Avoiding damaging mind games

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GillMarcusBlue Independent Newspapers. Reserve Bank governor Gill Marcus. Photo: Simphiwe Mbokazi.

Johannesburg - The monetary policy committee (MPC) of the SA Reserve Bank on Thursday indicated that its outlook for inflation over the next few years had improved marginally.

To quote the statement: “The bank’s forecast of headline inflation changed marginally since the previous meeting. Inflation is expected to average 6.2 percent in 2014, compared with 6.3 percent previously, with the peak of 6.5 percent (previously 6.6 percent) expected in the fourth quarter. The forecast average inflation for 2015 remained unchanged at 5.8 percent. The forecast horizon has been extended and inflation is expected to average 5.5 percent in 2016, and 5.4 percent in the final quarter of that year.

“Inflation is still expected to remain outside the target band from the second quarter of 2014 until the second quarter of 2015,” the MPC said.

It reported that inflation expectations were unchanged: “The Reuters survey of inflation expectations of economic analysts conducted in May is more or less unchanged since the previous survey. Inflation is expected to average 6.3 percent in the second quarter, and 6.2 percent in the final two quarters of this year, before returning to within the target at an average of 5.8 percent in the first quarter of 2015.

“Annual inflation is expected to average 6.2 percent in 2014, and 5.6 percent and 5.4 percent in the subsequent two years respectively, somewhat lower than the bank’s forecast.”

The growth outlook for the economy, according to the MPC, by strong contrast has “deteriorated markedly”.

“The domestic economic growth outlook has deteriorated markedly, with the reversal of a number of the tentative positive signs observed at the beginning of the year. The bank’s forecast for economic growth for 2014 has been revised down from 2.6 percent at the previous meeting to 2.1 percent, implying a further widening of the negative output gap.

“The forecast for 2015 remains unchanged at 3.1 percent, and growth in 2016 is expected to average 3.4 percent. However, the risks to these forecasts are increasingly to the downside against the renewed possibility of electricity load-shedding, among other factors.”

With this backdrop, one might have thought that a decision not to raise short-term interest rates would have been a formality. But not so for two members of the MPC – compared with the three at the meeting before – who actually voted for a further increase in rates.

What can be on their minds? It can’t be a belief that higher interest rates can do much to slow down inflation. The Investec Securities simulation for the Reserve Bank model of inflation and growth indicates that an increase of 25 basis points in the repo rate will only reduce its expected inflation by roughly 8 basis points and this would take seven quarters to take full effect.

In other words, not much help on the inflation front at considerable further risk to the state of the economy – and moreover in the knowledge that an unpredictable exchange rate can make nonsense of the inflation forecast (that the model treats as an independent influence, about which assumptions rather than predictions are made when running the model).

The hard-pressed economy had some good luck in the form of a stronger rand and a bumper maize harvest, which will help to hold down inflation in the months ahead. One gains an impression that had the rains not come when they did, the case for raising rates might have had more support.

That monetary policy is hostage to such obvious supply side shocks as drought and global risk aversion is not a comfortable thought. The reality is that local inflation has very little to do with the demand side of the economy (as the Reserve Bank acknowledges fully) and everything to do with factors over which interest rates have little influence: exchange rates and the harvest, as well as the pace of administered price increases, which is the province of the regulators and the tax collectors.

At least this time around, at the media briefing and Q&A, the governor was asked some leading questions about supply side effects and the influence of interest rates. She was even asked if the hike in rates in January (with hindsight surely a mistake) did any harm to the economy. There was little mea culpa in the response and a resort to the non-testable theory that had the bank not raised rates then second round effects – higher inflationary expectations – would have taken inflation higher.

In fact there is no evidence that inflation expectations lead inflation rather than the other way round. And, as the MPC indicated, inflation expectations remain unchanged and the great constant in the economic environment.

This Q&A unfortunately indicates the danger in monetary policy: that members of the MPC come to believe that in order to preserve their inflation fighting credentials, and because the markets may expect them to raise interest rates, that is what they have to do. This is regardless of the predicted outcomes for inflation and, more important, for growth.

The trouble with such reactions is that they can never be tested or refuted. The economic caravan always moves on, even as the dogs bark. Who can say with certainty what might have happened if the bank had acted differently?

Interest rates should have been lower, not higher, given the state of the economy over the past 12 months. The time for a cyclical upswing in interest rates is when the economy can justify it – not before. And there is no justification for higher rates given the growth outlook.

Brian Kantor is the chief economist and strategist at Investec Wealth and Investment.


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