Predicting interest rates has become a bit more puzzling
It’s sometimes easy to tell from the very first sentence of its statement what the Reserve Bank’s monetary policy committee is going to do about interest rates. Not this time. In July and in September, the committee opened its post-meeting statement saying risks to the inflation outlook were materialising and the inflation forecast had been revised upwards — but then opted to keep rates unchanged. This week, the committee began by saying the near-term inflation outlook had improved. It then cut the inflation forecast — but opted to raise interest rates.
The controversial decision may well signal a shift in the way the committee implements inflation targeting, one which will make its decisions that much harder to predict.
Two stand-out sentences in the committee’s statements make that clear.
The first comes in that opening sentence — the near-term outlook had improved, said the committee, “however, the longer-term risks to the inflation outlook remain elevated”. The emphasis on the longer term is new. It’s not that the committee shouldn’t be looking beyond the
12- to 18-month time frame it traditionally targets, and it clearly should have an eye on the risks to inflation beyond its standard three-year forecast period. Reserve Bank governor Lesetja Kganyago has lately been flagging the heightened global risks that come with the end of what he called the “Goldilocks” global economy, and the Bank in its recent Monetary Policy Review highlighted SA’s vulnerability to changing global conditions.
Explaining its decision this week, the committee flagged upside risks to the longer-term inflation outlook that included tighter global financial conditions, a weaker exchange rate and higher international oil price, as well as rising electricity and water prices. Though it upped its assumptions on the oil price and electricity tariffs, its forecasts for headline inflation and for core inflation still looked better for 2018 and 2019 and were unchanged for 2020, at levels well within the target range, even if still above the 4.5% midpoint.
In the past, that would have been used to justify keeping rates on hold, at the very least. But this time, said the committee, it “had to decide whether to act now or later” on the longer-term risks.
Many will agree with the assessment of the risks. But we have the Bank’s three-year inflation and growth forecasts, which are updated at each meeting. We don’t have its longer term forecasts — so life could become tougher for economists trying to predict the committee’s decisions.
That’s particularly so given the second stand-out sentence: “Monetary policy actions will continue to focus on anchoring inflation expectations near the midpoint of the inflation target range in the interests of balanced and sustainable growth.”
In other words, the committee is now targeting expectations, rather than inflation itself — and it is targeting the 4.5% midpoint more than the 3%-6% range. Kganyago has repeatedly emphasised his concern that inflation expectations have remained stuck near the 6% top of the target range.
Expectations do play a key role in inflation outcomes because they shape the behaviour of the price setters and the wage setters, but there is some debate among economists about the exact relationship between expectations and inflation.
Kganyago has made it clear he wanted to use the current period of relatively low inflation to get expectations down, in an effort to reduce SA’s structurally high inflation rate — and that he has 4.5% in his sights.
But that could mean more interest rate hikes to come than markets anticipated. Says Absa Capital economist Peter Worthington: “The perplexing decision by the MPC raises big uncertainties about the future course of monetary policy.”
The Bank will clearly need to do some explaining and engaging if it’s to maintain its track record of predictable, consistent and transparent monetary policy communication.
‘Perplexing decision raises uncertainties over future course of monetary policy’