Brian Kantor: SA monetary (inflation) policy – bad theory put into practice

Last week the South African Reserve Bank decided to hike interest rates by 25 basis points. It was a decision that left a bad taste in well-known economist Brian Kantor’s mouth. In the article below Kantor questions the bank’s theory of using inflation targeting as the measure in reaching its decision, saying the most important influence on inflation, the Rand, is beyond the influence of short term rates. An insightful read. – Stuart Lowman

By Brian Kantor*

Brian Kantor, chief economist and strategist, Investec Wealth
Brian Kantor, chief economist and strategist, Investec Wealth

The Reserve Bank is well aware that there are no demand side upward pressures on the inflation rate. In fact the opposite is very much the case. Weak demand is clearly constraining the power that sellers have to increase prices, not only in South Africa but globally. Hence for inflation forecasters, including those at the Bank, lower rather than higher than expected inflation.

Moreover, the price increases to come from Eskom and municipalities and perhaps also the Government (higher tax rates) can be expected to not only add to the CPI but deflate household spending even further in the months to come. But regardless of even slower growth to come, the Monetary Policy Committee (MPC) decided on a 4-2 count that a further sacrifice of expected growth was called for.

To quote the concluding remarks of its statement of 19 November:

“In the absence of demand pressures, the MPC had to decide whether to act now or later. On the one hand, given the relative stability in the underlying core inflation, delaying the adjustment could give the MPC room to re-assess these unfolding developments at the next meeting, and avoid possible additional headwinds to the weak growth outlook. On the other hand, delaying the adjustment further could lead to second-round effects and require an even stronger monetary policy response in the future, with more severe consequences for short-term growth.

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“Complicating the decision was the deteriorating economic growth outlook. Although the change to the growth forecast was marginal, the risks to the outlook, which were more or less balanced at the previous meeting, are now assessed to be on the downside. Against this difficult backdrop, the MPC decided to increase the repurchase rate by 25 basis points to 6,25 per cent per annum effective from 20 November 2015. Four members preferred an increase, while two members favoured an unchanged stance. “

The Reserve Bank has again been guided by a theory of dubious logic and unbacked by evidence that inflation expected in SA can drive inflation ever higher – regardless of the state of demand in an economy. Or in other words firms and trade unions with price and wage setting power, in their budgets and plans for the future, having set their new demands on consumers and employers with expected inflation in mind – will stick to them. Stick to them, that is, and then ask for still more at the next round regardless of the ability or willingness of customers or employers to meet these demands. Without support from the demand side of the economy and highly accommodative monetary policy responses to higher expected and actual inflation, ever higher prices cannot stick, and will not stick because such behaviour is simply not consistent with income maximising behaviour. It has not done so to date and will not do so as the theory of prices, properly understood, would predict.

In simple theories of inflation used by most central banks, including the US Fed, and as explained very clearly in an important speech given by Fed Chair Yellen recently, the influence of inflationary expectations on prices – that find the way into prices asked for – are combined with and excess demand or supply variable, known as the output gap. The theory is that the wider the output gap, the less inflation – for any given inflation expected. The Reserve Bank has seen fit to deny the role of the output gap and its own already higher interest rate settings in restraining inflation. It is a peculiar monetary policy and, more important, theory of economic behaviour that is being applied by the Reserve Bank.

Read also: Brian Kantor: Inflation flatlining. SA to get more austerity.

Furthermore, the evidence is very strong that inflation expected in SA is highly stable about the 6% level and is likely to remain so – if and when inflation in SA trends lower. It can and should do so if the rand strengthens – a force largely beyond Reserve Bank powers or powers to predict. Inflation leads inflation expected in SA, as it did between 2003 and 2006 when, thanks to a strong recovery in the rand, inflation receded and inflation expected followed.

We can only hope for a further episode of rand recovery, lower rates of inflation in SA to follow and less inflation expected as measured by the gap between conventional and inflation linked bond yields. If this should happen then the theory of inflation being driven by the mere thought of more inflation will be thoroughly and most helpfully disabused – as it should be.

As it happened on Thursday 19 November, the chances of this test of the theory improved for reasons, surely completely independently of the Reserve Bank decision that was taken at about 15h30 our time. As Bloomberg shows (see figures below) almost exactly at that time the MPC announced higher short term rates for SA, long term interest rates in the US fell quite sharply and long term rates in SA followed lower. A surprising combination of higher short term rates in SA and lower long term rates was to be observed. Also to be observed was a stronger rand. Again, this was caused by forces quite beyond Reserve Bank influence. Emerging equity markets enjoyed a nice bounce higher – consistently combined with the lower interest rates in the US – and even more consistently combined with a firmer rand. Clearly the fear of a Fed rate hike has been well priced into markets: the Fed decision to raise rates in December has become much more certain fact and its impact much less disturbing.

This confirms once more that the most important influence on inflation, the behaviour of the rand, is largely beyond the influence of short term interest rates in SA. Therefore the Reserve Bank can in practice only hope to influence the level of demand in SA, which it does consistently by raising or lowering interest rates. Given weak demand and the absence of demand side pressures on prices in SA, it should be lowering, not raising its repo rate. The Reserve Bank is relying on a theory that inflation in SA could become self-fulfilling and therefore demands higher interest rates, doing our economy a grave disservice in the process.

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  • Brian Kantor is the Chief Strategist and Economist at Investec Wealth and Investment in South Africa.