Category: Monetary Policy

The updates to the money supply and bank credit statistics (to July 2011) and GDP numbers (second quarter 2011) indicate that while the economy grew in recent months, it was at a declining rate. As is the inconvenient practice in SA, the GDP output and income numbers arrive unaccompanied by the other side of the national income identity, the aggregate expenditure estimates. And given that the current state of the SA economy can be attributed to little demand rather than to limits on the supply side of the economy, it is particularly inconvenient not to have details and explanations about the state of aggregate demand in the economy.

The GDP statistics indicated that activity closely connected to demands from households grew satisfactorily in the second quarter. Government consumption spending accounting for 15.9% of the economy (on employment benefits and consumables such as stationery and travel expenses etc) grew by a robust 5.7% (seasonally adjusted and annualized, as are all rates in this discussion, unless otherwise stated) in the quarter, while activity in the wholesale, retail and transport sectors (13.7% of GDP) grew by 4.1%. Activity in the very important financial and associated business service sectors (21% of GDP), grew by a more pedestrian 2.9%.

The laggards were primary production: agriculture (3.3% of GDP) and mining (7.2% of GDP) that declined at a 7.8% rate in the quarter with mining output falling at a 4.2% rate in the quarter. Industrial output declined at a seasonally adjusted 5.2% annual rate while manufacturing output, with only a 12.7% share of GDP, declined at a disturbing 7% rate. It should be appreciated that mining volumes and mining revenues can tell a very different tale, as they did in this quarter, when mining sales and profits were buoyed by rising prices, while the volume of output that could be exported was seriously constrained by railway capacity. As an indication of an improved top line for SA business the gross operating (profit) surpluses of business grew from R315bn in the first quarter to R346bn in the second. This surplus in money of the day was 11% greater than a year before. Employees took home an extra R7bn in the second quarter, representing an increase of 10%.

Thus the share of operating surpluses in gross value added continued to rise, to 48% while employees share was 44%, with the balance of value added attributed to taxes on output. South African business continues to become more profitable hiring fewer, better paid employees, whose share in value added has declined (despite higher real remuneration). Productivity therefore must have increased, aided by less expensive capital (which was freely available with a lower risk premium).

Money and credit: The housing factor

The underlying weakness in aggregate domestic demand is confirmed by the direction of money and credit supplies. As we show below the growth in the money supply broadly defined (M3) has picked up from mid recession growth rates of a year before. But the annual growth rates may well have stalled about the 5%-6% year on year rate. The private credit extended by the banks (approximately the other asset side of the balance sheets of banks) indicates a similar picture of growth, stabilizing at the 5% to 6% rate. The weakest aspect of bank lending, as may be seen, is mortgage lending. Growth in mortgage lending (while positive) appears to be declining to a roughly 3% year on year rate. This does not speak well of the housing market and the demand for extra building and renovation activity. Without a recovery in the housing market the top lines of the banks, about 50% dependent on mortgage lending, is unlikely to improve.

On the evidence of a slowing economy and growth in money supply and credit (which is barely keeping up with inflation), the case for lower interest rates to stimulate demand would seem uncontestable. The money market has begun to factor in the possibility of a cut in short term interest rates by the first quarter of next year. The odds of a 50bps cut in the repo rate are still below evens (about a 35% probability).

Unless the outlook for the domestic and global economies improves and money supply and credit growth pick up soon, these probabilities of a cut in rates will rise. Hindsight confirms what we have long argued, that interest rate settings in SA have been too high for too long for the sake of the economy – without any obvious influence on the exchange rate or the inflation outlook.

Christine Lagarde, now head of the IMF and recently Minister of Finance in the Sakorzy government, told the Jackson Hole Conference of central bankers on Saturday of the three key steps that Europe should take to work its way out of crisis:

Step 1 she recommended, was to “… sustain sovereign finances – more fiscal action and more financing….” and cautioned that this did not require “…. drastic upfront belt-tightening—if countries address long-term fiscal risks like rising pension costs or healthcare spending, they will have more space in the short run to support growth and jobs. But without a credible financing path, fiscal adjustment will be doomed to fail. After all, deciding on a deficit path is one thing, getting the money to finance it is another. Sufficient financing can come from the private or official sector—including continued support from the ECB, with full backup of the euro area members.”

Step 2 was more urgent and perhaps more controversial.

That is to say, European banks “….need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. ……The most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns…..”

European banks face a large difficulty that is not of their own making. Holding debt issued by their own sovereigns has always been regarded as the safest way for banks to lend out the cash they take in as deposits. Indeed they are often required by regulators to hold significant quantities of securities issued by the government and its agencies. Holding the debt issued by foreign governments has been optional for banks and some governments are more risky than others and pay higher interest rates accordingly. European banks currently own 45% of all European Government debt: some good, some bad and some downright ugly.

The notion that members of the Euro monetary union could default on their debts was unthinkable until recently. Ordinarily governments escape default on debt denominated in their own currency by requiring their central banks to monetize their debt.

The problem when a government is printing cash to fund its expenditure is potential inflation, not default. But, in the terms of the European Monetary Union, only the European Central Bank (ECB) can issue more euros. In the absence of a fiscal union to accompany a monetary union, such powers to print money to resolve a banking crisis have been compromised by national rather European interests. The fiscally sound members of the monetary union, mostly located in Northern Europe, are reluctant to subsidise the fiscally irresponsible members of the union to the south of them. For the central bank to treat all the government bonds issued by all European governments as having the same face value when exchanged for ECB deposits would mean a subsidy to the profligate.

In reality the ECB has been accepting government securities of all kinds without distinction offered to it by all European banks in exchange for cash at its discount or repurchase window. It has pumped in large supplies of cash to European banks who have demanded cash from the ECB, accompanied by collateral in the form of Euro government debt. Such action is within its discretionary powers. Had it not lent so freely Europe would have suffered a run on all its banks and a liquidity crisis. The decline in the yields on Italian and Spanish government bonds has revealed the success these ECB purchases have had in calming the Euro bond market.

That there is no liquidity crisis in Europe is identified by the increase in the cash held by European banks well in excess of their legal requirements to hold cash. As we show below European banks are following the example of the US counterparts in building up their cash reserves at the expense of their lending.

What the ECB cannot do of its own volition is the equivalent of the QE2 or TARP (Troubled Assets Recovery Program) activities conducted by the US Fed and the US Treasury. That is, they cannot go directly into the markets and offer to buy government securities and mortgage backed securities on a large scale to inject liquidity and (more important in the case of TARP) to inject fresh capital into the banks and other financial institutions.

As Mme Legarde has identified, it is capital rather than cash that the European banks are short of. Such a need to raise more capital is reflected by the lower values attached to the shares of European banks. European banks are trading at about half the value of the assets on their books. Their books have an important part made up of suspect government securities which may not have been written down to reflect market realities; while the scope for increasing the size of their books is impaired by the weak Euro economies. This decline in the equity market value of the banks makes them more vulnerable and less able to raise meaningful amounts of capital from their shareholders.

They need the equivalent of a Warren Buffett to come to their rescue, as he did with Bank of America. Failing this shareholders may have no choice but to subscribe to deeply discounted rights issues offered by banks that might otherwise go out of business. The further alternative is of course to rely on governments to subscribe to the capital of banks. The banks may hope that capital provided by governments is a temporary provision (as it has proved to be in the US where banks have paid back the government with a profit) and also not accompanied by too much political interference in the business of banking.

This then brings the discussion to step 3, which Lagarde believes Europe will have to take if it is to enjoy a full recovery and retain its monetary and banking systems in more or less their present form.

To quote her: “Europe needs a common vision for its future. The current economic turmoil has exposed some serious flaws in the architecture of the eurozone, flaws that threaten the sustainability of the entire project. In such an atmosphere, there is no room for ambivalence about its future direction. An unclear or confused message will add to market uncertainty and magnify the eurozone’s economic tensions. So Europe must recommit credibly to a common vision, and it needs to be built on solid foundations—including, for example, fiscal rules that actually work.”

The European monetary union is being sustained by the ability of the ECB to print money to keep its banks and governments afloat. The crisis is being overcome this way. Any permanent solution to the issues Europe faces requires fiscal stability and a fiscal union that effectively limits government spending in Europe to what European taxpayers can support. The hope for Europe is that fiscal responsibility can only be realized by governments spending less – especially in ways that discourage the work, savings and enterprise of its citizens. The limits to the taxes European governments can collect has long been exceeded, as its fiscal crisis makes clear.

There have been dramatic developments on the SA interest rate front over the past two weeks. The money market, having confidently predicted an increase in short term rates this year or early next year, now very confidently expects short term interest rates to stay on hold for 12 months or more. The figures below tell the story of how the prediction of slower global growth has influenced the outlook for the SA economy and so interest rates. The case for lower interest rates in SA, one we have made for some time, has become even stronger and might in turn become reflected in a negatively sloped rather than flat short term yield curve.

The long term yield curve has also flattened significantly in response to the outlook for lower short term rates. The slope of the long term yield is still positive, indicating that short rates are expected to rise rather than fall in due course. However the one year benchmark interest rate is now only expected to move above 7% in three years’ time. As may be seen in the charts below, the one year rate is now expected to flatten out below the 9% rate in about six years.

The question then arises as to what might cause the yield curve to flatten or steepen in the year to come. Were the global economy to grow faster than is now expected, this surely would be associated with strength in emerging market equities and therefore also in the rand. The outlook for SA growth would improve in these circumstances while the outlook for inflation (given rand strength) would not deteriorate. The yield curve might then shift lower at the longer end and there would be downward market pressure on short rates (which the Reserve Bank might choose to resist).

Were the outlook for the global economy to deteriorate further, there would be additional downward pressure on short rates. The yield curve might well turn negative, should short term rates be expected to decline given slower growth. However the rand is unlikely to be well supported in such circumstances and so the outlook for inflation may not improve if we were to see a combination of a weaker rand and lower global commodity prices, including a lower oil price. These opposing forces (slower global growth plus a weaker rand) will restrain any fall in inflation or inflation expected over the long run and so limit the fall in long term rates. A flat to negatively sloped yield curve might then prevail until the outlook for the global and SA economy improved.

Clearly the combination of faster global growth without more inflation (shielded by a stronger rand) is much to be preferred. However there is one great consolation, should the global economy not help the SA economy along: the danger of an increase in short term rates has passed. The money market is confirming this and the Reserve Bank will indicate as much in due course.

A sombre outlook for the domestic and the global economy was presented yesterday by Reserve Bank governor Gill Marcus, helping the case for leaving rates unchanged, as had been confidently expected. The case for higher rates any time soon was weakened by the arguments presented in the MPC statement and in the Q&A session that followed. The opportunity to lower rates was not considered, as we were informed, though perhaps it should have been. Cost push pressures on inflation were again emphasized in the statement – and second round effects of higher inflation expected (on inflation itself) were regarded as not in evidence. Inflationary expectations, as measured for the Bank, were reported as stable to lower.

The Reserve Bank expects the small breach of the upper 6% band of the inflation targets by the first quarter of 2012 but is of the view that this breach will be very temporary and therefore no reason in itself to raise the repo rate. Base effects are pushing inflation higher in the second half of 2011 and will reverse in 2012. The key to the inflation target remains the foreign exchange value of the rand and this is proving very helpful and we think will continue to be so – to the point that the Reserve Bank is over- rather than underestimating inflation.

Prominent reference was made in the statement and in the Q&A to the “core” rate of inflation, that is inflation excluding food and energy prices, which is of the order of just over 3%. An inflation target set in terms of core inflation rather than headline inflation is preferred by many of the leading authorities on inflation targeting and the Reserve Bank may well be moving in that direction. This represents an important and welcome departure from previous Governor Mboweni’s practice and rhetoric, who was determined to allow no such distinctions or escape clauses for meeting the inflation targets. This different mindset reinforces our argument for and prediction of low interest rates for longer. Moreover it raises the likelihood of generally more stable short term interest rates in the future which would be very helpful for SA business and its customers.

Closing the gap

At the Q&A, so called output gaps received interesting attention, that is the gap between potential GDP and actual levels of output. This gap is judged still to be open but is said to be closing with current growth rates ahead of potential growth. Potential output growth this year was indicated as only 3.5% with second half growth slowing down rather than picking up. This represents a very pessimistic view of SA’s long term growth potential and is not one consistent with much growth in employment and the government objectives for employment growth.

This Reserve Bank sense of potential growth is presumably derived from a limited estimate of SA’s ability to attract foreign capital, equivalent by definition to the sustainable size of the current account deficit – both usually measured as a share of GDP. We have argued that such pessimism may be unjustified and that growth can lead capital inflows that finance and sustain growth. In other words, grow faster to improve the returns on capital invested, and the capital from global sources will be forthcoming. There is a potential virtuous circle for SA that was in evidence between 2003 and 2007 (grow faster- attract more capital – sustain the value of the rand – holds down inflation and interest rates). But expressing faith or confidence in such possibilities of faster growth with less inflation aided by foreign capital, is not behaviour expected of inflation vigilant central bankers.

GDP growth is expected by the Reserve Bank to be about 3.7% in 2011 and 3.9% in 2012, increasing to 4.4% in 2013. When the presumed output gap is finally closed (on these assumptions) late in 2012 the case for raising rates will then be more confidently made. Pressures on global food inflation are however thought by the MPC to have peaked. The MPC outlook is for inflation at the upper band 6% rate by year end and is expected to remain above this 6% upper band for the inflation target until the second quarter of 2012 and receding thereafter.

Something in reserve …

Had we been at the Q&A session we would have asked the Governor and her bench of advisors why the Reserve Bank thinks it still useful to add to its already abundant supply of foreign exchange reserves. These are large enough for any conceivable emergency that might shock the SA balance of payments. The governor indicated her own confusion about the forces that drive the rand. Clearly Reserve Bank interventions in the currency market have had no predictable influence on the rand. The realised strength of the rand has made such intervention very expensive for the SA taxpayer on whose behalf the Treasury borrows rands at 6% to 8%, to offset the impact of dollar purchases on the money supply, for the Reserve Bank to invest in US dollars and Euros that return around 2% at best. It has been an expensive and futile exercise in trying to resist market forces.

We might suggest that the behaviour of the rand is not that mysterious and will continue to take its cue from global risk appetite, well reflected in emerging equity and bond markets. The well understood rand does not make it easier to predict. This remains the essential problem for monetary policy in SA, which is to hold inflation down not for its own sake but to encourage long term economic growth (lest we forget the purpose of inflation targeting).

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 22 July

The Reserve Bank, as expected, kept its repo rate steady despite raising its estimate of inflation to come, now seeing inflation as marginally above 6% by year end. However it also predicted to return to within the band in 2012. The explanation of this increase was “cost push” rather than demand forces, therefore not justifying higher interest rates (in the absence of “second round effects”).

Second round effects are defined as higher inflation caused by more inflation expected. This, according to the theory of monetary policy, might demand higher interest rates to fight inflation expected, even if this depressed the economy. This dilemma – the unhappy trade off between inflation and economic activity – is something the MPC would naturally prefer to avoid. The big question is will it continue to do so?

Our own work has unambiguously identified the absence of second round effects. Inflation in SA has influenced inflation expected, not the other way round. Thus we do not expect second round effects to show up. But the inflation outlook remains particularly uncertain given the uncertainty about the direction of the US dollar and the oil price in particular. And if the inflation rate rises and is expected to stay above the upper band of 6% this policy dilemma will become more acute, with or without measurable second round effects.

We notice again and welcome the willingness of the Reserve Bank to think beyond actual inflation to the causes of inflation and the recognition that monetary policy must also bear the outlook for economic and employment growth in mind. The revised mandate for the Reserve Bank makes this very clear.

It should be pointed out though that, in answer to a question, this point about a broader focus than a focus on inflation only was not made by the governor. The governor, like all governors of central banks, would hate to be interpreted as being soft on inflation, particularly when inflation is expected to rise above the target band and even when there is very good reason to ignore “cost push” pressures. And so anti-inflationary vigilance must always be stressed by central bankers, for fear that their lack of monetary action being misinterpreted as evidence of a lack of anti-inflationary conviction by the market place.

However, as was made clear by the MPC, the state of the economy does not support higher interest rates. As we have previously indicated the Reserve Bank is also of the view that economic activity may have decelerated rather than accelerated recently. And so, until the economy does pick up significant momentum, accompanied by significantly faster growth in bank credit the Reserve Bank will prefer to keep interest rates on hold. Yet it might feel obliged to raise rates despite the weakness of aggregate demand (wrongly in our view) should the actual inflation outlook deteriorate even if such higher inflation is beyond the control of the Bank itself.

The oil price remains the big unknown for inflation to come. It was remarked at the Q&A session that food price inflation may have peaked according to the Bank. The consolation is that higher commodity prices will very likely be accompanied by a stronger rand. If the rand price of oil remains unchanged or falls, the danger of higher interest rates will be averted for perhaps up to a further 12 months, that is until the economy gains real traction, which it will if the rand remains stable and the oil price does not detract further from household spending.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 13 May: Think Beyond Just Inflation

It seems clear that new Reserve Bank governor Gill Marcus has not yet brought anything of a different point of view to the
Monetary Policy Committee (MPC). The style was much more inclusive and open but the substance was largely the same as
before. She has deferred to the established positions of the MPC of which she is the only new member.

Therefore the sense held by the previous MPC that the economy is at a turning point and therefore needs no further
encouragement for fear of being too procyclical with interest rates (which have declined by 500bp has been maintained). Also
maintained is the concern with second round effects on inflation of electricity price increases – absent of which inflation would not
be regarded as a problem at all by the MPC.

The inflation problem is Eskom and interest rates remain where they are largely because of the Eskom effect on inflation. This
Eskom effect is creating great uncertainty and therefore is affecting inflationary expectations which are presumed to make ever
higher inflation inevitable, unless the Reserve Bank remains vigilant in setting interest rates accordingly.

Had I been at the Media Conference I would have asked this question. Does not the prospect of further electricity price increases
justify lower rather than higher interest rates given the impact of such price increases on domestic spending and therefore on
output and employment?

The answer that would have been provided would unfortunately probably have been something like as follows: no, because higher
inflation following such electricity price increases might lead to even more inflation – because of possible second round effects on
inflation.

That the MPC could still concern itself with second round inflation when the economy is as weak as it is and when the rand is as
strong as it is and when in the Reserve Bank’s view global inflation is not a threat at all to domestic inflation, speaks volumes about
the MPC’s lack of grasp of the causes and effects of supply side shocks on prices. But here nothing has yet changed with Ms
Marcus in the chair – which is the pity.

The right answer would have been yes – because Eskom’s price increase is a tax on consumers and tax increases lead to higher
prices and less spending and in the circumstances, while inflation will go up – profit margins will come down and employment
growth will remain subdued and so the economy will need some encouragement from monetary policy. Or in other words the
distinction between supply side shocks that drive inflation higher and demand led inflation should be emphasised by the
Governor. The Governor should make it clear that Monetary Policy can only be effective against demand led inflation and
monetary policy should not add to the demand reducing influence of higher levels of taxation.

Ms Marcus was also complacent about the negative growth in money supply and credit which other central banks have been very
active in trying, though not yet succeeding in combating. Again the MPC still does not wish to do anything to encourage SA banks
to ease up for the sake of the economy.

But this lack of action by the MPC was surely encouraged by a belief that the domestic economy is recovering. However such
predictions by the Reserve Bank were highly qualified as the quote from the MPC statement below indicates very clearly:

There are signs that the domestic economy will continue on its recovery path but economic growth is expected to remain below
potential for some time; and dependent to some extent on the pace of the global recovery, which still appears to be fragile and
uneven across regions. Economic growth is also expected to be constrained by subdued domestic consumption expenditure. The
domestic outlook for inflation remains favourable as a result of weak demand pressures and the main threat to the inflation outlook
emanates from possible electricity price increases.

We however see no signs of any meaningful revival in domestic spending. Reference was made to the particular unpredictability of
GDP growth this past quarter- of which preliminary estimates will be released next week. However marginally positive quarter-on-
quarter GDP growth may be recorded even as final consumption and investment demands decline. Improvements in net exports
and a reversal in inventory accumulation may yet allow GDP to grow even as final demand remains very weak. Even a modest
recovery in GDP growth would therefore not indicate the likelihood of the SA economy operating even close to its potential over
the next year – something that should concern the MPC greatly.

Should the Reserve Bank be surprised by the lack of economic recovery, it now only has its next meeting in January 2010 to
respond to it. We should not expect any emergency meeting before then and we should expect interest rates to remain on hold for
much of 2010. We can anticipate that a broader mandate for the Reserve Bank is in the offing that would allow it to concern itself
more with the growth outlook and less with the inflation outlook, especially when the inflation is supply side driven, as is clearly the
case now. We would welcome such a development as we would continue to support the independence of the Reserve Bank to act
as it judges – an independence that Governor Marcus will uphold determinedly.

A poisoned chalice

This is not an easy time to be taking over the reins at the Reserve Bank. Spending by households and privately owned firms (which account for a very large part of the economy – up to 80% of GDP) remains in the grip of a very severe recession. More important for Gill Marcus to take into account is that there seems little sign of any imminent recovery in this spending upon which the economy depends for its growth.

For technical reasons the third quarter GDP numbers might look better because exports declined less than imports and the run down in inventories was at a slower pace than it was in the second quarter when an extraordinary reduction in inventories took as much as 10% off the GDP growth rate. But such numbers will indicate just how weak the economy is and there will be little consolation to be found in the trends in spending by the private sector.

The case for a fresh dialogue

The case for the Reserve Bank in these circumstances doing all it can to help the economy by lowering interest rates and pumping in cash to encourage the banks to lend more, might appear unassailable. However the Monetary Policy Committee found reasons at its last two meetings not to lower interest rates or to ease quantitatively.

The arguments that would have supported such inaction would presumably have included the notions that real interest rates in SA were already very low. The argument would also have been made that inflation in SA remains unsatisfactorily high and that elevated inflationary expectations could continue to have an unwelcome self fulfilling impact on inflation itself.

Ms Marcus would do well to question the validity of such arguments. It was such arguments that helped raise interest rates to recession producing levels in the first place and restrained their reversal long after it was clear that the growth in spending by households, particularly on interest sensitive durable goods was falling sharply. The damage caused to the economy is there to be seen. As we have argued before the weakness in the SA economy was of our own making. The global credit crisis made it more difficult to escape from recession.

What exactly are real interest rates?

Firstly let us raise the issue of real interest rates that may be defined as the difference between borrowing costs and inflation. By reference to CPI inflation real money market interest rates in SA may indeed appear very low. However if prices realised by producers, represented by the Producer Price Index (PPI), are taken as the point of reference real interest rates have increased to exceptionally high levels as we show below. The reason for this difference is that while consumers in SA still face inflation, producers have to deal with significant and dramatic deflation.

CPI and PPI Inflation

Source: StatsSA and Investec Private Client Securities

The Consumer and Producer Price Indexes

Source: StatsSA and Investec Private Client Securities

SA Real short term interest rates

Source: StatsSA and Investec Private Client Securities

Real interest rates are very high – not very low

The simple idea behind the importance attached to real interest rates is that higher prices charged for goods sold offset the interest costs of borrowing. In an extreme case, if the prices firms can charge for their goods or services rise faster than the interest rates then doing no more than borrowing (cheap) money to fill up a warehouse with stuff that is bound to increase in value becomes a highly profitable business. For a household taking a loan to buy goods (a car or a house), the prices of which will rise as fast as the interest rates they are charged, may also seem like a good idea.

However as is very apparent SA households are not responding to the prospect of more inflation by borrowing more, even when banks or retailers remain willing to lend. They are borrowing less because the prices of the homes and cars and furniture they might in normal circumstances be in the market for are not expected to rise at anything like their cost of borrowing. They may even be expecting prices to fall. They will know that the rising prices they are forced to pay are for goods and services they cannot store – electricity and other municipal services that could better be described as higher taxes.

The firms that might ordinarily be encouraged to borrow funds to add to stocks and work in progress and to their complement of workers, or to add more plant and equipment, are facing and expecting deflation rather than inflation. For them the idea that their real costs of borrowing have declined is risible. Their real cost of borrowing, that is to say the real interest rates they are paying, has risen dramatically. This is why they are running down inventories, working capital and (most regrettably) workers employed.

The reality is that for producers in SA prices are falling, not rising. The further reality is that higher prices/taxes paid by their customers and themselves for electricity and other services and the higher wages they have been forced to pay their unionised workers have made it harder rather than easier for them to raise prices. The strong rand has most importantly made it more difficult for them to compete on the local or export markets. They have less, not more, pricing power because of the rising trend in CPI and wages. Their operating profits have come under such pressure and this has led them to invest less and employ fewer workers and managers.

Inflation is not a self fulfilling expectation

The notion that in these circumstances producers will not only expect more inflation but that such expectations could be self fulfilling in the absence of support from the demand side of the economy, is surely a damagingly false notion. It means damagingly high interest rates. In the absence of accommodating demands for goods and services inflationary expectations (that is to say in current circumstances, expectations of more supply side shocks for the economy in the form of higher electricity prices) will not lead to still more inflation. Supply side driven inflation expected will however lead to less output and employment. All the Reserve Bank can hope to do in such circumstances is to ease rather than add to the punishment.

The Reserve Bank needs to make the firm distinction between the inflation it does have influence over (demand led inflation) and supply side shocks that cause inflation and even expected inflation to rise – over which it has no direct influence.

Judging the right level of interest rates for SA without full regard to this distinction can prove very damaging to the economy. Interest rates influence the spending decisions of SA households and firms without necessarily having a predictable influence on the supply side of the economy and therefore on prices. The unpredictable link between interest rate changes and the exchange rate makes it even more difficult to know how interest rates will influence the inflation rate in SA.

Ms Marcus would do well to recognise these difficulties for the practice of monetary policy in SA. She should also be under no illusions that the only problem for the Reserve Bank to focus its attention upon for now is the very weak state of demand, not the rate of inflation.

The market is waiting to see what the new Governor will deliver

The SA market in fixed interest securities has adopted a mostly wait and see attitude to the appointment of Gill Marcus as Governor of the Reserve Bank. Both long rates represented by the R157 and short term rates represented by the three month Johannesburg Inter Bank rates (Jibar) were largely unmoved in response to the surely surprising announcement. The three month forward rate agreements (FRAs) were unchanged for contracts up to six months and then recede marginally as we also show. This indicates that short rates are still not expected to be reduced for at least six months with only a slightly improved chance of lower rates beyond then (See below).

Long and short rates July 2009 (Daily Data)

Source: I-Net Bridge and Investec Private Client Securities

Three month Forward Rate Agreements (FRAs)

Source: Bloomberg and Investec Private Client Securities

Inflation expected remains at high levels

Expected inflation, or more correctly, compensation for bearing inflation risk in the RSA bond market, had increased sharply in Q2 2009 and has only receded slightly over the past week. This provides the most objective measure of inflation expected. Inflation compensation is measured below as the difference between the yield on the R157 and the inflation indexed R189.

The expected value of the rand has improved

The compensation for bearing the risk of rand weakness against the US dollar – based on expected differences in SA and US inflation over the long run – is recognised in the yield gap between RSA bonds and their US equivalents. This yield difference may be regarded as the market’s measure of expected exchange rate movements. This yield gap has shown little direction this year, unlike the inflation compensation series, but has receded helpfully in the past week (See below).

Inflation compensation and expected rand depreciation July 2009 (Daily data)

Source: I-Net Bridge and Investec Private Client Securities

Mboweni took inflationary expectations very seriously

Governor Tito Mboweni paid particular attention to expected inflation when determining interest rate settings. The decision by the MPC not to reduce interest rates in June, despite the manifest weakness of domestic demand and the wide negative gap between domestic demand and potential supply, was explained as a response to more expected inflation.

The argument for combating expected, and not only actual, inflation with tighter monetary policy, is that expected inflation is self-perpetuating, that more expected inflation leads to more actual inflation. Thus monetary policy, with the long term outlook for inflation in mind, has to fight inflationary expectations as much as inflation itself.

This general argument we find hard to appreciate. For us the ability of price setters in contested markets to raise prices and to keep them up (whatever their inflationary expectations) depends on the actual state of demand. Monetary policy can influence the actual state of demand and by so doing can disabuse falsely held inflationary expectations. Furthermore profit margins may easily shrink if labour costs and employment benefits are not contained when markets conditions deteriorate. Passing on higher wages to customers in the form of higher prices will prove self defeating if demand is weak.

Worrying about inflation expectations at times like these is particularly difficult to accept

We have found such arguments about the self perpetuating nature of inflation expected particularly unhelpful now that actual demand in SA is so patently weak. The sharp deflation of prices now being realised at the SA factory doors and farm gates is very clear evidence of the weakness of aggregate demand and so the lack of pricing power enjoyed by most SA producers – despite more CPI inflation expected. The prices that have driven the CPI higher in recent months are mostly beyond the influence of monetary policy.

A much more activist approach from the Reserve Bank was called for and was not forthcoming – costing Mboweni his job

The MPC of the Reserve Bank under the direction of Mboweni has been unable to accept that monetary policy can affect demand and output and employment very severely, as it has done in SA, without necessarily having much of any immediate impact on the CPI, or indeed on inflationary expectations. The failure of the Bank under Mboweni to adapt monetary policy aggressively and actively, in unusually difficult times and conditions, with appropriate and convincing analysis and explanations, surely made Mboweni’s reappointment politically impossible. The focus of inflation and inflation expectations was not good enough for the times.

The market knew that Mboweni’s tenure was limited – hence more inflation expected

The notion that inflation would rise permanently in SA after Mboweni was inevitably to be replaced by somebody much less concerned about inflation and after the independence of the Reserve Bank had been compromised, understandably gained credence. Hence the increased inflationary expectations the Reserve Bank were fighting so unwisely were unfortunately and unintentionally much of the Reserve Bank’s own making.

Marcus must disabuse markets of the notion of permanently high inflation – by demonstrating a sensible and sensitive regard for the state of the economy

The appointment of Gill Marcus holds every promise of disabusing the markets of the notion that inflation in SA is permanently on the rise. But it will take sensible and sensitive monetary policy to do so. Monetary policy must take and must be seen to take full account of the state of the economy as well as of the causes and consequences of inflation and inflationary expectations for the economy. The current emphasis on fighting inflation has to be moderated with out compromising the importance the Reserve Bank attaches and is believed to attach to realising low inflation as the means to the end of a more efficient economy.

The independence of any central bank is always conditional on its ability to convince the public and the politicians who represent public opinion, that it is fully capable of helping the economy realise its potential- with the aid of low inflation. Ms Marcus will undoubtedly be very well aware of the importance for sustaining the independence of the Bank from direct political interference, of not only doing well by the economy, but of being seen and understood to be doing what is sensible and right for the economy.