Reserve Bank should react to new reality
The Reserve Bank’s monetary policy committee decided not to offer relief to the hard-pressed economy last week. This window of opportunity to lower interest rates was provided by declining rates of inflation and less inflation expected in future.
If cutting rates was not opportune on September 21, when will circumstances ever allow the Bank to do so?
The committee referred to a deteriorating assessment of the balance of risks. Risks to the inflation rate will always be present and will remain difficult to anticipate.
What should be expected from a central bank is not accurate risk assessments, but that it will react appropriately to the new realities, especially to the effect on prices of changes to the exchange rate, to which the economy has proved particularly vulnerable.
Such events are described as supply side shocks, to be distinguished from the extra demand that might be forcing prices higher. These supply side forces reverse as the exchange rate recovers or stabilises, or the harvest normalises or tax rates do not increase any further. They are temporary and should be left to their own devices to work themselves out of the system without help or hindrance from higher interest rates.
The Bank tends to react to inflation whatever its underlying causes. It often refers to second-round effects of inflation. The presumed danger is that when inflation rises, for whatever reason, firms with pricing powers will plan for more inflation and set prices accordingly. And so, inflation can become a self-fulfilling process unless corrected by higher interest rates to cause enough of a reduction in demand to prevent firms from charging much more.
Slack — an economy operating below its potential — is, therefore, the price that might have to be paid to achieve low rates of inflation, as the economy is now experiencing. The problem with this theory of self-fulfilling inflationary expectations in SA is that there is little evidence of it. Inflation and expected inflation mostly run closely together.
Expected inflation has been much more stable than realised inflation. This strongly suggests that expected inflation would have been a constant rather than a variable influence on actual inflation.
Expected inflation is surely not a simple extrapolation of past inflation. Inflation expectations will take account of the forces that are known to have caused inflation in the past including the effect of reversible supply side shocks on prices.
They will be informed by models very similar to the Bank’s own inflation-forecasting model, which predicts inflation of about 5% in 18 months, close to the inflation expected by the bond market.
The Bank and the market’s ability to forecast inflation is highly vulnerable to error given the unpredictability of the exchange rate and all the other supply side shocks that may send inflation temporarily higher or lower.
The inflationary forces that the Bank can influence consistently are those that emerge on the demand side of the economy, not the supply side. The problem for the economy is now one of far too little demand; too much slack and too little growth.
The Bank should adopt a very different approach to supply side shocks and alter its narrative accordingly to one that might convince the market that interest rate reactions to supply side shocks do not make economic sense. And that by not reacting to them when the economy is performing well below its potential does not mean the Bank is soft on inflation.
Kantor is chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity.