South Africa’s interest rate policy: Prudence demands a Bold Move

Industrial economies are experiencing a very fast and deep worsening of economic conditions. Attempts to stop the rot with massive injections of fiscal resources and easy money have been largely ineffective. Since the middle of October, the crisis has been transmitting rapidly to emerging countries via stock markets, commodity prices and demand for exports.

South Africa is not immune, as the significant slowing down of the economy and collapse of asset prices testify. This picture is complicated by the persistence of inflationary pressures coming from the previous cycle of high commodity and food prices that are filtering through the rest of the economy, coupled with the significant depreciation of the rand of the last few months. The issue is what the correct monetary policy response is.

The problem is, this is one of those classical situations in which our models are not a good guide of future economic developments. In the same way that the dimension of the crises in the developed economies was largely unpredictable, so the size and speed of the effect on emerging countries are impossible to quantify at the moment. In this situation, monetary policy prudence might imply policy choices that are appropriate to the worst possible outcome from the economic crisis.

Although inflationary pressures are still a reality in the South African context, this is not the greatest fear that we are confronting. The real worry is the uncertainty around the effect that a standstill of international economy would have on our domestic economic dynamics. Already real growth is much slower, consumer expenditure is rapidly contracting and the worsening current account figures tell of difficult export market conditions. Keeping interest rates unchanged at this moment might worsen sentiment and contract internal demand beyond what is required to maintain monetary stability. A prudent response might entail an immediate reduction – by 50 basis points – of the cost of borrowing to signal a readiness to respond to worsening international economic conditions.

The great advantage of inflation targeting is that it allows a transparent and accountable use of judgment and intuition once our formal models fail to provide a safe guide of future economic dynamics. Let’s hope we are lucky too.