Monetary policy and the South African landscape

The South African economic landscape is an ever changing one that in recent months seems to be at the mercy of external global market trends and fears. Whether the current monetary policy framework of inflation-targeting approach is the best for South Afr

In a recent study by Kabundi and Ngenya (2011) published in the South African Journal of Economics they examined the actual impact of monetary policy on the real economy – how effective is monetary policy in determining nominal prices and shaping real economic outcomes. The study involved using a new model, which simply used about 110 different monthly economic variables to measure the actual impact of changes in monetary policy. The outcome of their studies proved quite interesting and concluded that even though monetary policy does have an impact on key macroeconomic variables, the actual effect does not really translate into the long term[1].

There have been various studies that have looked at the direct link between growth levels and inflation. The overall consensus reached is that there is a negative correlation between long term economic growth and inflation. This means that over the short term a once-off hike in inflation can contribute to an increase in real output, but over the longer term a continuous rise in inflation will reduce growth levels. Research also showed that a higher level of inflation actually leads to greater inequality[2].

Therefore the best monetary policy should be one that targets and maintains a moderate level of inflation while ensuring against excessive volatility in the shorter term. Out of the three possible frameworks, that being Friedman’s k% growth rule, exchange-rate peg and inflation-targeting, the latter proves to be the most flexible and best fit for our emerging country. A study done by Arron and Muellbauer (2007) shows that since the implementation of inflation targeting in South Africa, we have experienced improved transparency, credibility and predictably of monetary policy decision making. The study also shows since the framework has been implemented there has been an improvement in macroeconomic indicators in South Africa and that on average there has been lower inflation volatility and therefore reduced economic uncertainty[3].

Inflation targeting has proved to be the best framework yet there are some academics and policy makers that remain sceptical. While some of these fears and criticisms are unfounded there are possible valid concerns, some of which started to emerge during the 2007 oil crisis and after the 2008 market crash. The financial meltdown exposed the fragility and inefficiencies of many markets but it also did something else that many investors and academics were not consciously aware of until that point – it showed just how intertwined and connected the global economy had become. As a relatively small and open economy, South Africa is vulnerable to exogenous shocks and will be more exposed to high trading volatility. Having inflation targeting as a monetary policy framework has raised concerns around the extent to which supply shocks (like oil prices changes) affect the efficiency when implementing decisions.

The rocky market conditions over the last few years have shown us that although our monetary policy was designed to focus and contain demand-induced inflation and to create a smoother business cycle, it should theoretically not respond to supply-shocks. For example if there is a shortage of oil, theoretically this would result in a reduction of real output and therefore oil prices would rise. In order for monetary policy to be effective and to contain inflation arising from the supply-shock, interest rates should in theory be aggressively increased. This is not really a viable option and the question emerges about why monetary policy responds to supply-shocks at all. A study conducted by Bernanke (1997) actually proposed the volatile after-effects of oil (supply) shocks were due not only to direct changes in oil prices, but rather from the tightening of monetary policy that resulted. This means that monetary policy decision responses to such shocks could produce the short-run volatility that results[4]. Prior to 2010 we saw our monetary policy committee actually doing just this – becoming more responsive to movements in the oil price. This defeated the actual aim of inflation targeting as a monetary policy framework as it meant that monetary policy was trying to control supply shocks that were out of its control. Since 2010 we have seen a change in policy approach and now inflation targeting is doing what it is supposed to – that being to focus on demand-induced inflation. This explains somewhat the MPC’s dovish and accommodative stance despite rising inflation - as global crude oil prices still remains a key risk.

The MPC has identified the main source of current inflation as coming from cost-push pressures rather than from demand. This as well as the fact that economic variables point to the slow-down in the domestic economy means that they will hold off increasing the repurchase rate for as long as possible. When inflation targeting was implemented it aimed at not only creating a system that would promote economic stability and growth but also to enforce transparency and accountability. The South African Reserve Bank (SARB) has managed to do this, as well as being able to identify the possible challenges and find ways to solve them. This article merely touches the surface of the dynamic of the current monetary policy framework and its limitations – it is something that is much more intricate. In saying that, at present - based on our emerging market economy, we believe that the SARB are implementing the inflation targeting framework as effectively as possible. While it may seem to some that they are not actively doing anything to offset inflation and influence the markets, based on what our monetary policy aims to achieve, in current market conditions their lack of reaction could be the best decision.

1 A.Kabundi and N. Ngwenya. Assessing Monetary Policy in South Africa in a Data-Rich Environment, SA Journal of Economics (2011)

2 S.Fisher, The Role of Macroeconomic Factors in Growth, Journal of Monetary Economic (1993)

3 D.Hodge, Inflation and Growth in South Africa, Cambridge Journal of Economics (2005)

4 B.S Bernanke, M.Gertler, M.Watson, C.A Sims, B.M Friedman, Systematic Monetary Policy and the effects of Oil Price Shocks, Brookings Papers on Economic Activity (1997)