Public Lecture by Lesetja Kganyago,
Governor of the South African Reserve Bank,
At the University of South Africa, Pretoria
24 July 2019
Delivering on our mandate:
Monetary policy, inflation, and balanced and sustainable growth
Good morning, ladies and gentlemen.
Today, I would like to talk about the South African Reserve Bank's (SARB)
mandate: what it is, how we interpret it, and where we are in our national
conversation about the SARB.
Although central banking has a global reputation for being boring, in South
Africa it has been getting a lot of attention. Much of this is welcome: it is
largely a useful opportunity for improving public understanding of what the
SARB does, while we at the SARB also learn and benefit from our
interactions with people all over South Africa.
However, some parts of the discussion are problematic because they
distract us from more pressing priorities. As Mr Tito Mboweni, the Finance
Minister, has pointed out: this 'obsession', to use his phrase, is getting in
the way of a more fundamental discussion about economic growth, job
creation and dealing with inequality.1 This economy used to grow at 3% or
4% a year, but now it grows at about 1%.
As we in the SARB have tried to communicate: the growth problem in
South Africa is mainly structural in nature, beyond the reach of monetary
policy alone. Perhaps part of the problem is that whenever we get a new
gross domestic product (GDP) statistic, the news bulletins and the
newspaper articles end up talking about what it means for the next
Monetary Policy Committee (MPC) meeting.
Given this pattern, you might well assume that interest rates have large
growth consequences. But we need some perspective. If we reduce rates
by 25 basis points, and there are no other reforms in the economy, our
modelling tells us that growth will be about 0.1 percentage points higher,
one year later. That's all.
Remember that when we cut rates, borrowers have more spending power
but lenders have less. Exporters may do better from a weaker rand, but
firms that use imports do worse. Investment may pick up, but that depends
on long-term rates, not just the repurchase rate (repo rate) - in addition to
many non-monetary factors.
So the growth effects of a rate cut are small. And if we as a country obsess
about the SARB and monetary policy as the only answer to our growth
problems, we will fail to discuss the difficult but vital reforms that might
actually rescue us from our growth malaise.
Failing to get that conversation about growth going has further
repercussions, because it feeds the notion that the SARB's private
shareholding matters to the policy framework we have and the decisions
made on policy. And again, this shareholding debate is more damaging to
our economy than it should be. It sends a signal to investors, both here
and abroad, that our macroeconomic framework is at risk, making the cost
of debt higher than otherwise and undermining confidence. Who loses
from all this? One of the biggest hits is to indebted households and the
beneficiaries of public spending, who pay the price for skyrocketing
interest costs on our public debt as the resources to spend are squeezed.
These very serious problems aside, the fact that South Africans want to
engage with the SARB and its mandate is welcome, and we applaud it. Of
course, not everyone agrees with us 100% of the time. A certain amount
of disagreement is normal, in central banking, as in so many other things.
Indeed, not only is public engagement and discussion of monetary policy
appropriate. When it is based on evidence, it is something we encourage.
In the old days, central bankers did everything in secret, and any public
statements were deliberately complicated. Nowadays, we try to be open
and transparent. We have learned that monetary policy works better with
communication. An economy is populated with people. If these people
understand what the central bank is trying to do, they adjust their
behaviour, which in turn helps the central bank to achieve its policy goals.
Furthermore, we appreciate that having independence creates a duty to
be transparent and accountable; we are not, and do not want to be,
exempt from democratic principles.2
This talk is a contribution to the discussion on our mandate.
So let us talk about the SARB's mandate.
The Constitution, in section 224, instructs the SARB to protect the value
of the currency in the interest of balanced and sustainable growth. This
mandate reflects an understanding that protecting the value of the
currency is a critical foundation for achieving lasting growth.
Clearly, the mothers and fathers of our Constitution did not want us to let
inflation run. We might have got more growth but it would have been
unsustainable. As many countries have discovered, after a temporary
boom, we would end up in stagflation, with weak growth and high inflation.
The framers of our Constitution also cared about macroeconomic
imbalances, which might, for example, result from a debt boom, or if we
spend well in excess of what we produce, with imports running too far
ahead of exports.
The Constitution tells us what to do, but it is not explicit about how we do
it. We had to figure out a monetary policy framework for ourselves. In fact,
it took us a few years to arrive at the approach we use now: the
Constitution was passed in 1996, but we only started inflation targeting in
2000 - after a false start using the so-called 'eclectic approach' that
included a failed attempt to control the exchange rate.
The inflation target, agreed between the SARB and National Treasury,
was initially set at 3-6% before being shifted to 3-5%. The emerging
market crisis of 2001 led to the reinstatement of the 3--6% target, and it
has remained since then. More importantly, the target created a clearer
framework for decision making and enhanced public understanding of the
SARB's monetary policy objectives.
But this choice of target also left important questions open. In particular,
because the 3-6% we ended up using is a wide range, it created
uncertainty about the SARB's true objective. I recall that a consultant
helped us with some educational materials, including for our website, who
wrote that with a 3-6% target the SARB would cut rates when inflation was
under 3% and hike rates when it was over 6%. That was a logical
interpretation, but it was completely wrong. The fact is that during the
inflation-targeting era, the SARB has not seen targeted inflation below 3%.
We have nonetheless cut rates on many occasions. In fact, these rate cuts
have typically happened with inflation over 5%, already in the top end of
the target range. Various analysts and academics have spent a lot of time
trying to estimate the SARB's de facto target, and they have tended to
conclude it has been close to 6%.3
Four years ago, we took a critical look at our monetary policy and reflected
on our shortcomings. We realised we had let underlying inflation, and
inflation expectations, drift to the very top of our target range. This wasn't
a problem of supply shocks or demand shocks; it was a problem of the
trend inflation rate. The analysts and academics were right: we had ended
up with a 6% target. This meant we had a high inflation rate relative to
other countries. We found that about three-quarters of other countries had
lower inflation. In addition, with 'normal' inflation already near 6%, every
new adverse price shock would push us outside of the target range. This
would force us to act, rather than be flexible, or would cost us credibility,
ensuring a higher inflation rate. To make matters worse: because
everyone was used to inflation around 6%, indexation had set in - prices
and wages across the economy were locked in to grow at this pace.
This left us in a trap: nominal interest rates had to be high because
inflation expectations were anchored at around 6% but high interest rates
meant there was always pressure to cut. Meanwhile, the indexation bias
meant that inflation never fell much, and so in turn interest rates stayed
structurally high.
The paradox is that we have often been accused of being hawkish and
keeping interest rates too high, when in reality we have often tolerated as
much inflation as we can, ignoring the bottom half of our target range. This
is the main reason why our interest rates haven't fallen further. We tend
to spend a lot of time comparing ourselves to low inflation and low interest
rate economies, when we really are not in that particular picture frame.4
Given this analysis, we decided to make some changes. We could better
achieve permanently lower interest rates if we were clearer about where
exactly we want inflation to be, within our range.
The simplest and most honest option would be to emphasise the middle
of our target range, 4.5%, as our goal. By analogy, we began to think of
the 3-6% target range as the lines on a road. When you're driving down
the road, you try to steer between the lines. You don't drive along the
yellow line or the centre line, unless you're a bad driver. Of course, you
can't keep the car dead-centre in the middle of the road all the time, but
every time you start to drift towards the lines, you correct, aiming back for
the middle of the lane. For monetary policy, the 4.5% midpoint is the
middle of the lane in this metaphorical road, and 3-6% are the lines.
When we decided on this adjustment, we were aware that using interest
rates to move inflation expectations from the top of the target to 4.5%
could be costly. For this reason, we started with some communication,
expressing our preference for inflation expectations moving towards 4.5%
over time. We also began more detailed work on 'sacrifice ratios', which
is the term economists use for how much growth it costs to lower inflation.
These exercises generated a range of estimates, but, broadly speaking,
they suggested we would have to do a series of rate increases, lifting the
repo rate to 8% or higher, to get inflation to 4.5% - assuming everything
else in the economy was normal. The estimated output sacrifice ratio was
in the range of 1-1.5% of GDP.
However, while we were studying this problem, a fortunate thing
happened. Inflation began to slow, falling to around the middle of the
target range by the middle of 2017. This occurred mainly because of
positive supply shocks. In particular, food price inflation declined to
unusually low levels, around 3%, compared with a long-term average
nearer 7%. The exchange rate also stabilised: after depreciating every
year from 2011 to 2016, it began trending sideways, which helped to
moderate inflation for imported goods. We also like to think our
communication made a difference. People were seeing inflation around
4.5%, and they were hearing the SARB say that's where we planned to
keep it, so they used that information in setting prices and wages. All of
this happened without us having to adopt a tight policy stance - we started
with the repo rate at 7%, and we never had to go above that. Put simply,
we got a good opportunity to get inflation lower, and we used it.
Did we do the right thing? Again, I appreciate that informed people
disagree, and these are good-faith disagreements. People who
understand economics and genuinely want what is best for South Africa,
take different views. But let me make two points about our decision.
First, what we are doing is completely consistent with our target and our
mandate. Some people tell a story that in February 2010 there was a letter
from the Minister of Finance changing the SARB's target and how the
SARB is now ignoring that letter.5 It is strange for me to be told what that
letter was about, because at the time I was Director-General in the
Treasury, under Minister Pravin Gordhan, so I should know the content of
that letter. It did not establish a new target close to 6%. Rather, it
reaffirmed the 3-6% target range, and it reaffirmed the SARB's practice of
pursuing this target in a flexible way.
Flexibility means the SARB should avoid excessive volatility in growth and
interest rates. In other words: if an inflation shock moves inflation outside
of the target range temporarily, the SARB doesn't have to hike interest
rates to return inflation to target immediately. The SARB just needs to do
enough to get inflation to return to target over time. The Minister's letter
specifically recognised that inflation expectations need to be anchored,
and that well-anchored inflation expectations under credible monetary
policy are good for growth.
The approach we are taking now, emphasising the 4.5% midpoint, is our
best attempt at implementing the 3-6% target framework optimally. As I
have noted earlier, the SARB and National Treasury had originally agreed
to lower the target range to 3-5%. With hindsight, by postponing it to some
unannounced future date, we made a mistake. We should have
announced we would get to 3-5% more slowly, instead of reverting to 3-
6%.
If we reformed the target now, in consultation with National Treasury, we
would likely go to either 3% or 4%, with a tolerance band of maybe 1
percentage point on either side. This is where most of our peer emerging
markets are already, or where they are heading. For instance, this is
where inflation targets are for Brazil, Chile, China, Colombia, India,
Indonesia, Mexico, Russia and various other peer countries.6 But we
never reformed our target, so we are still using 3-6% and we are making
policy target that range as best we can.
The second question I would like to tackle is whether emphasising 4.5%
is an optimal monetary policy for South Africa? My view is that this is a
key macroeconomic accomplishment. We have positioned South Africa to
have permanently lower inflation. This is valuable progress.
Critics will say we could have cut rates to get higher growth. But, as I have
noted earlier, South Africa's growth problem is caused mainly by structural
factors, like a constrained electricity system as well as policy uncertainty.
Given these constraints, a monetary policy that tolerated higher inflation
for the sake of more demand would have yielded, at most, relatively small
and temporary benefits, at the price of long-term costs.
As an exercise, we have modelled what would happen if the MPC started
aiming for a 6% target again. If we cut rates by about 100 basis points,
growth would be half a percentage point higher, at its peak, and about a
third of a percentage point higher the year after that. That isn't much
growth, and certainly not a game-changing growth recovery. The
exchange rate would depreciate, the output gap would close, and inflation
expectations would start shifting higher. Core inflation would hit 6% after
about two years. By around this point, growth would slow once again;
there would be no permanent increase in output. Interest rates, however,
would be permanently higher, given the implicit 6% target. Higher inflation
begets higher interest rates. If the country needs long-lasting low interest
rates, then we must have lower inflation.
This last point is something you should bear in mind whenever you hear
someone arguing for a higher inflation target. Many of you are students,
so it matters for you as much as for anyone else. A higher inflation target
would mean higher interest rates. Over the short term, one or two years,
tolerating more inflation can allow a looser stance. But this effect is
temporary. If we decide to tolerate more inflation now, by the time you
graduate and go to work, you are going to face higher interest rates. Your
student loan repayments will be higher. A car payment will be more
difficult. A mortgage will be costlier. All this will have real implications for
your incomes.
This does not mean the SARB should avoid all rate cuts. Rather, we
should avoid cutting if the price of doing so is permanently higher inflation.
We can cut rates if we feel confident we can keep inflation under control
over time.
Our modelling framework balances growth and inflation over the medium
term using a Taylor rule. If the model sees growth underperforming the
economy's potential, the rule suggests a looser policy stance. If inflation
is simultaneously higher than the target, it compromises, aiming both to
hit the inflation target and to move growth back to potential over the
forecast period, of two to three years. Given this process, the MPC
decided to reduce rates at its July meeting, because growth is
underperforming and inflation appears to be under control. So this is one
responsible way to do rate cuts.
You may wonder why we say 'growth' instead of 'employment'. Of course,
the two are linked. Better growth generally means more jobs. But we don't
refer to employment because of technical issues with our employment
data, making them difficult to interpret. For example, despite the negative
GDP growth in the first quarter of the year, the Quarterly Employment
Survey told us that the economy had created an extra 49 000 jobs. That
was probably not a signal the economy was picking up. Unfortunately, the
data throw up these kinds of puzzles all the time, making it hard to rely on
them as guides for monetary policy. At a more fundamental level, it
doesn't make much difference if we use growth or employment in our
Taylor rule, a point made by academics assessing our policy decisions.
They find that the SARB cares about jobs as well as growth, and does not
behave as if it cared about inflation and nothing else.7
We can also measure our policy stance with reference to something called
a 'neutral real interest rate', which in recent years has increased. This
makes it more difficult to cut rates without inducing inflation. A part of the
rise in our neutral rate has come from higher global rates, which affect us
because we have to borrow from foreigners to finance our current account
deficit. A larger part of the rise comes from an increasing risk premium.
The risk premium is the price that lenders demand for putting their money
here in South Africa instead of somewhere else they perceive as safer.
Our risk premium has increased by about three-quarters of a percentage
point over the past five years. If risk subsides again, perhaps because we
borrow less or invest more to grow faster, we will have more monetary
space and might cut rates responsibly.
Ladies and gentlemen, to conclude, let me make a point frankly. We don't
have balanced and sustainable growth in South Africa. With annual GDP
growth rates under 1%, we barely have any growth. Indeed, adjusting for
the increase in our population, we have been getting poorer for half a
decade. We also don't have balance or sustainability. Government's debt-
to-GDP ratio is moving steadily higher, and with bailouts for state-owned
enterprises, there are real risks we will soon have one of the highest debt
levels amongst our emerging market peers. Because we have borrowed
so much from abroad, we pay a rapidly rising amount of interest to non-
South African creditors, and this is contributing to a large current account
deficit - again, one of the biggest in our peer group.
There are real limits on what monetary policy can do to help. By anchoring
inflation expectations at lower levels, we lower long-term interest rates,
supporting investment and helping government to finance a growing debt
burden. By maintaining a credible monetary policy and a short-term
interest rate that compensates investors for risk, we help to maintain
capital flows into South Africa. Our repo rate setting is accommodative
relative to our estimate of neutral, and it is low compared with historical
averages. Rate cuts, like the one we've just decided on, provide some
help on the margin, but inflation shows few signs yet of further moderation.
There is a healthy debate about where exactly we need to go with the repo
rate. But we see no monetary policy stance that would single-handedly
transform South Africa's prospects. And as our economic circumstances
get more difficult, I worry that more people will choose to avoid making
hard choices and pretend they do not need to be made, as if the SARB
could just cut rates enough and all will be well.
The facts are, central bankers care about growth and employment, and
the SARB is no exception. But we do not face a permanent trade-off
between inflation and growth. There are short-term trade-offs involving
growth, but after a while, inflation and interest rates are the things that
permanently increase.
The SARB can deliver low and stable inflation. But balanced and
sustainable growth also requires contributions from many other parts of
government and society. As a country, we need to maintain prudent
macroeconomic policies and we have to make further progress on a range
of structural issues. Ultimately, prosperity cannot be created by an MPC
setting interest rates. We are but one part of the orchestra; we are not
soloists. We are doing our best but we can't put on a show alone.
Thank you.