Lesetja Kganyago: The outlook for monetary policy
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the 2016
SA Tomorrow Investor Conference, New York City, 4 October 2016.
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Good morning Ladies and Gentlemen. It is a great pleasure for me to be here today to highlight
recent monetary policy developments and the outlook.
Monetary policy continues to face a difficult environment. Targeted inflation has been outside
the target range of 3-6 per cent during the first half of the year, and despite a decline to within
the range, to 5,9 per cent in August, this respite is expected to be temporary.
For some time we have been lamenting the fact that we are experiencing the classic central
banker dilemma: one of low and slowing growth alongside high and rising inflation. This
combination has been driven by exogenous factors interacting with the particular price and
wage determination processes of South Africa, which compounds the dilemma. We have
focused on reducing inflation to within the target range and containing inflation expectations,
while at the same time limiting the possible negative impact on growth. Since January 2014,
we have raised our policy rate by 200 basis points, from 5 to 7 per cent, or a little more than 1
per cent in real, ex ante terms.
Our most recent policy statement reflects the sense of the committee that monetary policy
actions have helped to better contain inflation expectations and that the outlook has improved
for some of the external factors impacting on the inflation forecast. We still face considerable
uncertainty, but we believe downside and upside surprises are now about equally likely,
allowing the committee to assess the balance of risks to be neutral.
The challenge for monetary policy is that we have experienced repeated exogenous shocks
which have fed into core inflation and wages. As a result, we now expect core to reach 5,9 per
cent, almost at the top of the target range, while inflation expectations have converged on 6 per
cent. These sorts of shocks pose a different sort of problem to excess demand enabling
ongoing price increases. During the past three years, these shocks have included the
exchange rate, domestic electricity prices, international oil prices and food prices. They have
coincided with negative growth shocks. Global growth has been relatively weak in recent years
and commodity prices have fallen since 2011, limiting foreign demand for South African
exports. Meanwhile, domestic demand has decelerated. In the mid to late 2000s, household
debt levels reached unprecedented highs. In the aftermath of the crisis, however, credit
extension to households has been subdued, reflecting a moribund housing market, regulatory
demands and pro-cyclical behaviour by financial institutions - despite historically low interest
rates.
Meanwhile, fiscal policy was used to provide a counter-cyclical response to weaker domestic
and global demand, yet as government's debt metrics deteriorated and growth kept slowing,
while US monetary policy normalisation raised interest rate risks, it became clearer that
government needed fiscal consolidation. These headwinds to growth were reinforced by more
idiosyncratic shocks, including electricity shortages and drought. The final result was a mix of
stagnant growth and higher inflation.
As monetary policymakers, we have over time looked through the first-round or impact-effects
of exogenous shocks, and tried to assess second-round effects, where higher prices translate
into higher generalised inflation and higher wage settlements.
With modest economic growth and robust wage growth, partly in response to these exogenous
forces, unit labour costs have remained an underlying support to core inflation. Stronger growth
in investment, exports or productivity resulting from sustained real exchange rate depreciation
should have provided greater lift to growth in disposable income and helped to moderate unit
labour costs. In recent years, this hasn't transpired, keeping core and headline inflation high,
and pushing down on potential growth. This has limited the scope for maintaining low real
interest rates.
Over the past few months we have downwardly revised our inflation forecasts. Since the
January MPC, the expected average inflation rates for 2016 and 2017 have declined from
respective averages of 6,8 per cent and 7,0 per cent to 6,4 per cent and 5,8 per cent; the peak
on the inflation forecast, which has been consistent for the fourth quarter of this year, declined
from 7,8 per cent to 6,7 per cent; and the length of the breach of the target has been shortened,
with inflation now expected to return to within the target range during the second quarter of
2017, rather than in the fourth quarter of 2017 as forecast in January.
These are sizeable revisions. However, before we get too complacent we should note that the
revisions to the 2018 forecasts have been a lot more modest. While the expectation remains
for inflation to be within the target range for the whole of that year, the trajectory, at an average
of 5,5 per cent, remains uncomfortably close to the upper end of the target range. Similarly,
our forecasts of core inflation also show a persistence well above the 5 per cent level over the
forecast period.
There are two main reasons for the more favourable forecasts. In part, the rise in the
repurchase rate of 200 basis points since January 2014, with the most recent increases this
year in January (50 basis points) and March (25 basis points), has helped to guide expectations
of future inflation. As the forecasts that we consider in MPC meetings are based on an
unchanged policy rate, the forecast in January would not have incorporated the cumulative
75 basis point increase that transpired in that and the subsequent meeting.
The second part relates to changed assumptions regarding the exogenous variables in the
model. In particular, the assumption regarding the rand exchange rate outlook has improved
as a consequence of greater stability and appreciation over the course of the year. The
international oil price assumption has been increased from its low point in January, but not
sufficiently to offset the positive revisions.
There has also been a change to how we see the risks to the forecast. In January, the risks
were seen to be unambiguously to the upside. An upside risk was maintained for the next three
meetings, despite downward revisions to the forecast, and in July the MPC assessed these
upside risks to have moderated. In the September meeting, the risks were seen to be more or
less balanced. However, as the MPC pointed out, while the outlook has improved, these
improvements are highly vulnerable to changes in the risk factors affecting inflation, and these
factors can change very quickly.
I will now highlight some of these risk factors.
The global growth outlook continues to be challenging. Growth in the advanced economies
remains subdued. Uncertainty about the strength of the US recovery has contributed to a delay
in further monetary policy tightening in the US. These delays have supported the rand and
other emerging market currencies. While an interest rate increase in the US is inevitable, the
timing continues to remain uncertain. This uncertainty, and changing perceptions, is likely to
keep the rand relatively volatile. This may be tempered somewhat by a more muted trajectory
for US rates.
These developments have impacted on the pattern of global capital flows. Data from the
Institute for International Finance show a sustained recovery of capital flows to emerging
markets since earlier this year, following the pronounced decline in the second half of last year.
The predominance of flows into emerging market bond markets suggests that the search for
yield remains a driving factor. Reflective of this pattern, since the beginning of the year,
nonresidents have been net sellers of South African equities, but net purchasers of South African
government bonds.
Apart from US monetary policy, other potential global risks pertain to China and Brexit. The
effect of a slowing Chinese economy on South Africa is mainly through commodity prices. The
ultimate impact on our terms of trade however will depend on the extent to which oil prices are
also affected. Nevertheless there is no doubt that falling commodity prices are negative for
South African growth, the value of our exports and the exchange rate. While the outlook for
China has improved since the beginning of the year, concerns about the stability of the financial
sector persist.
The impact of the UK decision to leave the EU is still unclear, but the high degree of market
volatility that followed the decision subsided somewhat. For now it seems that the impact will
be mainly contained within the UK, with some fall-out on the EU. But until the full terms of the
withdrawal are clear, uncertainty will persist, which will impact negatively on investment
sentiment in the UK. The direct short-term impact on South Africa is expected to be fairly
limited, but there could be longer term impacts on trade and financial links, and on tourism
from the UK into South Africa, should a sharp growth decline transpire. We are also likely to
be affected indirectly to the extent that there are broader negative global spillovers than
currently expected.
A consequence of the decline in commodity prices has been a slowdown in growth in
SubSaharan Africa (SSA), for many years one of the world's fastest growing regions. The IMF
forecast for SSA growth for this year is 1,6 per cent, compared with the past decade average
of 5,5 per cent. With the region accounting for almost 30,0 per cent of South Africa's
manufactured exports, we are particularly exposed to this slowdown and will weigh against a
sustained improvement in our trade balance (as is discussed in our recently released Monetary
Policy Review).
Most of these developments impact the exchange rate, either directly or indirectly. The rand
remains an important determinant of inflation, and therefore we need to have a careful
assessment of the risks. This is complicated by the fact that the observed pass-through from
the exchange rate to inflation appears to have declined in recent years. Given the pressure
this places on the margins of South African firms, the monetary policy committee has been
concerned for some time that this subdued pass-through could reverse at any stage.
The rand started off the year in a particularly vulnerable spot following domestic developments
in December that raised risk perceptions, followed by renewed concerns in January regarding
the outlook for the Chinese economy. Since its low point in late January, while remaining
volatile, the rand has appreciated by about 24 per cent on a trade-weighted basis, and by about
15 per cent year to date. Appreciation has been pronounced against troubled advanced
economy currencies, but less so compared to other commodity producers and emerging
market economies. The Chinese economy appears to have stabilised, capital flows to
emerging markets have resumed, and US monetary policy has remained on hold.
Domestically, the positive second quarter growth outcome and the significant narrowing of the
current account deficit, and more recently speculation regarding the large M&A transaction in
the market also helped to underpin the rand's recovery.
Going forward, it is uncertain whether the rand will sustain current levels. The rand remains
vulnerable to global factors, as well as domestic risks, including a possible ratings downgrade,
though the rating got affirmed during the course of the mid-year. Unfortunately, predicting the
rand is extremely difficult, given the multiplicity of factors affecting it. In our model, we make a
simplifying assumption of a stable real effective exchange rate over the forecast period,
(implying a nominal change in line with inflation differentials) and then try to assess the risks
to this assumption.
The starting point is critical. We generally set the starting point at the prevailing level of the real
effective exchange rate, unless we believe that that level represents a clear over- or
undervalued position. At the most recent meeting of the MPC, the risks to inflation from the
exchange rate were seen to have moderated somewhat, given recent positive developments.
I should emphasise that our focus on the rand is not because we would like to see a particular
level of the rand. Rather, our focus is on the possible impact of the rand exchange rate on the
inflation outlook. This needs to be assessed in conjunction with all the other factors that are
impacting on the inflation outlook at that time. We would also need to assess the extent to
which any movement is likely to be persistent, or if it is merely short-term volatility.
A related point concerns the questions recently raised as to whether we would be purchasing
dollars in the M&A transaction. Our position on the rand and reserve accumulation remains
unchanged.
First, we remain committed to a flexible exchange rate, determined by market forces. However,
in the event of abrupt movements in the rand exchange rate that could threaten the orderly
functioning of markets, the SARB will consider becoming involved by way of facilitating the
smooth execution of trades, with the objective of ensuring orderly market functioning.
Second, in the case of inflows that display somewhat more permanent characteristics (such
as FDI or M&A related inflows), we may seek to increase our foreign exchange reserves when
these opportunities arise and/or market conditions are conducive. Any changes in our foreign
exchange reserves position will be published in our monthly statement of asset and liabilities.
Any such purchases will be for the purpose of accumulating reserves, rather than to achieve a
desired exchange rate outcome.
Not all the drivers and risks to inflation are external. For some time food prices have been an
upside risk to the inflation outlook in the face of the protracted drought experienced in the
country. For the past few months our food price forecasts have been more or less in line with
outcomes, and we expect prices to peak in the third quarter at over 12 per cent. This assumes
that normal rainfall patterns that are currently predicted do in fact occur. Alternatively, should
crop estimates surprise on the upside, food prices could fall faster than expected, and pose a
downside risk to the inflation outlook. This is despite the fact that meat prices are expected to
remain elevated as farmers restock their herds. The global context, however, also matters, and
we have seen FAO data showing global prices to have ended a sustained deflationary
trajectory.
A final consideration in the inflation forecast is the role of wage growth in a weak economy.
Our forecast includes some decline in private employment which, alongside some pickup in
the aggregate growth rate, results in a rise in productivity per worker and moderates growth in
unit labour costs.
The domestic growth outlook remains a concern, despite the favourable second quarter
outcome, which followed a quarter of contraction. We assess the outlook to remain relatively
subdued, but our forecast was revised up for this year to 0,4 per cent, and to 1,2 per cent and
1,6 per cent in the next two years. We assess the risks to this forecast to be more or less
balanced. Our estimate of potential output for this year is 1,4 per cent, rising to 1,7 per cent by
2018. This suggests below-potential growth and a negative output gap over the forecast period.
However, because our estimates of potential output growth have been revised down during
the past year or so, the output gap is not as wide as previously thought.
Lower potential growth and a small output gap suggest that the cyclical stimulus that monetary
policy can give to growth is limited. The growth constraint is structural in nature, and should be
tackled through structural reforms, for example those envisaged in the National Development
Plan.
Nevertheless, in a flexible inflation targeting context we have to be mindful of the impact of our
actions on the cyclical element of growth. For this reason, the current interest rate cycle has
been very moderate, particularly in comparison with previous interest rate cycles.
At our most recent meeting, we highlighted the moderation of the inflation forecast, and the
balanced nature of the risks. We noted further that, should current assumptions and
expectations transpire, we could be close to the end of the tightening cycle. This implies that
policy remains very data dependent. Calling the peak of a cycle with precision is difficult at the
best of times. Under current conditions of heightened uncertainty both globally and
domestically, it is even more difficult.
However, even if it turns out that we are at the end of the cycle or close to it, this does not
mean that further accommodation is imminent. As I underlined earlier, the expected inflation
trajectory, while within target, is uncomfortably close to the upper end of the target range,
leaving little room for error. We would prefer to see an inflation trajectory more firmly and
sustainably within the target range. For this reason we see the bar for a cut in interest rates as
being set high.
Part of our concern relates to the impact of wage settlements and inflation expectations in
contributing to inflation persistence at levels near the top of the target range. While we are
pleased that inflation expectations have not become unanchored during the current inflation
target breach, the longer term expectations remain at the upper end of the target range.
Similarly, average wage settlement rates have been consistently above inflation, contributing
to inflation persistence at higher levels.
At current levels of the real interest rate, monetary policy is assessed to remain
accommodative. But a lot depends on where we see the neutral interest rate, which is
notoriously difficult to calculate. Since the global financial crisis, many countries have
progressively reduced their estimates of their neutral interest rates, alongside declining
estimates of potential output. However, there are different views as to whether these revisions
represent short-term deviations from longer term unchanged values, or whether these
represent a longer-term "new normal".
One complication in estimating neutral real rates is that most models don't explicitly assess
the role of external factors, nor other structural and shorter run determinants. In particular,
long-run determinants like the savings culture of households and decisions by fiscal
authorities, or shorter-run factors like the impact of policy uncertainty, and critical drivers of
capital stock growth such as the exchange rate, are not clearly identified in the models, but
would seem to be quite important.
Generally speaking, for emerging-market economies, global surplus saving pushes down
neutral real rates, while structurally weak domestic savings pushes them back up. This
suggests that neutral real rates should be below long-term averages, but well above the levels
applying in advanced economies. Where investment-saving imbalances are sticky and risk
premia reflect sustained higher inflation or weakening policy frameworks, neutral rates should
probably be higher.
In conclusion, it is almost trite to say that monetary policy is always made under conditions of
uncertainty. Since the crisis in particular, we have been experiencing a prolonged period of
elevated uncertainty. We have, however, benefitted in recent months from movements in from
some global and domestic factors that have aided downward revisions to our inflation forecast.
We also know that the positive factors underlying the more favourable outlook can change very
quickly, and therefore there is no room for complacency. A continued rise in inflation would put
at risk our current low interest rate environment and its cyclical support, and threaten long run
sustainable economic growth and employment.
The SARB remains committed to its constitutional mandate. We will pursue this mandate
vigorously and without fear, favour or prejudice. We would continue to do that within a flexible
inflation targeting framework. We can do this with confidence in the knowledge that our
constitution guarantees our independence. Of late South Africans from all walks of life have
defended the SARB. Our strength and credit lies with the institutions of our democracy. The
SARB is one such institution. Together with National Treasury, we remain a pillar of strength
in macroeconomic management and we remain resolute in pursuing our mandate.
Thank you.