By Jac Laubscher, 20 January 2016
It therefore follows that in principle one can expect the two policy regimes to be well aligned when it comes to the required policy stance in the face of current macro-economic conditions, in particular as far as its cyclical aspect is concerned.
Where policies addressing structural challenges are concerned the two policy regimes can (and should) deviate according to the ability of each to address a specific structural issue. In the past the SARB in particular has been very clear that the responsibility regarding most structural policies in general does not reside with it. The unfortunate reality is that the cyclical behaviour of the economy is often overwhelmed by structural issues, as is the case at the moment.
The prevailing macro-economic situation is tricky to say the least. Economic growth (unlikely to exceed 1% in 2016, with a real possibility of a technical recession) is far too low for the country’s needs, inflation is heading towards the high end of the inflation targeting zone with the risk being to the upside (mainly because of an untethered rand and rising food prices), the traditional balance of payments constraint appears set to tighten as the availability of international capital to finance the deficit on the current account contracts, and confidence is at a multi-year low.
How much of this is attributable to an unsupportive international environment and how much to domestic weaknesses is a moot point, although it has an important bearing on what the correct policy response should be. An epochal shift appears to be taking place internationally to the detriment of emerging-market countries, adding to home-grown structural deficiencies that have been neglected for much too long. It is similarly difficult to disentangle cyclical and structural issues, although the latter seem to dominate.
So how does monetary and fiscal policy come into play given this background? Is there any room at all for either policy to respond positively to the weakness in real economic conditions?
The fact of the matter is that fiscal policy finds itself in a tight bind. The fiscal space that was available when the current administration took office in 2009 has been wasted through a sharp increase in recurring current expenditure (in particular the government wage bill) instead of it being used to address some of the structural bottlenecks that are holding the economy hostage. The increasing trend in government debt needs to be arrested to at least have a chance of avoiding a credit rating downgrade to junk status, although it may not be enough. (Rating agencies increasingly emphasise the low growth potential of the economy.)
A further tightening in fiscal policy is therefore to be expected, probably in the form of increasing taxes rather than cutting government expenditure. Creating room for addressing structural deficiencies would require a reallocation of government expenditure from current to capital expenditure ̶ an unlikely outcome. (More about fiscal policy options in my next commentary.)
What then about the contribution of monetary policy? Should it reinforce the tight fiscal policy? Or should it lean against the headwinds coming from a tight fiscal situation?
Normally one would say the alignment of monetary and fiscal policy requires them to pull in the same direction, be it expansionary or contractionary, and not opposite directions. But is a tightening of monetary policy in conjunction with an unavoidably tight fiscal policy the best option at this point in time?
Should monetary policy not lean towards being accommodative to partially compensate for a contractionary fiscal policy forced on South Africa by the need to stabilise government finances? And is there room for a more lenient monetary policy stance in view of the SARB having declared itself to be in a tightening cycle to combat inflation and protect its credibility?
The starting point is of course how sacrosanct the 3 - 6% inflation target should be. The target was chosen at a stage when low and stable inflation was seen as the holy grail of macro-economic policy and developed countries targeted a 2% inflation rate. Since then the wisdom of a singular focus on inflation as the objective of monetary policy has been questioned, deflation rather than inflation has become a major concern for some central banks, the difficulties of dealing with the zero lower bound on interest rates have been well demonstrated, and the appropriateness of a 2% inflation target for developed countries is no longer cast in stone, with reputable macro-economists such as Laurence Ball and Olivier Blanchard, a former chief economist of the IMF, suggesting that 4% could be a better choice.
The SARB would probably argue that relaxing the inflation target when it is under threat would leave inflation expectations without an anchor and undermine its credibility, and understandably so. It would be preferable to relax the target when inflation is well inside the current target band. So at this point in time the question is rather whether the SARB should be even more flexible in its approach than it has proved to be in the past and what the consequences for inflation expectations, the acid test for monetary policy credibility, would be.
A fundamental question is whether we (meaning the SARB and mainstream economists) do not overestimate the role of inflation targets and therefore monetary policy in the formation of inflation expectations. Research recently conducted among firms in New Zeeland, the pioneers in inflation targeting having first adopted it formally as a monetary policy regime 25 years ago, shed some interesting light on this question.
The research shows firstly that firms differ a lot in the attention they pay to recent macro-economic conditions, with beliefs regarding recent inflation being widely dispersed. It is noteworthy that most firms do not regard aggregate inflation as important for their business decisions and therefore put little effort into keeping informed about it ̶ they rather focus on variables such as economic growth, exchange rates and interest rates. Inattention to recent macro-economic conditions plays an important role in the diversity of future expectations, also with regard to inflation.
Secondly, firms that face less competition tend to pay the least attention to macro-economic data, in particular aggregate inflation, probably as a reflection of confidence in their pricing power – a point that is highly relevant to South Africa with its dominant oligopolistic market structures. Thirdly, firms that do not employ professional inflation forecasters (e.g. economists employed by large firms) tend to have higher inflation expectations. Fourthly, firms tend to respond more to negative news than to positive news, resulting in asymmetrical expectation formation (which could explain the upward bias to their inflation expectations).
The researchers concluded that firms have only a limited grasp of the stability in inflation dynamics under inflation targeting. It also follows that monetary policy making that relies on managing inflation expectations as part of the transmission mechanism may not be effective. Come to think of it, it is probably unrealistic to think that firms will take pricing decisions bearing in mind the consequences thereof for aggregate inflation, knowing well that their competitors are unlikely to do so.
It would be interesting if similar research could be conducted among South African firms. It is an open question to what extent firms’ inflation expectations and pricing decisions are in fact influenced by monetary policy, specifically the official inflation target.
Readers will probably refer to the existing inflation expectations survey conducted by the BER on behalf of the SARB. However, the research envisaged here will differ in important respects from the official survey. Firstly, it will include a much greater number and variety of firms. Secondly, it will employ a different methodology, in particular omitting the guidance provided to respondents by informing them of the recent history of inflation, resulting in what could be described as “managed” expectations. (In the New Zeeland research 20% of firms believed inflation to have amounted to 10% in the previous 12 months, compared with the actual number of 2%, while a third were more than 5 percentage points off the mark!).
With the exchange rate of the rand being the most high-profile economic variable in South Africa it is probably the single most important influence on inflation expectations. In so far as monetary policy does not target the exchange rate (as repeatedly emphasised by the SARB) and indeed can do little to influence it, it is questionable whether inflation expectations are as well anchored as generally supposed.
That leaves us with the conclusion that with a tightening in fiscal policy being unavoidable, a somewhat looser monetary policy that does not aim to further dampen already weak domestic demand would be in order and need not be dogmatically feared.