Bank governor gets inflation goal in while the going is good

Reserve Bank governor Lesetja Kganyago likes to move ahead rather than holding still. He used a key policy speech at the University of Stellenbosch recently to set out how he wants to take forward SA’s inflation-targeting policy. Kganyago told Business Times and the

Financial Times a couple of months ago that he wanted to see the 3%-6% target lowered, in an effort to cut SA’s inflation rate to levels closer to those of its major trading partners. This time, he was categoric that he wanted the target changed to a point target of 3%, to bring SA in line with the best performing of its emerging-market peers.

He used the speech to spell out the success of SA’s inflation-targeting policy in bringing down the rate to an average 4.5% over the past five years, from its 8% average of the past 60 years. He bemoaned that even at this level inflation was still high. The only way to cut it further, he argued, was to cut the target and so lower expectations that drive the behaviour of price setters.

With inflation and inflation expectations now well anchored at the midpoint of the target range, Kganyago evidently wants to lock in the gains while the going is good. But why he chose this moment to intervene is a question.

The new finance minister, Enoch Godongwana, has hardly had time to put his feet under the desk. It’s not clear whether Kganyago was trying to put him under pressure on the monetary policy front, or putting down a marker to ensure inflation targeting has a slot in the minister’s in-tray — along with the many other arguably more pressing problems Godongwana has to deal with.

In theory, a strong case can be made to lower the target over the next couple of years. In practice, there are significant risks. Foremost is what it might cost in terms of the higher interest rates the Bank might have to implement to get inflation to 3% and keep it around there. Kganyago suggested a “tolerance” range of 1% above or below, so between 2%-4%, which is far below 4.5%. But SA managed to get to 4.5% without high interest rates, he said, urging us to “not be especially worried about disinflation costs”.

Perhaps not. But what if inflation doesn’t stay as well anchored as the Bank and the market believe it is? If SA’s economy were miraculously to stage a strong recovery over the next couple of years, new and unexpected inflationary pressures might emerge that could force the Bank to raise rates sharply to get inflation down towards a new 3% target. That, in turn, could derail the recovery miracle — and we’d find ourselves worried about disinflation costs. That could happen, too, if the global environment were to turn sharply against emerging markets. Inflation isn’t as vulnerable as it used to be to a weaker rand, but the currency still matters, and the world is an uncertain place.

A second, even bigger, risk is administered prices. The inflation rate excluding administered prices — such as electricity, rates and water — is already heading towards 3%, so getting those prices under control is crucial to Kganyago’s ambition to lower the target, as he makes clear. He might almost be trying to use a lower target as a lever to drive the structural reforms that would be needed to get the inflation rate down for those prices.

The only way to get them down on a durable basis would be through efficiency-boosting reforms in municipalities and state-owned companies. Those are not in the central bank’s mandate. And the risk is that if it can’t get the buyin from administered price setters, it might have to drive other prices in the economy down with harsh action on interest rates to achieve a lower inflation target.

A third set of risks, though also of rewards, is in the fiscal policy space. Governments such as our own with large debt burdens don’t always like lower inflation because it takes away their ability to inflate away the value of that debt. And it already has a lot of expensive debt in issue priced for higher inflation and high political risk.

Against that, though, the government stands to benefit from lower inflation that reduces the cost of borrowing on its inflation-linked bonds. It could benefit also from lower inflation to the extent that spending items such as wages and grants are inflation-linked.

Godongwana might want to weigh up all of those factors. But one has to wonder whether cutting the inflation target would be top of the list of the political battles he wants to fight right now. Meanwhile, Kganyago has urged a “serious conversation” on the inflation target. It needs to be an honest one.