Monetary policy: the limits to inflation targeting

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Is South Africa’s monetary policy accommodative? It all depends on whose inflation and whose interest rates you have in mind. We are told by the Reserve Bank that monetary policy in the country is “accommodative” because interest rates are below the rate of inflation. That is because real interest rates are negative. But whose interest rates and whose inflation rates can the Reserve Bank be referring to?

From the perspective of savers, the interest paid on savings accounts in the banks are not keeping up with inflation – and more so if tax has to be paid on interest income. Low real interest rates are tough on savers but, for a good reason, borrowers may be unable to pay any more for the use of their savings. And borrowers who invest in businesses that offer employment need all the encouragement they can get.

From the perspective of business borrowers, especially small firms still able to borrow from banks at prime plus (something over 9 percent), finance may in reality be expensive. The presumption of negative real interest rates is that businesses will be able to increase the prices they charge customers at more than the 9 percent per annum they pay in interest.

If this were the case, simply financing a warehouse of non-perishable goods that increase in value by more than the costs of finance (after taxes) becomes a no-brainer of a profitable business decision. This would presumably make monetary policy accommodative and encourage business to borrow and invest more.

But is this the case for many businesses serving the domestic market? Do they have the power to price their goods or services ahead of the rate of inflation, which was 5.4 percent in December last year?

The weakened state of demand for goods and services may prevent this, as the more detailed inflation statistics bear out.

The headline consumer price index is the weighted average of the prices of goods and services consumed by the mythical average household, some of which have risen by more than the average and others by less.

It is administered prices, those charged by municipalities for water and electricity etc and those subject to additional excise duties, for example alcoholic beverages (up 7.2 percent on average, with beer up 9.2 percent on December a year before), that have been making the inflation running. Administered prices were up nearly 8 percent on a year before in December 2013.

By contrast, the price of clothing and footwear is estimated to have increased by 3.6 percent and 3 percent, respectively. The food basket was also up 3 percent. The farmers, food retailers and manufacturers will know all about their lack of pricing power and the pressure on their sales volumes and profit margins.

It is clear that rising prices have little to do with strong demand registered by consumers or firms. As is well recognised, households are under increasing budget pressures from higher prices and taxes imposed on them. And, most relevant, they are suffering from a lack of pricing power in the most important market for their services, the labour market.

By recent accounts from Adcorp, the rate of dismissal from private sector jobs is accelerating and workers are less mobile. They are presumably holding onto the jobs they have, rather than moving to better paid ones. This is not an environment likely to encourage growth in spending, despite interest rates in the money market being below the headline inflation rate.

Monetary policy is doing little to encourage domestic spending and, with the recent increase in benchmark short rates, has become less so. Even less demand-side pressure on spending can be expected as prices continue to rise, driven especially by a weaker rand, over which domestic interest rates have little or no influence.

That the economy is as weak as it is indicates that interest rates should have been significantly lower than they have been, and should be falling, rather than rising, given the deteriorating state of the economy.

Targeting inflation when prices are rising for supply-side rather than demand-side reasons makes little economic sense. Inflation targeting can only make sense when the exchange rate responds predictably to interests rate settings.

The rand in the past 12 years has not behaved like this. It shows there is no consistent relationship between exchange rate and interest rate movements. The correlation of daily changes in short-term interest rates, represented by the Johannesburg interbank three-month forward rate since January 2006, is close to zero (0.0001330). Using daily changes in the actual rather than the forward three-month interbank rate yields the same zero correlation.

Aiming for low inflation is good monetary policy. Trying to meet inflation targets is proving again to mean poor monetary policy in South Africa.

* Brian Kantor is the chief economist and investment strategist with Investec Securities.

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