Reserve Bank fails to learn lesson of 1998

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The Reserve Bank raises rates modestly and falls into the trap set by other central banks. Too little by half to impress the markets – more than enough to damage the economy.

The Reserve Bank fell into the trap set for it by its central bank peers in Turkey and Brazil, which raised short-term rates to defend their weakening currencies.

That this strong-arm defence (including direct intervention in the foreign exchange markets) failed to support the Turkish lira or the Brazilian real, might have given pause to the monetary policy committee (MPC). A minority of members voted against the increase presumably because they know that higher interest rates have an unpredictable influence on exchange rates – particularly when global capital markets are under strain – while having a predictably negative influence on already weak domestic spending and therefore economic growth.

The governor or the MPC members cannot explain how higher interest rates will reduce inflation rates, unless the exchange rate strengthens in response to higher rates, which it may or may not do. The immediate response to the 50 basis points increase has been a weaker rather than stronger rand, though it may be argued that the market expected a more hawkish response of at least a 100 basis points increase and sold the rand accordingly. That is, the MPC surprised the market, not because it raised rates, but did not (fortunately) raise them much further.

What the economy needed and did not get from the Reserve Bank was a vigorous explanation why, in current circumstances of capital market volatility, raising short-term interest rates would have done nothing to reduce inflation because the rand would not benefit from such action, while damaging growth prospects that would weaken the case for investing in South Africa and, if anything, further weaken the rand. More inflation for less growth is a most unfortunate and likely trade-off.

A full explanation should then have been provided by the governor as to why a 50 basis points increase would at best be irrelevant for the exchange rate and harmful to the economy, and why any larger hike in interest rates, even when perhaps expected in the market place, was unthinkable given the weak economy. Nor, it might have been pointed out, would an even larger increase in short rates have helped the rand, any more than it helped the Turkish lira.

Such a spirited defence of the case for not raising rates will be as imperative the next time the MPC meets, should the rand not have gained strength by then, the inflation outlook remains as unsatisfactory as it is now, and the economy is even less well placed to tolerate a further increase in rates. Without such an argument, the economy may well set off on a 1998 spiral of higher interest rates in response to a weaker currency and the higher inflation that follows, leads to slower economic growth. In other words, a further enactment of the economic theatre of the absurd.

We have been here before and should remember how much better the Australians coped at that time with Aussie dollar weakness by sitting on their interest rate hands and not reacting to the essentially temporary inflation danger presented by a (temporarily?) weaker exchange rate.

The comparison between the success the Aussies had doing nothing and the pain suffered for example by the South African, New Zealand and Chilean economies in the late 1990s, where interest rates were increased aggressively in response to exchange rate weakness driven by an emerging and commodity market crisis, makes a most instructive case study.

The right response to a weaker exchange rate driven by forces beyond the control of the central bank is not to react at all. That is, to ride out the exchange rate weakness as best you can and focus on the requirements of the domestic economy.

The MPC did not have the wisdom to do this and unfortunately made a modest concession, a mere 50 basis point concession, to poorly considered market expectations and poorly executed monetary policy reactions in other emerging markets.

We can only hope it does a much better job before and during the next MPC meeting of defending the economy against ill-considered and unhelpful interest rate increases. Monetary policy needs to be not only data dependent, as the governor has indicated following the US Federal Reserve mantra, but accompanied by another Fed innovation – good and appropriate guidance for the market about monetary policy that makes good economic sense.

That is, to have it widely appreciated why we will not be embarking on an interest rate spiral unless the economy can justify it – which it is very unlikely to do anytime soon.

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


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