The Reserve Bank persists in arguing that its interest hike will benefit the South African economy, and hence society in general, because it will bring down the rate of inflation.
The Bank accepts that the hike will have the undesirable short-term effect of limiting growth but maintains that in the longer term it is “worth it” because of the positive economic impact of lower rates of inflation and, it stresses, lower expected rates of inflation.
The Bank is referring to consumer price headline inflation, which covers all consumer goods in the economy. It is this measure of inflation that the Bank targets with monetary policy, using a target range of between 3% and 6%.
The Bank takes it as a given that inflation is particularly bad for the economy at this time of low growth and rand weakness. In fact, so bad that it is worth damping down growth further to hold back the rate of inflation.
In reality, the problem with inflation is the uncertainty attached to rising prices, rather than the rising prices themselves. If all prices and wages rose at a predictable rate, it would have very little impact on an economy as business and consumers could plan for the future. Business would know that their input costs and selling prices would rise together, and consumers would know that their wages and the prices of goods they purchased would rise together.
The problem with inflation is the uncertainty attached to rising prices, rather than the rising prices themselves
This of course is not the case, and price rises in South Africa are unpredictable because they are mainly influenced by the rand exchange rate which, itself, is very unpredictable. What’s more, the higher the rate of inflation, the higher the variability of that inflation and the higher the levels of associated price uncertainty for business and consumers, as future prices become increasingly unpredictable.
What we mean by higher variability is this: larger things have more measured variability than smaller things (same units assumed). So if inflation was really high from year to year, say in the region of 50%, then it would probably be swinging mainly between 40% and 60%. In other words, a businessperson would be facing these wild swings of 20 percentage points in prices for inputs and items they sell. That is a real problem.
If, however, inflation was generally low at about 3%, then it might be swinging between 2.5% and 3.5%. In other words, the businessperson is only dealing with a 1 percentage point swing, which wouldn’t be a huge problem.
Therefore, high rates of inflation tend to dampen growth because of this added uncertainty and the resulting difficulty for future planning.
In the case of South Africa — a small, open economy — price changes are particularly difficult to forecast and have proved volatile in the past. This is because most price changes are closely correlated with the rand exchange rate, which is subject to a backdrop of supply-side shocks, including high levels of load-shedding, disintegrating infrastructure and an often dysfunctional government.
Reflecting this weakness and instability, our sovereign risk has risen, leading to a sharply weakening currency over the past six months, and very low and inadequate growth rates in an economy with 33% unemployment.
Strangely, in the face of this economic crisis, the Bank’s playbook sounds more like something from the US Federal Reserve than from Pretoria
Strangely, in the face of this economic crisis, the Bank’s playbook sounds more like something from the US Federal Reserve than from Pretoria.
Bank governor Lesetja Kganyago said in a recent address to the American Chamber of Commerce: “Our primary goal as a central bank is to anchor inflation expectations and to reduce the extent to which higher inflation does spill over into pricing behaviour in the following year. Our role as central banks is to keep inflation expectations anchored to prevent wage spirals from generating permanently higher inflation.”
Managing inflationary expectations may be a focus of the US or European central banks, but it is curious why it is the primary goal of their South African counterpart.
In fact, we may easily extract inflationary expectations (as perceived in the market) as the difference between the yields on inflation-linked and fixed-rate RSA government bonds. These inflationary expectations closely track the movements in the rand/$ exchange rate over time. Actual measured inflation also follows the rand/$ closely, but with a lag of between three and six months.
Critically, neither inflation expectations nor inflation itself are consistently related to short-term interest rates, the tool used by the Bank to implement monetary policy. The overwhelming determinant of South Africa’s rate of inflation is the exchange rate. So while inflationary expectations may constitute an input into, say, public sector wage bargaining, they constitute a misconstrued focus for the Bank.
By raising interest rates in a depressed economy already facing higher prices and depressed demand, the Bank has achieved little beyond crushing any residual growth prospects. This might be appropriate for an overheating economy with full employment in North America or the EU, but is entirely inappropriate for South Africa’s situation now.
Barr is emeritus professor of economics and statistical sciences at the University of Cape Town; Kantor is head of the Investec Research Institute and emeritus professor of economics at UCT
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