Mr Stals addresses the subject of inflation targeting as an anchor for monetary policy in South Africa  (Central Bank Articles and Speeches, 17 Mar 1999)
Central bank: sarb | Type: speech | Date: 1999-03-17

## Mr Stals addresses the subject of inflation targeting as an anchor for monetary poli South AfricaAddress by the Governor of the South African Reserve Bank, Dr Chris Stals, at a br meeting of the Johannesburg Branch of the Institute of Bankers in South Africa on 1 1999.

## 1.

IntroductionThe debate on whether South Africa should formally introduce an inflation target as for monetary policy recently revived again.

Such targets were introduced by a number countries over the past twenty years, in most cases with relatively good results.

Am countries can be mentioned New Zealand, Canada, Australia, Israel, Sweden, the Republic, Turkey and the United Kingdom.

The new European Central Bank recently deci to follow a more eclectic approach in which both the money supply and inflation targeted, with due recognition of an important role for a number of other monetary/ aggregates in the process of inflation creation.In the case of South Africa, formal targeting of the M3 money supply was introduced mid-1980's to serve as an anchor for monetary policy.

Like in many other countries, for monetary policy served South Africa well for some years and made an impo contribution towards the gradual reduction in the level of the rate of inflation embedded double-digit figure of between 12 and 20 per cent over a twenty-year perio 1972 to 1993 to an average of well below 10 per cent over the past five years.

The money supply as an anchor for monetary policy is based on the assumption that there stable relationship over time between changes in the money supply and total spen goods and services and prices, that is inflation.

Monetary policy is therefore direc controlling the rate of expansion in the total money supply as an intermediate obje the ultimate goal of protecting the value of the currency.

To achieve the int objective, the central bank uses various operational instruments such as open operations, variable minimum cash reserve requirements and changes in the conditi discount window facilities to influence the amount of liquidity in the banking sect of money) and the level of short-term interest rates (demand for money).In this monetary policy model, the central bank therefore has an ultimate objective the value of the currency), an intermediate objective (to control the money s supportive objective (to influence the amount of bank credit extension) and a nu operational instruments that can be used to achieve the goals of monetary policy. pointed out that, apart from the fairly generally accepted ultimate goal of protecti of the currency, central banks can choose any one of the more important elements model as an intermediate target for guiding their shorter-term decisions on monetar Some central banks may prefer a target for total domestic bank credit extension (DCE may prefer more direct controls over the amount of liquidity in the banking sector; set a more direct objective for the level of interest rates.

Be that as it may, the model as described above is a consistent model in which fairly stable relationsh between the various components of the model.

Whatever element may be chosen as an an for monetary policy, the other components of the model cannot and should not be ignor

## 2.

Moving from an intermediate objective to the ultimate objective of monetary policyIn South Africa, like in many other countries with a comparable experience of econom development, changes in the money supply in recent years lost some of their usefulness a anchor for monetary policy, and as an intermediate objective for achieving the ultimate g protecting the value of the currency.

This has happened, as in many other countries, ma because of a major liberalisation of the financial markets, a huge increase in the vol transactions in the money and capital markets, and an opening-up of the country f international participation, not only in respect of trade, but also for the inward and th movement of capital across international borders.In the process, huge increases in the money supply occurred that were not related direct indirectly) to total spending on real goods and services.

In technical terms, the add money supply remained in financial circulation and was reflected in a large decline i income velocity of circulation of the money supply.

More money became available for ever one unit of goods and services produced in the country.

And yet, these increases in the m supply did not lead to increases in the rate of inflation.

On the contrary, inflation Africa remained on a steady downward path, interrupted only by the adverse effects of exchange rate depreciations of 1996 and 1998.Reserve Bank guidelines for an acceptable rate of increase in the money supply, based on objective of a gradual reduction in the rate of inflation and providing for a desira realistic rate of growth in real economic activity, were overshot by a substantial margin each of the past four years.

Taking account of developments in the financial markets, an acknowledgement of a growing need for more money to service the growing volumes of financial market transactions, the Reserve Bank remained indulgent about these 'excessi increases in the money supply, as long as inflation continued to decline gradually.These developments, however, impinged on the credibility of the continued use of M3 as t intermediate target of monetary policy in South Africa, and opened up the way fo unreasonable criticism of monetary policy decisions taken by the Reserve Bank.

After mo than four years of a persistent 'excessive' growth in M3, with a clear downward trend inflation at the same time, the question has arisen whether the time has not come for Africa to follow the example set by many other countries and to switch from a money supp anchor for monetary policy to a more direct targeting of the ultimate goal, that is, inf its own right.In many statements made since 1997, the Reserve Bank has expressed its support for gradually moving towards this new approach.

In the annual monetary policy statements issu by the Bank in March 1998 and again in March 1999, the Bank indeed distinctly moved towards what it referred to as 'informal' inflation targets.

The view was expressed tha new approach was indeed more clearly linked to the directive contained in the Constitutio the Republic of South Africa in terms of which the Reserve Bank has been tasked with t responsibility of protecting the South African rand in the interest of economic developme the country.The Bank has always held the view that, in the case of South Africa, it is essential t Government through the Minister of Finance should endorse Reserve Bank targets or alternatively set quantitative inflation targets together with the Reserve Bank for the pursue.

Inflation expectations play a major part in the ongoing inflation process,commitment by not only the Reserve Bank but also Government to lower inflation wil credibility to a resolute and collective objective of bringing inflation in South with the relatively low levels that now apply in most other countries of the world.A recent view expressed by the Minister of Finance that South Africa should consi possibility of introducing inflation targeting, fuelled renewed speculation on the p such a move in the near future.

The ignorance revealed about inflation targetin subsequent public debate exposed once again the need for a better understanding intricate process of inflation in a modern economy.

It is often overlooked, for ex inflationary pressures can be created in many sectors of the economy and, if not de source, can require draconian monetary policy measures to avoid monetary accommodat with a continuing process of vicious inflationary circles that can harm the country time.It is also a fallacy to believe that a switch from money supply to inflation targeti South Africa to have lower interest rates almost instantaneously.

Taking account once the intimate relationships that exist between the various components of the moneta model, there is but little difference between inflation targeting and money supply (or for that matter a DCE, liquidity or interest rate anchor for monetary policy). will only decline to a lower level once inflation has been reduced on a sustainable lower level, and expectations about higher inflation in future have been elimin success from the minds of the majority of economic agents.

## 3.

Introducing inflation targetsThe introduction of inflation targeting is no easy task.

Apart from the question of be responsible for the establishment of the target, the following questions mus answered:

## How should inflation be measured?Although it is widely accepted that some form of a cost-of-living index or a consu index should be used for this purpose, there is no consensus on how exactly inflati be

measured ideally for the purpose of implementing monetary policy.

One of the deficiencies of any kind of price index for this purpose is that the statistics are consumption expenditure, and do not take account of possible future purchases - a de that does not apply to money supply targeting, where accumulated money balances for of the base aggregate.

## At what level or range should the target be set?'The

purpose of an inflation target is to provide the central bank with a rule monetary policy decisions.

For that purpose, a target band is not necessary: a si target is sufficient' (William A.

Allen: Inflation Targeting: The British Experience England publication).

A fixed point, however, is much more difficult to hit tha within a range.

Moving within a band also leaves some discretion to the central bank also provide more flexibility in the case of unforeseeable future price shocks.What models should be used for forecasting inflation?It must be understood that inflation targeting is about the future.

Any monetary p decision implemented today, for example a decision to raise interest rates, will normall affect actual measured inflation with a time lag of, say, twelve to eighteen months (or longer in some countries).

Inflation targets can therefore only be set in a forward-l model that takes account of long-delayed effects.

A reliable system for forecasting f inflation therefore becomes an essential precondition for any monetary policy model based inflation targeting.To what extent should inflation targeting be concerned with asset price inflation?It is well-known that the Board of Governors of the Federal Reserve System in the Unit States of America is always concerned about the dangers of financial and property asset inflation, and of the risk of a 'bursting bubble'.

The experience of Japan in the late can be quoted, where measured consumer price inflation never exceeded 4 per cent pe annum, and yet excessive increases in bank credit extension and the money supply creat unrealistic asset prices.

Eventually, when the bubble burst, the total Japanese eco collapsed.

## 4.

ConclusionIt is mainly for these reasons that many countries still prefer to stick to a more con intermediate target such as M3 or DCE, rather than the more complex and difficult infla targets.

South Africa's expressed intentions to move towards inflation targeting therefor careful preparation.

The Reserve Bank is in the process of improving its techniques forecasting inflation, and continues to analyse the changing relationships that are emerging in the new situation between the various components of the monetary policy modelReference should, in conclusion, be made to a third alternative in addition to interm targets, such as the money supply and inflation targeting, that can also be consider countries as an anchor for monetary policy, and that is explicit targeting of the exchan of the currency.

Countries such as Argentina, Hong Kong and the People's Republic of Chin have opted for this alternative with a reasonable measure of success.

There are, howe many reasons why this option is not regarded as appropriate for the present South Afri situation.

Suffice it to say that, in the macroeconomic monetary policy model used by Reserve Bank, the exchange rate is included as an important element in the comprehensi model, but it comes out as a result of the policy process, and not as an independent obje