods and services, in response to a sharply weaker exchange rate or a drought, for example. Higher interest rates at times like these simply reduce spending further and growth slows more than it should, for want of demand.

Currency weakness can, however, have its cause in global events that influence the supply of foreign capital or local political events; a response to fears about the future of the economy that leads to less capital flowing in and more out, enough to weaken the exchange rate. This then leads to higher prices. These supply-side shocks greatly disturbed the South African economy from 2014 to mid-2016. The drought and the persistent weakness of the rand initially linked to the strength of the dollar and then weakened further by political developments in SA that threatened the stability of the economy, especially in late 2015, were among the shocks with which economic agents had to cope.

However, from 2014 to 2015 the Bank resisted any distinction between supply-side and demand-side forces acting on prices in SA. It raised its repo rate to further inhibit spending and output growth that remained highly depressed over the period. The economy thus grew slower than it would have done had interest rates been lower and spending more buoyant. The review acknowledges that the recent value-added tax (VAT) increase is contractionary — not persistently inflationary — representing the equivalent of a supply-side shock that will raise consumer price index (CPI) inflation by only about a half a percentage point over the next 12 months, after which, assuming no further VAT increase, it will fall out of the inflation numbers.

What is true of the temporary effect of a VAT increase was surely as true of the food price effect of a drought and the succession of exchange rate shocks that forced South African prices higher after 2014.

These were temporary price shocks, even reversible ones, that serve to contract spending and are best ignored by monetary policy settings. Indeed, the more favourable inflation trends observed recently in SA represent the reversal of the price shocks — the rand and the drought — that raised the CPI from 2014 to mid-2016. The demand side of the economy still remains repressed, although lower inflation recently helped lift the growth rate in household spending, particularly on goods with high import content.

A further objection is that since “monetary policy affects the economy with a lag of one to two years”, it must be forward-looking. Such interventions can only be helpful when forecasts of inflation, interest rates and real growth fall within a narrow range. The forecasts of the Bank as indicated in the review qualify very poorly in this regard.

The fan charts provided by the review indicate very conspicuously the lack of confidence policy makers should attach to the most likely outcomes forecast by the forecasting model. The point forecast for the repo rate, for example, is 7.5% per annum in three years, 125 basis points higher than the current repo rate but with considerable uncertainty around this figure. The chart, for example, vindicates a high probability (15%) of the forecast being between 8.7% and 10% and a similarly high probability (15%) of being much lower, between 5% and 6.3% — a case of having to take your pick for the repo rate as anywhere between 5% and 10%.

Similar conclusions could be reached about the forecasts of GDP or inflation. In the case of GDP, you can take a pick between a forecast of -1.2% per annum and a booming 7% real growth in 2020. As for inflation, the forecasts offer a pick between 1.8% and almost 9% per annum in 2020.

This inability to accurately forecast the economy has been undermined by the self-same shocks the economy and rand have suffered from. The quality of these forecasts will not improve unless the shocks that have so affected the economy are of much diminished scale and range. If the economy turns out very differently to the forecast, delayed responses to interest rate changes made in advance can be damaging to the economy.

The review contends that its interest rate settings in recent years have been accommodative rather than restrictive and will likely remain so. As the review states: “Viewed through the lens of the Reserve Bank’s quarterly projection model, the policy stance will be expansionary over most of the forecast period, helped by the recent rate cut. The projected rise in near-term inflation, which lowers the real interest rate, is largely due to the VAT increase. This will reduce disposable income and is in this respect actually contractionary. The recent rate cut mitigates this effect, making policy more clearly accommodative through the rest of 2018 and 2019.” If in fact inflation turns out as expected — about 5% per annum — a lower repo rate therefore appears unlikely.

Ideally monetary policy should help eliminate slack in the economy, negative or positive. The persistence of slack is evidence that policies were too tight rather than too loose, that interest rates were too high not too low

Evidence of demand running well below potential levels is overwhelming enough to conclude that interest rates have been too high rather than too low in the circumstances of such weak spending propensities. The persistence of an output gap, a gap between actual and potential output that is the longest on record according to the review, is strong evidence of too little spending and thus to be inferred as the result of contractionary rather than accommodating monetary policy.

Ideally monetary policy should help eliminate slack in the economy, negative or positive. The persistence of slack is evidence that policies were too tight rather than too loose, that interest rates were too high not too low. Further direct evidence of tight monetary policies comes with the direction of the growth in money supply and bank credit. These growth rates have declined consistently over recent years but receive surprisingly little attention in the review.

The notion, much relied upon by the Bank over the years to justify its interest rate settings, that inflationary expectations are self-fulfilling — that the more inflation is expected the more inflation is realised, regardless of the slack in the economy — is questionable. The evidence for such persistent second-round effects on inflation is very weak.

Inflation in SA tends to lead and inflation expectations follow — with some regard for what are seen to be temporary forces that may have pushed up prices. And if inflation rises because of supply-side shocks these increases will be temporary and may even be reversed when the shock passes through. The review appears to concede this point.

It remarks, in justification of reducing its repo rate in April by 25 basis points, that “a second consideration was that lower inflation could be used to bring inflation expectations closer to the target midpoint of 4.5% over a shorter time frame. However, these factors do not preclude fine-tuning of the interest rate. The MPC [monetary policy committee] is also not committing to a rate-cutting cycle.”

The notion that deficits on the current account of the balance of payments represent danger rather than opportunity for the economy, as the review appears to regard them, is questionable. By definition the current account deficit is equivalent to the capital flows an economy is able to attract from abroad. Faster growth will mean larger current account deficits and larger capital inflows. Growth leads and foreign capital can follow the prospective faster growth and make it possible.

The opportunity to grow faster by attracting more capital that funds an increased supply of goods and services, augmented by more imports and fewer exports, should not be prematurely frustrated by higher interest rates, for fear that capital flows may reverse. Growth itself boosts confidence and improves credit ratings and attracts capital, a virtuous cycle.

The Bank may have no option but to think on its feet and react to events as they occur. It is to be hoped it will do so with good judgment about the causes and effects of inflation, which may call for very different interest rate reactions.

A different narrative from the Bank is called for to explain why the different causes of higher prices can call for different policy responses, responses that do not have to mean being soft on inflation for politically convenient reasons

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 21^st 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.

The success of Quantitative Easing (QE) in promoting a global economic recovery calls for its reversal and the resumption of more normal in monetary affairs. The scale of QE, that is the creation of cash by central banks since 2008, has been extraordinary and unprecedented. Why this injection of cash has not led to more spending, much more inflation and a much greater expansion of the banking systems and in bank deposits than has occurred has been the big surprise. Providing an explanation for these highly muted reactions can explain why the reversal of QE may also be less eventful than might ordinarily be predicted.

The total assets of the major central banks, US, Europe and Japan grew from just over 3 trillion dollars in 2007 to their current levels of over 13 trillion USD, an amount that is still increasing The Fed balance sheet grew from less than one trillion dollars in 2008 to over 4 trillion by 2014.

The key fact to recognize is that almost all of the trillions of cash created by the Fed and other central banks buying the bonds and other securities that so bulked up their balance sheets, came back in the form of extra bank deposits. Commercial member banks before 2008 held minimal cash reserves in excess of what regulations said that were required to hold. They exploded thereafter. These excess reserves in the US peaked at 2.5 trillion dollars in 2014 remain above 2 trillion dollars worth of potential lending power.

The banks holding cash rather than making loans or buying assets has not only led to less spending than might have been predicted, it has also led to a much slower growth in bank deposits. It has shrunk the dramatically the ratio of total US bank deposits to the cash base of the system. This money multiplier has declined from nine times in 2008 to the current 3.5 times. Therefore the size of the banking system relative to the GDP has declined and made the US economy less dependent on bank credit. The US commercial banks on September 27^th cash assets were equal to an extraordinary 20% of their deposit liabilities.

Extra bank lending requires that banks attract not only extra cash but also extra capital. Banks were undercapitalized before 2007 and have had to add to their capital to loan ratios. This has restrained bank lending as has a reluctance of potential clients to borrow more. Holding extra cash rather than making additional loans was an understandable choice. The extra cash held by US banks also earns interest, a further incentive to hoarding rather than lending cash. Low inflation – more so deflation – falling prices – can make holding deposits with the Fed, a good investment decision. The Fed minutes released yesterday reveal a concern that currently very low inflation may be “more than transitory”

Coming reductions in the supply of cash to the banking system are very likely to be offset by reductions in the excess cash reserves banks hold. Given the volume of excess cash reserves held by banks the danger is still of too much rather than too little bank lending to come. Were excess cash reserves to be exchanged on a significantly larger scale for bank loans the FED would have to accelerate its bond sales and raise interest rates at a faster pace.

This would all be a sign of faster growth and welcome for it. But there is possibility of a slip twixt central bank cup and lip and that markets will misinterpret the signals coming from central banks. So adding volatility and risks to markets before or as a new normal is established. Past performance will not be a guide to what will be another  unique event in monetary history- first was QE- then its reversal.

The Monetary Policy Committee (MPC) of the Reserve Bank last week found reasons to deny any relief to the hard pressed SA economy in the form of lower short term interest rates. And to do so despite the very good prospect of less inflation and still slower growth to come.

According to the MPC statement:

“The MPC assesses the risks to the inflation outlook to be more or less balanced. Domestic demand pressures remain subdued, and, given the continued negative consumer and business sentiment, the risks to the growth outlook are assessed to be on the downside.”

Concern about the possible direction of the rand appears as the principle reason for the MPC to delay any action on interest rates and wait for further evidence of lower inflation.

To quote the MPC further:

“The rand remains a key upside risk to the forecast. The rand has, however, been surprisingly resilient in the face of recent domestic developments. This is partly due to offsetting factors, particularly positive sentiment towards emerging markets and the improved current account balance.”

But as the MPC must surely know, the future of foreign exchange value of the rand – weaker or stronger – will always be uncertain because it is at risk of political and global forces well beyond the influence of Reserve Bank actions or interest rate settings. Over the past year the rand has strengthened for global reasons, common to all emerging market currencies and, as acknowledged by the MPC, despite the Zuma-induced uncertainties about the future course of fiscal policy.

What is known about changes in the exchange value of the rand is that it will make exports and imports more or less expensive and usually lead the inflation rate higher or lower. In the figures below we show how the Import Price Index leads the Producer Price Index that in turn leads the Consumer Price Index in a consistent way. Given the recent strength in the rand, the trend is strongly pointing to lower inflation to come. Indeed, the MPC was surprised by the latest lower headline inflation rate reported for inflation, a lower rate that has still to be incorporated into its own forecasts of inflation.

The so-called pass through effect of the exchange rate on domestic prices, will also depend on also uncertain, global prices that also effect the US dollar prices of imported goods and services- particularly the dollar price of a barrel of oil. Other uncertainties will also influence domestic prices as the MPC acknowledges (for example electricity prices) as will expenditure taxes and excise duties – again forces not influenced by the interest rates. The unpredictable harvest is another major uncertainty that influences prices in SA – for now this is helping materially to reduce the inflation rate.

Exchange rate moves and other shocks, unconnected to the level of spending in the economy, are regarded as supply-side shocks that register in the CPI temporarily. Unless the shocks are continuously repeated in the same direction, they fall out of the CPI after 12 months. Hence monetary theory tells us these are temporary forces acting on prices that should best be ignored by monetary policy.

Interest rates will however influence spending in the economy in a predictable way and are called for when there are excess levels of demand. This is usually accompanied by increases in the money and credit supplies. This is far from the current case in South Africa, where spending and credit growth remains subdued and hence calls for lower interest rates, perhaps much lower.

This all raises the rationality of interest rate settings in SA that react to forces that are impossible to predict with any confidence – for example the exchange rate, over which monetary policy has no influence. Supply side shocks on inflation in SA have (wrongly in my opinion) allowed to influence interest rate settings with all inflationary forces treated as the same threat by monetary policy, regardless of its provenance. This has been the case since early 2014 in response to rand weakness and a drought that both forced prices higher. But a positive supply side shock on prices of the kind South Africa is now benefitting from (a stronger rand as well as a much improved harvest) is surely to be acted upon with urgency. Waiting to see what will happen to the exchange rate is simply to prolong the agony of tolerating slow growth for no good anti-inflation reason.

And in response to the inevitable Reserve Bank retort that failure to act on inflation will lead to more inflation expected and hence more inflation to come, I would suggest that this theory, on which the Reserve Bank relies so heavily to justify higher interest rates, has little support from the evidence of the inflationary process in SA. Inflation expectations have remained persistently high, as has the expected weakness of the rand, even as inflation itself has moved higher or lower. Evidence furthermore suggests that inflation expected, if anything, follows rather than leads realised inflation.

More important, it is highly unlikely that inflation expected can decline with the persistent market view that the rand will weaken by 6% p.a. or more each year for the next 10 years, as has been the persistent trend. Inflation expectations have proved very hard to subdue, despite the determination of the Reserve Bank to act against inflation, without obvious benefits for the inflation rate and regardless of the negative impact higher interest rates have on the subdued growth in demand.

Inflation expectations are measured below by the difference between nominal bond yields and their inflation-linked equivalents of similar tenure. The expected path of the USD/ZAR is measured by the difference between RSA bond yields and their US Treasury equivalents. These are compared to actual inflation in the graph below. As may be seen, inflation has been far more variable than inflation expected or the expected weakness of the rand. For the record, since 2005, measured at month end, the headline inflation rate has averaged 5.9% p.a, with a standard deviation (SD) of 2.2% p.a. Inflation expected has been much more stable, while it also averaged 5.9% p.a with a reduced SD of 0.71% p.a, while the spread between 10 year RSA yields and US Treasuries – a very good proxy for the extra cost of buying dollars for forward delivery – averaged 5.25 p.a. at month end with a SD of 1.2% p.a.

It will probably take an extended period of low inflation to reduce these expectations of inflation and rand weakness. Sacrificing economic growth for an inflation rate that has proved largely beyond the control of the Reserve Bank has never seemed to me to be good monetary policy. And it makes even less sense now that the inflation outlook has improved, even if this should prove temporary. 31 May 2017