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