A public lecture by Lesetja Kganyago,
Governor of the South African Reserve Bank,
at
Stellenbosch University, Stellenbosch
6 March 2019
Independence and policy flexibility:
'Why should central banks be independent?'
Good evening, ladies and gentlemen.
Thank you for your kind invitation to come and speak at Stellenbosch University today.
At a time when our country is embarking on a course of political and economic renewal,
I would like to focus for the time that I am here with you on the public good enshrined
in our Constitution that concerns monetary policy. In particular, I would like to talk
about why central bank independence matters for that broader public good and how it
relates to achieving our inflation-targeting objective.
The constitutional mandate and independence
Our Constitution provides the mandate for the South African Reserve Bank (SARB):
protect the value of the currency in the interest of balanced and sustainable growth.
The Constitution sets our mandate in this way for a simple reason: it is an expression
of a public good. When we attain that public good, it helps us to reach the kind of
economic growth we want. It does not mean that achieving our mandate alone will
necessarily generate that outcome. But it is necessary for achieving it. Many other
policies and behaviours play similar and necessary, but not sufficient, roles.
Having been given a mandate, the central bank needs to achieve it. This requires
setting out an operationally relevant policy target and ensuring that the institution has
the powers to achieve it. Central bank independence is really just about giving the
SARB the institutional freedom to get on with those two things. But, of course, hitting
an inflation target is not a simple matter of declaring a target and then browbeating
economic actors to set prices and wage demands in line with this target. For those
actors, the gains of higher (or lower) inflation exceed the costs they experience, but
they do not exceed the costs to society as a whole. This is a common political economy
problem; it arises in many areas of policy. And because of it, nearly all countries
choose monetary policy frameworks with clear and simple targets, and with targets
that imply balanced growth. I will return a bit later to the issue of alternative policy
frameworks.
However, ensuring that independence delivers good, socially optimal outcomes also
requires that it is conditioned by a complementary framework which ensures
transparency and accountability. Paul Tucker, a former Deputy Governor of the Bank
of England, sets it out in this way in his recent book: central bank delegation should
namely
have the following principles, 'a clearly articulated regime, simple instruments,
principles for the exercise of discretion, transparency that is not deceptive,
engagement with multiple audiences, and, most crucially, testimony to legislative
committees'.1
In line with those principles, and in order to get to low inflation, central banks need to
explain to the public what they are doing and how they are doing it. And they also need
to be held accountable for their efforts. Independence is the flip side of accountability;
a central bank cannot be easily held to account if private and/or political actors have
the ability to sway its decisions. Nor can a transparent target be easily manipulated to
show success when there is in fact none.
Our mandate is implemented by targeting an inflation rate, which is interpreted not as
literal price stability (an inflation rate of 0%) but as a low and stable growth rate in the
price level. Our targeted inflation rate, set in consultation with government, is a range
of inflation between 3 and 6% on an ongoing annual basis. In other words: we target
a monthly, year-on-year inflation rate of not lower than 3% and not higher than 6%.
In practice, we aim for inflation to come out near the middle of our target range, at
around 4.5%. This gives scope for variation and shocks to hit the economy. These
shocks move inflation above and below 4.5% but, by the design of our framework, they
do not necessarily require policy adjustments. This is the meaning of 'flexible' inflation
targeting, and it allows us considerable leeway in looking through or past temporary
shocks to the inflation rate. Since the beginning of the inflation-targeting period, which
started in 2000, our average annual inflation rate has been 5.5%, a full percentage
point higher than the midpoint.
This points to mixed success in the history of our inflation management. Inflation has
stayed moderate, well below the high levels of the 1980s and 1990s. But inflation has
not really been sufficiently low to get our high long-term interest rates lower, and this
creates an economic cost that weighs more heavily on job creation as time goes on.
We have indicated that a consistently lower rate in the near term, at the midpoint of
our target band (4.5%), would lower long-term interest rates and be more supportive
of balance in the economy.
What do we mean by balance? First, let me say what it is not. Balance is not about
achieving an inflation rate that meets the demands of some groups of people but not
-
others. And it is not about reaching an inflation rate that causes economic damage
neither too low nor too high.
Rather, balance is about supporting competitiveness and job creation in the export
industries and about reducing the bias to growth in the non-tradeables sectors caused
by high inflation. As it happens for most countries, emerging and advanced, that
inflation target is between 2 and 3%.2 Our trading partners and competitors typically
have lower inflation than we do. It is also about getting the balance right between
saving and investing; inflation should be at or around a rate which maximises both the
supply of credit and the demand for it.
So why would anyone want higher inflation? Prices rise at different rates. Some
sectors may see stronger rises than others, giving them stronger revenue growth
relative to those not seeing the same price increases. This implies redistribution. For
example, some businesses like higher inflation because, via currency depreciation, it
increases the prices of the goods they sell faster than the cost of production. Of course,
the costs eventually catch up as inflation rises in response to the weaker currency, but
while these prices are catching up, exporters get a small and temporary gain. In this
instance, higher inflation redistributes a little from exporters in other countries that
compete with ours. But, more importantly, it redistributes from domestic consumers
and producers to those gaining from higher prices. Once costs rise, however, the
economy is where it started in the first place.
Along similar lines, debtors prefer higher inflation because, over time, it reduces the
real value of their debt. A particular example I like to think about is those who want
higher inflation because they like to borrow to make their living out of short-term
activities, often in the financial markets. Their frequent criticisms are always the same:
if we didn't worry
we worry too much about inflation, both now and in the future, and,
so much, we could all enjoy lower short-term interest rates today.
The catch here is that when lower short-term rates today push up inflation in the long
run, then borrowing for investment is skewed away from the long term to the short
term. We shouldn't be surprised if this
also skews job creation away from the types of
jobs that are sustained over the long run. That is not a trade-off that we believe is
consistent with the public good mandate set out in the Constitution. The real test of
monetary policy is not the short-term interest rate but what happens to the long-term
rate.
We should by now be able to recognise the problem with allowing inflation to go up in
ways that benefit some groups: the gain is temporary and costs other groups. To claim
back what they have lost, the losers want compensation, which creates additional
negative distortions. And, because the advantage is temporary, the beneficiaries want
policy to give them the gain again and again. Giving in to this desire, trying to conjure
up temporary gains, lies behind many, if not most, historical instances of
macroeconomic failure.
Let me turn now to the losers from high inflation. There are three social groups that
we should all worry quite a lot about, for both economic and ethical reasons.
The first are younger people. Higher inflation and higher interest rates make it more
expensive (and often impossible) to start borrowing for housing, education or
transport, or starting new businesses.
The second group are workers. Here it is often argued that more inflation would create
more jobs for blue-collar workers. This is the old idea of the Phillips curve which has
proven, except in very particular circumstances, to be wrong.
First, some basic facts. For South Africa, the economy grows more strongly when
is low. If you don't believe me, take a look at the historical data series
inflation
yourself.3
Second, some empirics. The original Phillips curve idea worked as follows. If there are
suddenly higher prices, businesses will believe that this is stronger real demand. They
will respond to this demand by increasing production because they think they will be
able to sell more and because their return is higher relative to the cost of production.
But this is not 'time-consistent'. When workers respond to their real loss of income
(higher inflation minus last year's wage level), they ask for higher wages and the cost
of production rises. Suddenly, the business is not more profitable anymore, cannot sell
more of its product, and retrenches.
In macroeconomic policy, the temporary gain of the Phillips curve is illusory. You end
-
up with less employment and higher inflation. Your 'misery index' increases and yes,
there is such a thing, invented by Arthur Okun, and it measures exactly that.
Finally, I would like to note that the third group that gets hurt the most by higher inflation
includes those that cannot defend themselves from it: the poor. Without the power to
demand higher compensation for inflation, the poor and those living off fixed nominal
incomes, pensioners in particular, are most vulnerable. It is for these people, above
all others, that low inflation is both morally and economically right.
At the end of the day, central bank independence allows the SARB to hear what
different interest groups have to say, but gives it the policy space to make decisions
about inflation that on balance benefit all. By having an inflation target range, we make
a commitment to explaining transparently how we have achieved that target.
Monetary and fiscal policy coordination
Independence also matters for ensuring effective monetary and fiscal policy
coordination.
Much monetary theory involves figuring out how to avoid high inflation and its
impoverishing effects. Sometimes high inflation is caused by the excessive ambitions
of sovereigns to spend fiscal resources on projects that do little to generate long-run
economic growth. Continuous fiscal deficits reflect those ambitions, and because
those deficits are financed with debt, they create a tax liability for citizens in the future.
When debt rises too rapidly and above certain levels, our borrowing today both
constrains what future generations of South Africans can do (as they are forced to
repay our debt) and undermines their own living standards (as they pay the higher
taxes). All of this directly generates pressure to allow inflation to rise. We cannot blame
future generations for this. It is a function of the choices we make now.
Some of you may disagree with this and argue that governments need to address
social deficits and therefore will always run large deficits. But while I certainly agree
that those social deficits need to be rectified, it has to be done sustainably and with a
critical emphasis on spending public funds on those things that raise the potential
growth rate of the economy. If our spending does not do this, then we will end up not
being able to spend more in the future. Future generations might simply end up having
to pay more interest and more tax.
Another important argument for ensuring central bank independence is avoiding what
is called 'fiscal dominance', which is the need for monetary policy to prevent the
sovereign from going bankrupt because of excessive spending on current
consumption.
Inflation targeting as an expression of the mandate
Let me now turn to a discussion of how inflation targeting is a good expression of our
constitutional mandate to support balanced and sustainable growth.
The independence of central banks gives them the opportunity to keep on top of global
research and use human capital to best understand how to achieve their mandates.
Oftentimes, criticism of their independence is really about not liking the objective set
out in the Constitution. If the SARB had no independence, then other objectives could
be imposed on it. But what are those other objectives, and where do they come from?
Have they been researched and understood properly? Or are they wishful thinking?
Perhaps they do reflect good intentions and legitimate aspirations. But the test of
whether they are the right or even useful objectives has to be based on analysis and
research, comparative assessment, and technical know-how. Inflation targeting has,
in recent times, become a popular policy framework mainly because it has proven
successful in achieving good outcomes where other approaches have failed.
Nonetheless, it is always useful to consider alternatives.
Dual-mandate frameworks are one alternative. But even the central banks with
multiple mandates tend to act as if they were inflation targeters because low inflation
helps to keep interest rates low, and the two together help to maximise employment.
The mandate is achieved because the rate of inflation determines the sustainable
outcome of the other two objectives.
For this reason, the move to include employment creation as a mandate alongside
inflation targeting for the Reserve Bank of New Zealand has proven less eventful than
its political sponsors had advertised. Why? One reason is that employment levels are
determined by many different things, so putting a specific target on it for the central
bank to try and achieve is unrealistic and can result in unintended consequences. Say,
for example, that inflation is rising and employment is falling because of adverse
technological change. In this instance, there is little monetary policy can do to increase
employment levels. But responding by cutting rates, which seems like the right thing
to do, only increases inflation further and eventually undermines job creation further
as well.
Like other central banks, we already include concern about growth and employment
in our Taylor rule. And because we apply the framework flexibly, we don't respond with
policy to every upward move in inflation. The difference between a flexible inflation
central bank just isn't very meaningful. Over time, keeping
target and a dual-mandate
inflation expectations low and well-anchored is the clearest and most effective way of
helping the economy to achieve full employment.
Another alternative is to target the exchange rate directly. Keeping it perfectly stable
would, at least on the surface, suggest a better fit with the letter of the mandate in the
Constitution. But it is often not well understood just what maintaining a fixed currency
actually means, or what this requires in terms of policy. In a nutshell, fixing the currency
requires fixing it against another currency or a basket of currencies. Then, our
are required to adjust regularly to keep the rand's value
monetary and fiscal policies
stable against those currencies. But those third currencies keep moving, and this
means that we need to move our policies in line with their moves, even when the
economic cost may be high.
you a concrete example of how problematic this can be, let's consider the case
To give
of Argentina in the early 1990s. Argentina had pegged its currency to the US dollar.
But Argentina was not as productive as the United States (US), despite the peg giving
them a similar inflation rate. Eventually, Argentina could not afford to maintain the peg,
as the peso's value was under pressure to fall and
the country had no reserves left.
The peg was dropped and the economy fell into a deep recession, with very high
inflation, massive job losses and a sharp rise in poverty.
Argentina is an extreme case, but it demonstrates how a country's
You may think that
policies can become subordinate to, and ultimately determined by, the actions of other
countries. Our inflation-targeting framework and floating currency means that we have
considerable freedom to set our policies in line with the inflation outcome that we want
to achieve.
Some commentators have suggested that this freedom to float the currency means
that our monetary policy works against export-led growth. Our currency is too strong
in this view. It is worth reminding ourselves of what the International Growth Panel, led
by Prof. Ricardo Hausmann, suggested to us back in 2006. They showed us how a
more export-led growth strategy needs to be predicated on a more competitive
exchange rate achieved by running a fiscal surplus to create space for lower interest
rates, and supplemented by an effective inflation-targeting framework.4
In fact, under inflation targeting, excessive exchange rate appreciation has been rare
and short-lived. These discrete periods occurred when capital flowed in as a result of
high commodity prices, sustained public borrowing, and low yields in advanced
-
economies not because of inflation targeting. All else being equal, the inflation-
targeting framework has lowered inflation and rates, reducing the pull on hot money in
recent times. In fact, a fundamental objective of inflation targeting has always been to
achieve a more competitive exchange rate, and the best way to achieve this is to get
inflation to be permanently low.
Conclusion
The Constitution recognises and expresses the public good which is price stability
because it helps societies to achieve balanced and sustainable economic growth. It is
necessary but not sufficient. Like the mandate, central bank independence is also not
a static, ivory-tower concept. It is a living and breathing idea. It is an idea that is
practical. It gives life to the mandate set out for the SARB by the Constitution.
This independence means that the SARB can make the case for how best to achieve
that goal, in consultation with government and with full transparency to the general
public. As an institution, we have worked with government to identify the inflation-
targeting framework as the best way of achieving the mandate, for all the reasons
I have set out today.
We believe that the case for the existing framework is very strong. We have achieved
a historically low rate of inflation and, as a direct consequence of this, historically low
interest rates. Of course we would like to improve on this track record and edge both
inflation and interest rates lower on a sustainable basis. This is the most important
contribution that monetary policy can make to full employment, economic growth and
the well-being of our society.
Thank you.