MONETARY POLICY: Late interest rate hike would still make sense
The question arises whether it makes sense to raise interest rates when inflation is about to peak and economic
activity is already slowing
THE RESERVE BANK should already have raised interest rates if it plans to do so, as monetary policy is supposed to be forward-looking. It won’t make sense to raise interest rates just as inflation is about to peak and the economy is slowing down. That’s the word from Sanlam group economist Jac Laubscher, although he puts the argument more subtly than I have summarised it.
Laubscher writes: “Time is marching on and this expectation [that the Bank will increase the repo rate later this year] is becoming increasingly doubtful. The question is whether an increase in the repo rate in the near future will still make sense given the normal lag in the impact of monetary policy and the expected course of the economy.”
In other words, the time it takes for interest rates to take effect and the expectation of a slowdown in SA’s economy would make an interest rate increase unnecessary by the time inflation is at or near its peak – in first quarter 2012.
Laubscher argues the shape of the global economy doesn’t augur well for our local economy. At an international level, economic activity has slowed markedly over the past quarter, especially in the manufacturing sector.
Although the decline is likely to be temporary and economic conditions will improve again later this year, growth next year is nevertheless expected to be hardly better than this year and forecasts are being adjusted downward. It therefore seems as if the low level of core inflation in developed countries will be maintained and the upward pressure on headline inflation over recent months as a result of rising commodity prices is probably close to a high.
Laubscher writes the European debt crisis essentially remains unresolved, as the political will to end it once and for all is lacking. European policymakers are apparently trying to gain time in order to enable the system to absorb the eventual losses without disrupting the markets, among others by giving banks time to strengthen their capital positions. The uncertainty about the European debt crisis will continue for some time to come.
With regard to SA’s economy, the outlook for the economic cycle is not very different. Economic growth is expected to slow after a better than expected performance in first quarter 2011 and there’s a real chance economic growth next year will be lower than in 2011.
Inflation is likely to reach a high in the next nine months. That could even be lower than 6%, depending on the rand and oil. The turning point will be within the normal lag period for monetary policy to take effect. Put differently, an increase in the repo rate in second half 2011 will make no difference to the course of inflation until after it has reached its high.
For Laubscher the question arises whether it makes sense to raise interest rates when inflation is about to peak and economic activity is already slowing down. However, monetary policy has become reactive since the introduction of inflation targeting.
Turning points in the interest rate cycle follow turning points in the inflation cycle instead of preceding them, which is contrary to the idea that monetary policy is forward looking in nature. Laubscher ascribes that to the politicisation of interest rate decisions and concludes with the question: “A late reaction by the (Bank’s) Monetary Policy Committee cannot be excluded, but will it make sense?”
Laubscher’s argument is convincing, but I believe the Reserve Bank has no choice but to raise interest rates if inflation nears or breaches the target – even if cost-push factors, such as oil and food, are the main reason for that, rather than demand. The Bank needs to send a message to the public that it will react to high inflation. It needs to do that to manage expectations. The answer to Laubscher’s question is: Yes, it will make sense to raise interest rates later on, as expectations feed into the inflationary process.