Gill Marcus: Has monetary policy independence been undermined?
Address by Ms Gill Marcus, Governor of the South African Reserve Bank, to the 1926 Rand
Club, Johannesburg, 30 November 2010.
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Introduction
We are nearing the end of a difficult year, a year that began with so much promise but is now
ending on a note of high uncertainty. On the global front, the expectations of a normalisation
in the advanced economies were proved to be wrong, and indications are that low growth
and accommodative monetary policies are likely to be sustained for some time. This has
contributed to the strength of the rand exchange rate as capital continues to flow out of the
advanced economies in search of higher yields. Domestically, growth has also disappointed.
However the strong rand has contributed to the more benign inflation environment which,
along with a persistent negative output gap, has contributed to lower interest rates.
During the year there has been a focus on issues relating to monetary Policy Independence
in response to the letter from the Minister of Finance clarifying the mandate of the Bank, as
well as the recent New Growth Path document, in which reference was made to a looser
monetary policy stance.
There are perceptions that these documents have undermined the independence of the
Bank, and there has been a tendency to over-interpret monetary policy actions in terms of
these discussions. For example, when the repo rate was reduced at the previous meeting,
some analysts argued that because there was no economic rationale for this move, it
therefore must have been politically inspired. A few days later, when the disappointing
growth figures were announced, these analysts conceded that our decision was vindicated
on economic grounds. There are some who believe that any reference we make to growth or
unemployment is an indication that we are not independent enough. At the same time there
are elements in society who believe that we are too independent and that the goals of
monetary policy should be changed.
In my talk this evening, I will state the Bank's perspective on these issues and then briefly
review our monetary policy actions over the past year.
Monetary policy independence
In discussing the issue of monetary policy independence, it is useful to distinguish between
goal independence and instrument or operational independence. The former refers to the
setting of the objectives of the central bank, while the latter relates to the actual
implementation of the mandate that is given to the bank. It is generally accepted that the goal
of monetary policy should be set by the elected representatives of the country. But even here
choices are constrained by what monetary policy can achieve. The objectives should be set
within the parameters of what monetary policy can achieve, not what we would like it to
achieve but is unattainable. Monetary policy independence generally relates to operational
independence, and derives from the need to avoid using monetary policy for political
expedience and to avoid the so-called political interest rate cycle, where there was a
temptation for some governments to reduce interest rates before a general election and then
raise them soon thereafter.
In South Africa, monetary policy independence is enshrined in the Constitution. In terms of
the Constitution, the primary objective of the Bank is to "protect the value of the currency in
the interest of balanced and sustainable economic growth ... The South African Reserve
Bank, in pursuit of its primary object, must perform its functions independently and without
fear, favour or prejudice, but there must be regular consultation between the Bank and the
Cabinet member responsible for national financial matters."
There are three important issues that come out of this. First, the goal of monetary policy is to
maintain the value of the currency, which means low and stable inflation. The current
framework is one of inflation targeting with the actual target set by the government. This is
very much in line with the practice in many countries. But it is important to note that the
objective of low inflation is not for its own sake, but in the interest of sustainable and
balanced growth. In other words it is a recognition that monetary policy should contribute to
long-term growth, which it does through providing a conducive environment for growth. But
as we have stated before, we also have to recognise the limits to our impact on growth.
Monetary policy can and does affect cyclical growth around long run potential output growth.
In other words, we can affect the size of the output gap by impacting on cyclical growth.
However, our impact on potential output itself is limited - this is really the job of
microeconomic and structural policies.
Second, while the Bank does not have goal independence, it has independence in the
application of monetary policy. Thus it is we who are responsible and accountable for how
we implement policy within a given goal. Third, we are required to consult regularly with the
Minister of Finance. This is not an undermining of independence, but rather a mechanism to
ensure effective macroeconomic coordination.
It should be clear then that central bank independence is not absolute. We are an integral
part of the economy and therefore not independent of the economy. We are not an ivory
tower, or in our case a glass and granite tower that is independent of and impervious to the
economy in which we operate. We also take our cue with respect to our goals from the
constitution and from government.
The "mandate letter"
We are aware that there is still some uncertainty in the public domain relating to the letter
that was sent by the Minister of Finance to myself in February, in which he clarified the
mandate of the Bank.
The letter very clearly confirms that the primary objective of monetary policy is the
containment of inflation within the target range of 3 to 6 per cent. Furthermore the letter
confirmed the flexibility of the mandate in allowing for deviations from the target in the event
of exogenous shocks, and the need to avoid unnecessary instability in output and interest
rates under such circumstances. This is the essence of flexible inflation targeting.
At the same time it is stated that in taking monetary policy decisions, we should have due
regard to the factors that might impact on the attainment of balanced and sustainable growth.
These factors include the output gap, credit extension and asset bubbles, employment and
other labour market developments and the stability and competitiveness of the exchange
rate. These factors are not only taken into account with respect to their impact on inflation,
but our actions have also been affected by a concern for the impact of our actions on these
variables. A number of studies have borne this out, including a 2007 paper by Ortiz and
Sturzenegger in which the reaction rule of the Bank was estimated and found to be in line
with those estimated for a number of advanced economies. The study showed that
compared to emerging markets, South African monetary policy has been more stable, with a
more consistent anti-inflation bias but with a somewhat larger weight on output, although a
low weight on the exchange rate.
There is nothing in the mandate letter that we feel undermines our independence with
respect to monetary policy implementation. There was however an additional aspect to the
letter which is often overlooked. That is the additional specific mandate for financial stability
that was given to the Bank. Although the role of financial stability is generally implicit in the
mandates of central banks, it is often not explicit. The financial crisis underlined the
importance of clarifying the roles of the different institutions in the economy with respect not
only to normal microprudential regulation and supervision of the banking sector, but also to
broader macroprudential oversight. The central role of the Bank in this respect was
reaffirmed in the recent Medium Term Budget Policy Statement. A great deal of work is
currently under way in various international fora to get a deeper appreciation of what
macroprudential oversight actually entails, and the organisational structures and legal
framework that needs to be in place.
Monetary policy and the New Growth Path
Government's new growth path was published recently and places employment creation at
the centre of government's strategic focus. Given the high rate of unemployment in the
economy, this is as it should be. While I would not want to comment on the detail of the plan,
it would be appropriate for me to say a few words about the proposals that affect the Bank
directly. But before doing so, I wish to emphasise an aspect that came through strongly in the
Growth Path proposals: that is, the need for policy cohesion and coordination. Apart from the
need for common purpose, different elements of policy can only work effectively if there is an
appropriate policy mix, and if the different policies are coordinated. Policy consistency,
coordination and sequencing are essential requisites for policy success. The macroeconomic
proposals outlined in the new growth path should be seen in this context.
According to the New Growth Path, the macroeconomic stance will be guided by "a looser
monetary policy and a more restrictive fiscal policy backed by microeconomic measures to
contain inflationary pressures and enhance competitiveness ... The monetary policy stance
will continue to target low and stable inflation but will do more to support a more
competitive exchange rate and reduced investment costs through lower real interest rates.
This will be accompanied by measures ... to contain inflationary pressures and enhance
competitiveness". These latter measures include more effective competition policies, and a
review of administered prices to ensure that their increases are not higher than inflation
unless there are compelling reasons. Furthermore, the proposals include a social accord to
moderate or cap wage and salary increases.
Our interpretation of this is that the proposals recognise that the Bank's mandate remains the
achievement of low and stable inflation. In a low inflation environment, nominal and possibly
real interest rates will be lower, and the real exchange rate will be more competitive because
our prices and wages will not be increasing relative to those of our competitor countries.
Monetary policy actions are guided to a large extent by the pressures that are being placed
on inflation. For a long time we have noted that the main risks to the inflation outlook are
administered price increases, many of which are significantly above inflation, as well as wage
increases that are unrelated to inflation and productivity increases. The lack of competition in
some sectors of the economy has also been identified as a constraint to price-setting that is
more responsive to domestic demand conditions, and therefore more responsive to changes
in the monetary policy stance. Improvements in these areas can help to reduce inflation and
create the space for a more accommodative monetary policy stance.
The same is true for a tighter fiscal policy. There is a clear theoretical rationale for a tight
fiscal policy and loose monetary policy mix, and this was at the heart of the macro-economic
proposals of the Harvard-led international panel in 2007.
Theoretically, lower interest rates will allow for a weaker exchange rate because of the
narrowing of interest rate differentials which make it less attractive for foreigners to buy
interest-bearing securities. But because of the inflationary impacts of the low interest rates
and the weaker currency, fiscal policy needs to compensate for this by reducing expenditure
and providing the additional policy instrument.
At this stage further work needs to be done to determine the degree to which fiscal policy
needs to be tightened in order to support monetary policy in this way. It is also not clear that
fiscal policy has the flexibility to take over the role of monetary policy as an antiinflationary
policy on a cyclical basis. Discretionary changes to the fiscal policy stance take time to
implement, unlike in the case of monetary policy.
The current fiscal policy stance is tighter than it was at the height of the crisis, but the
estimated structural deficit of around 4 per cent represents a much looser stance than was
the case during 2000-2008 when it was generally well below 2 per cent. Similarly, real
interest rates are currently much lower than was the case over the past years. The long term
real repurchase rate has averaged between 3-3,5 per cent over the past decade. The
current real repurchase rate, assuming an expected inflation of around 4,5 per cent, is
equivalent to 1 per cent. Should inflation surprise on the upside, this real rate would decline
as well.
This suggests that currently both fiscal and monetary policies are relatively loose, which in
our view is appropriate for the current state of the economy and the low global real interest
rate environment. However, should the economy, particularly domestic expenditure, start to
pick up significantly, this mix would have to be changed.
We must also not forget the issue of sequencing and coordination. Some of these proposals
may take some time to implement and to be effective. Monetary policy cannot be loosened in
advance of these other reforms unless there is a clear notion of the extent of fiscal tightening
and certainty about the time horizon over which microeconomic reforms can be effectively
implemented and achieve results.
In the absence of such coordination, excessively low real interest rates will not necessarily
bring about increased investment. They are more likely to result in higher inflation and
consequently higher long term interest rates, which will impact negatively on the cost of
government borrowing and the cost of capital. Under such circumstances, real long term
interest rates are likely to rise even further because of a possible increase in the risk
premium.
The proposals as set out, if successful, will help to contain inflationary pressures and thereby
give an additional degree of freedom to monetary policy and allow for the "looser" monetary
policy stance that is proposed. Such a stance of monetary policy would in fact follow
automatically under such circumstances, particularly under conditions of weak domestic
demand.
The Bank's view therefore is that the independence of monetary policy is not undermined in
the New Growth Path proposals. Our mandate remains the attainment of low and stable
inflation, and to the extent that other policies and micro-economic interventions are
supportive, we will have greater flexibility in the conduct of monetary policy.
However, as I indicated above, we have to be realistic about what monetary policy can
achieve in solving an unemployment problem that is essentially structural in nature.
Part of the rationale for the monetary policy proposals were to deal with the strong exchange
rate. The New Growth Plan recognises that intervention in the foreign exchange market is
not a simple solution as intervention is expensive and not necessarily effective. Nevertheless
further intervention is not ruled out and is consistent with the Bank's activities in the foreign
exchange market.
However we must bear in mind that competitiveness of the currency refers to the real
exchange rate i.e. the nominal exchange rate that is adjusted for relative inflation rates.
Achieving a more depreciated nominal exchange rate will not help with competitiveness if it is
simply offset by higher inflation. Therefore the need for low and stable inflation cannot be
overemphasised, and this is apart from the adverse effects that inflation has on the poor in
particular.
In advocating the macroeconomic policy mix of tight fiscal policy and loose monetary policy,
there is an underlying assumption that the main determinant of the exchange rate is the
interest rate differential, and that lower domestic interest rates will reduce interest sensitive
capital flows. However, experience has shown us that reality is not so simple. There have
been periods in the past, and this was true for much of the 2000s, when capital inflows were
dominated by flows into the equity markets. In other words, capital was attracted by growth
prospects rather than interest rate yield differentials. To the extent that lower interest rates
improve the growth outlook, the decline in interest-sensitive inflows may be more than offset
by flows into the equity market or to direct investment.
Finally, I should emphasise that while the proposals may have an internal economic logic,
the reality may be far more complicated. In particular, it is not always possible to achieve the
goals of low and stable inflation, a competitive exchange rate and low real interest rates
simultaneously. There are unfortunately times when conflicts between these objectives will
arise, and the bank should be in a position to act independently, in line with its constitutional
mandate, when such a situation arises.
Recent monetary policy
The past year was a challenging one for the conduct of monetary policy. At the beginning of
the year, the view that policy normalisation in the advanced economies would begin by the
middle of the year implied an expected moderation of capital flows to emerging markets
during the year. Domestic growth was also expected to be positively affected by the
improved global environment. At that stage, when the repurchase rate was still at 7 per cent,
the exchange rate was at around R7,60 against the dollar and inflation expected to average
just under 6 per cent over the year. It was also our view that we had possibly reached the
bottom of the interest rate cycle. The interpretation of the high frequency data at that time
was also complicated by the distortions created by the World Cup.
As the year progressed, it became increasingly apparent that the monetary policy environment
in the advanced economies was likely to remain highly accommodative for longer, and this
view was reinforced by the emerging sovereign debt crisis in Europe. This had implications
for the rand exchange rate and its expected future path, as well as for the outlook for
domestic inflation. Domestic growth was also expected to be negatively affected by these
events. As a result, our inflation forecast was progressively revised downwards. For
example, at the March meeting, the expected low point for inflation in the third quarter of
2010 was 4,9 per cent. By the September meeting this had been revised down to
3,7 per cent.
Furthermore, and of greater significance, the longer term expected trend of inflation was also
revised downward to the extent that the entire expected inflation trajectory over the forecast
period was seen to be comfortably within the inflation target range. The forecast in
November 2010 indicated that inflation was expected to be 4,8 per cent at the end of the
forecast period in the final quarter of 2012.
Against the backdrop of relatively weak domestic demand, we felt that there was room for
further monetary accommodation to help stimulate the economy without jeopardising the
inflation target. If inflation is, or is expected to remain within the target, monetary policy will
have greater flexibility to focus on growth issues, particularly when the growth rate is below
potential. This is entirely consistent with a flexible inflation targeting framework.
The repurchase rate was reduced by 50 basis points on three occasions: in March,
September and November. On each occasion it was the view of the MPC that we were either
at or close to the bottom of the interest rate cycle and we had signalled that the room for
further cutting was limited. However, in subsequent meetings, as I have said already, the
outlook had changed significantly, and in effect the real interest rate was increasing with the
decline in expected inflation.
It is important to reemphasise that any signal is not a commitment, but a signal conditional
upon no significant changes in the outlook. Under periods of heightened uncertainty, as we
have been experiencing, it is likely that conditions will change more rapidly, although the
direction and extent is not always clear. As we signalled in our most recent meeting, the
room for further rate cuts is limited by the fact that we are now seeing more definite signs of
a sustained recovery in household consumption expenditure and domestic credit extension.
Conclusion
Monetary policy is always made under conditions of uncertainty. The lags in the impact of
monetary policy mean that policy has to be made on the basis of expected developments
and expected inflation outcomes. The more uncertain the environment is, the more difficult it
is to have a clear future path of interest rates.
Monetary policy settings will need to change in line with changing circumstances. At the very
least, we should strive to be consistent on the basis of how we view the rapidly changing
world. Our actions have been and will continue to be guided by how we see and interpret
these developments, and we will continue to implement monetary policy independently, but
mindful of the impact on other variables in the economy.
The policy rate is currently at its lowest level in over 30 years, the real rate is below its long
term average and the inflation rate is expected to remain within the inflation target range for
the forecast period. These developments are a result of a consistent application of a flexible
inflation targeting mandate. As always the Bank stands ready to play its part in contributing to
longer term sustained economic growth in the economy by ensuring a low inflation
environment. Low inflation or price stability can contribute to long-term growth by providing
greater stability and reducing uncertainty, which will be positive for longer term investment.
Thank you.