Bank’s tough choice as pressures build

AFEW weeks ago, the EFF marched to the Reserve Bank to hand over a list of 23 demands. The one that stood out for me was the second: cut interest rates and abandon inflation targeting to encourage more money to be invested in productive and manufacturing sectors — to stimulate jobs — rather than speculative sectors.

The EFF is not the only organisation that associates inflation targeting with stifling economic prosperity.

I believe the failure of government initiatives to address unemployment and economic growth has led many to believe the monetary policy regime is not working.

High inflation, which is the rise in overall prices, has negative effects on the real economy as it leads to distorted information. It erodes savings, inhibits growth, makes economic planning a nightmare, discourages investment, and encourages capital flight as domestic investors put their funds into foreign assets, commodities or real estate.

In its extreme form it provokes social and political unrest. High inflation tends to exacerbate inequality because the poor, whose wealth is in cash, lack access to advanced financial instruments, which act as a protection against inflation for the wealthy.

Choosing the correct monetary policy regime comes with certain trade-offs. Given the policy goals of monetary independence, financial integration and exchange rate stability, choosing any two would eliminate the possibility of choosing the third.

South Africa relies on foreign investment to maintain its current account surplus, therefore it is unlikely to abandon financial integration with the rest of the world. This leaves policymakers with one of two choices: stabilising the exchange rate by pegging the currency, or adopting an independent monetary policy such as inflation targeting, allowing market forces to determine the exchange rate.

In 2000, the Reserve Bank adopted inflation targeting as the core of its monetary policy by setting its long-term goal for CPIX (consumer price inflation less mortgage payments) of between 3% and 5%, later widened to 6%.

The bank also adopted transparency and accountability, continuous reassessment of policy based on updated forecasts and high-level discretion when setting monetary policy.

The alternative to inflation targeting is targeting growth in money supply (M3 targeting), which formed the core of the bank’s monetary policy until the mid-’90s. It was abandoned due to the unstable relationship between money supply and aggregate prices. M3 targeting is also a less comprehensive approach to inflation targeting.

Many argue that we should target the exchange rate. This camp blames inflation targeting for significant capital inflows, which it believes overvalues the

Inflation targeting does not stifle growth

currency. This argument is confusing because we need inflows to fund investment necessary for growth, especially since we are a lowsaving country. Also, foreign exchange market distortions caused by adopting an inflexible exchange rate regime have a negative effect on long-run growth.

Inflation targeting does not stifle economic growth. The bank’s mandate is to target inflation, but after the 2008 financial crisis it developed a leaning towards growth considerations. This is why it finds itself in a bind. With inflationary pressures indicating that rates need to increase to tame future price increases, slow economic growth compels the bank to keep rates steady.