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Is the Reserve Bank using the right tool to fight inflation?

04 December 2009 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

South Africans are all too familiar with the Reserve Bank’s main weapon against inflation – interest rates. The bank ups interest rates whenever it feels the domestic economy – as measured by CPI – is overheated. And it cuts interest rates when it feels p

Economists are puzzled by the slow response of South Africa’s inflation rate to recent interest rate cuts. Since December 2008 consumers have benefited from six rate cuts totalling 500 basis points, while inflation has shown incredible stickiness. This apparent disconnect prompted a team of economists to investigate the country’s obsession with inflation targeting. Professor Charlotte Du Toit from the African Institute of Economic Modelling (AFRINEM) of the University of Pretoria and Carel Van Aardt of the Bureau for Marketing Research (BMR) of UNISA met with journalists on 26 November 2009 to reveal their initial findings. “South Africa suffers from relatively high and sticky price inflation,” said Du Toit. The question is why prices and inflation failed to drop significantly in line with those in the global economy?

South Africa is different

To understand the debate we must familiarise ourselves with the term structural inflation. This is quite simply that portion of consumer inflation that remains in the economy irrespective of changes in domestic economic activity and interest rates. Once we accept the existence of structural inflation we gain an appreciation of just how ineffective interest rates are as a tool for fighting inflation. Du Toit described interest rates as “a very blunt and ineffectual tool” This statement is proven by measuring structural inflation.

AFRINEM and the BMR applied three cutting edge economic techniques to quantify this phenomenon. The first was a comprehensive supply-side econometric analysis. The idea with this analysis was to determine a “dynamic basis – a very good sense of how the economy would respond if you tweak here and there,” said Du Toit. This analysis captures the underlying capacity constraints too. The second technology is knows as the elasticity of CPI to changes in the Repo rate. The economists wanted to know “how sensitive inflation is to changes in the Repo rate.” And the final method is a sophisticated modern-day economic analysis technique known as Neural Network Analysis.

Some interesting discoveries

During their research the team defined and tracked two important inflation measures. The first is known as NAGRI, or non-accelerating output growth of inflation. This measures the percentage of inflation that remains in the event of an economic contraction. If GDP growth trends to zero – or falls into negative territory – NAGRI is the inflation that remains? NAGRI thus approximates the structural rate of inflation that exists irrespective of economic adjustments. The team determined this structural rate of inflation at around 4.5%. The team noted that there has – since the 1990s – been a marked decline in the NAGRI – from around 15% in 1989 to just 4.5% today. Even so, the finding has massive implications where the Reserve Bank’s target band is concerned. It makes no sense to keep the lower limit of the band at 3% when structural inflation is significantly higher.

The second measure was introduced as NAGRINT, the non-accelerating interest rate of inflation. The team calculated NAGRINT for three different interest rate measures, the long interest rate, the 3-month bank acceptance rate and the Repo rate. In each of these measures the structural inflation was calculated at between 3.7% (long) and 5% (Repo). The conclusion: “4.5% of CPI will remain and will not adjust to changes in economic activity – while approximately 5% of inflation will not adjust if we change the Repo rate,” said Du Toit.

Future inflation targeting solutions

There are many factors driving inflation. Unemployment, regulated prices, additional taxes and the rand/dollar exchange rate to name a few. This study proves that too many of the items in Statistics SA CPI basket are non-elastic to interest rates… In other words the price of things like medical aid, municipal services and regulated goods and services show no correlation with changes in interest rates. Almost half of the goods included in the basket fall into this ‘inelastic’ category. Using this basket as a measure of the success of interest rate cuts or hikes is simply inappropriate – and likewise – using interest rates as a tool to affect prices in the basket.

There are numerous constraints in capacity which affect the likely structural inflation in an economy. For this reason simply tampering with interest rates might never create the significant declines in inflation the Reserve Bank is aiming for. Instead government needs to focus on constraints in capacity. We have to accept that inflation can be brought under control by targeting labour market issues, capital issues, productivity issues and institutional and environmental issues. Du Toit noted: “You cannot curb inflation unless you know what the fundamental drivers of inflation in the economy are included.”

Will the governor take note?

Could we see a policy change under the new Reserve Bank governor? Gill Marcus has already indicated a reluctance to tamper with the bank’s tried and tested approach. But she’s not averse to making changes either. She seems to have more of a personal touch than her predecessor, Tito Mboweni. At her first Monetary Committee Policy (MPC) press release she addressed the press as a member of the MPC team. And soon afterward she appointed two senior Reserve Bank officials (and also MPC members) as advisors.

Editor’s thoughts: It seems absurd to use a poison (interest rates) that only works on a small percentage of the weeds (items in the CPI basket) – yet that’s exactly what the Reserve Bank is doing… They use interest rates as if they have a significant impact on domestic inflation, when in reality the impact is limited at best. Are you among the thousands of frustrated consumers who believe its time to do away with the Reserve Bank’s inflation targeting policy? Add your comments below, or send them to gareth@fanews.co.za

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