Gill Marcus: Fourteen years of inflation targeting in South Africa and the
challenge of a changing mandate
Opening address by Ms Gill Marcus, Governor of the South African Reserve Bank, at the
Biennial Conference of the Bank "Fourteen Years of Inflation Targeting in South Africa and
the Challenge of a Changing Mandate", Pretoria, 30 October 2014.
* * *
It gives me great pleasure to welcome you all to the biennial conference of the South African
Reserve Bank. The theme this year is "Fourteen Years of Inflation Targeting in South Africa
and the Challenge of a Changing Mandate". Lessons from history tell us that nothing is static,
that societies and economies evolve, as do policies and policy frameworks. When things
appear to be going well, it is often difficult to imagine that this will not continue or that the
status quo will change, or how indeed it will or can change. During the so-called "great
moderation" of the mid-2000s, when global inflation was low, the battle against business
cycles was seemingly won, and inflation targeting, or some variant thereof had gained
widespread acceptability, it was hard to envisage what would come next, and what would
cause us to reconsider the adequacy of the framework.
Little did we know that very soon, in the wake of the global financial crisis, we would be
asking the question whether inflation targeting was enough, and if not, how should the
framework be modified or augmented, and should central bank mandates be expanded? The
global financial crisis was a salutary reminder that nothing is static, that central banks largely
deal with the unknown future, and that we have to adapt to changing and unexpected
circumstances. However, there is still an intense debate about whether monetary policy
should change, and how it should change. The aim of this conference is to provide a platform
to debate these issues rigorously, and we are indeed privileged to have a high-level line-up
of recognised authorities in the field, both international and local, to stimulate these
discussions.
Although the focus of the conference is more about the future, the topic does imply some
assessment of the framework, and I will attempt to provide brief reflections of the past
14 years of inflation targeting in South Africa. I will also reflect on global developments in
monetary policy and in particular in respect of the expanding mandates of central banks and
how these developments relate to our domestic circumstances.
Has inflation targeting been a success in South Africa? It is hard to say in the absence of the
counterfactual, but there are a number of indicators that suggest it has been a positive
experience. One way of looking at it is to compare the pre- and post-inflation targeting period
outcomes. While this approach gives us some indications, the causal relationships may be
unclear, and the different periods were subject to different shocks which may distort the
picture. Nevertheless, the data does show that inflation targeting has been consistent with an
average inflation rate lower than in the previous decade, and accompanied by lower volatility
and lower nominal and real interest rates. Similarly, growth outcomes have been more
favourable, which undercuts the argument that is sometimes made that inflation targeting is
inimical to growth.
We have adopted a flexible inflation targeting approach, conscious of the trade-off between
short-term inflation variability and output variability. This approach has been appropriate both
in dealing with exogenous shocks, as well as responding to periods of slow growth, as is
currently the case. While growth does have a positive weight in the MPC's objective function,
and consideration is given to the real economy in making monetary policy decisions, we
believe that monetary policy, whatever the framework, does not impact significantly on long
term potential output growth.
Looking at some of the comparative data, we see that in the 10 years before inflation
targeting was adopted, inflation averaged 9,7 per cent, and this declined to 6,3 per cent in
the full inflation targeting period, while average GDP growth improved from 1,6 per cent to
3,3 per cent. The average nominal policy rate declined from 15,5 percent to 8,5 per cent,
while the average real policy rate declined from 5,7 per cent to 2,2 per cent. If we simply look
at the period from 2010, inflation has averaged 5,3 per cent, real GDP growth 2,6 per cent,
the repo rate 5,5 per cent and the real repo 0,3 per cent. The volatility of all these variables is
also lower in the inflation targeting period. Other positive indicators are the increased
contracyclical nature of monetary policy (as noted inter alia in work by Ben Smit and Stan du
Plessis), as well as the relative stability of inflation expectations, albeit, in the last three
years, at the upper end of the target range. This topic will be explored further in the
presentation by Alain Kabundi.
But it has not all been plain-sailing, and as the averages suggest, inflation has not always
been within the target range. Despite the improved outcomes during the inflation targeting
period, there have been significant divergences of inflation from the target range, particularly
in 2002-03 and 2006-08. However, these deviations were primarily a result of exogenous
shocks, and therefore "justifiable" in a flexible inflation targeting framework. Such deviations,
if communicated and responded to appropriately, should not undermine the credibility of the
framework. These shocks have been primarily in the form of significant exchange rate
changes, and global oil and food price increases. A criticism sometimes leveled at inflation
targeting is that the response to such supply side shocks could lead to pro-cyclicality of
monetary policy. Our approach has been to try to "see through" the first round effects of such
increases, and focus on the possible impact on inflation expectations and the emergence of
second-round effects. Depending on the extent to which inflation expectations are anchored,
we could also take a more flexible approach by, for example, extending the policy time
horizon. However, this is often easier said than done as a lot depends on the nature and
duration of the shock, which is not always easy to discern ex ante.
For example, the oil price increases in January 2004 from around US$30 per barrel, were
initially expected to be temporary. Prices did not reverse, but then settled in the
US$60US$70 per barrel range for some time. From the beginning of 2007, oil prices began to
increase almost persistently, but our own forecasts, based to a large extent on market
forecasts at the time, kept underestimating these increases. Oil price increases continuously
surprised on the upside, resulting in almost continuous upward adjustments in the Bank's
inflation forecasts. Each forecast round produced a higher trajectory, and a higher oil price
assumption. As these increases fed quickly through to headline inflation, coupled with
accelerating global food prices and a depreciating currency, disentangling first and second
round effects became increasingly difficult. It may be relatively easy to see through a
temporary shock or a once-off permanent shock, but dealing with a continuous or persistent
one-sided shock is more challenging, particularly in the emerging market context.
One approach to dealing with exogenous shocks would be to target core inflation, which
would strip out volatile supply side shocks. Most countries target headline inflation, but some
use a measure of core inflation for operational purposes. While we have paid increasing
attention over the years to a measure of core inflation, and we publish our forecast for this
measure alongside our forecast for headline inflation, we have kept the main emphasis on
headline inflation for ease of communication. We have, however, found core inflation to be a
good indicator of the underlying inflation pressures excluding some exogenous and volatile
components and exogenous shocks, and therefore a useful policy guide. Whether or not
policy should focus primarily on core inflation is an issue that will be addressed by Stan du
Plessis, and I am sure it will generate some interesting debate.
A related challenge to the inflation targeting framework has been dealing with large
exchange rate changes which were primarily responsible for the deviations from target
experienced in 2002-3 and to some extent in 2014. Although pass-through from the
exchange rate to CPI has declined significantly over the period, it remains an important driver
of inflation. The rand is prone to overshooting in both directions, at times for extended
periods, and is vulnerable to terms of trade swings. In addition, because of the openness and
depth of the South African foreign exchange market, the exchange rate is sensitive to
changes in risk perceptions in global financial markets and associated changes in capital
flows, an issue highlighted in Shakill Hassan's paper.
Reacting to exchange rate movements has the potential to confuse the signals about the
objectives of monetary policy and the commitment to the inflation target, particularly when a
conflict between the objectives arises. However, while an inflation targeting framework
requires exchange rate flexibility, it is generally accepted that some intervention is not
inconsistent with the framework, as long as the motives are fully communicated and
understood, and that precedence is given to the inflation objective when a conflict between
the objectives arises.
Changes in the exchange rate could have inflationary impacts, but reacting to them could
pose a challenge for communication, particularly when a currency depreciation has been
accompanied by a tightening of monetary policy. We have tried to emphasise that such a
reaction is to the potential inflationary impact of the exchange rate change and not an
attempt to target the exchange rate itself. The exchange rate is one of a number of
determinants of inflation, so any response to an exchange rate change would have to be
assessed in conjunction with the simultaneous impact of changes in other variables, some of
which may be offsetting.
The response to exchange rate changes would depend on the nature of the shock, where
monetary and portfolio type shocks would require different interest rate responses. The
reaction of the exchange rate to interest rate changes has also been uncertain: during the
mid-2000s, when equity capital flows dominated in South Africa, lower interest rates
encouraged growth sensitive inflows, and currency appreciation. The impact of the exchange
rate has become even more relevant given increasing evidence of monetary policy spill-over
effects from advanced economies. In particular, low interest rates and quantitative easing in
the US and associated capital flows (and reversals) have impacted on the rand, with
attendant consequences for inflation and inflation expectations. In this regard, domestic
monetary policy has had to respond to both domestic factors and changes or potential
changes in policy globally. The issue of spillover effects will be taken further by John Taylor,
while Vivek Arora highlights the diverse response of emerging markets to shocks.
Inflation targeting, however, has not been without its domestic critics and political economy
challenges. There has been a lot of resistance to the framework from sections of the labour
movement in particular, where the idea of a long run trade-off between inflation and
employment persists, and, not surprisingly, opposition has tended to intensify during upward
phases of the interest rate cycle. This animosity is problematic, as societal buy-in and public
support are considered to be important prerequisites for the successful implementation of the
framework. Nicola Viegi, for example, argues in his paper that a lack of a strong response of
wages to labour market conditions is likely to undermine the efficiency of the framework.
Initially, inflation targeting was introduced without much prior publicity, public education or
consultation beyond the Bank and the National Treasury. In retrospect, we could have
embarked on a more aggressive education campaign to underline the benefits of low
inflation, the limits to what monetary policy can do with respect to growth, and why a flexible
inflation targeting framework is not necessarily inimical to growth. There was, and still is, a
widely held view that monetary policy can do more for structural growth and employment
than it can in reality.
To counter this, during the past few years, we have engaged in intensive stakeholder
consultations and instituted an "outreach programme" where we meet regularly with political
parties, trade unions, business federations and civil society to discuss our view on the
economy in general and on monetary policy in particular. Communication with the public has
become an integral part of our overall strategy. It has taken time to develop a modus
operandi for communicating with the public, and this remains an area of constant evolution
and refinement.
Unfortunately, although the animosity towards inflation targeting has declined significantly,
almost 15 years after the implementation of the framework, and despite our communication
initiatives, the views of some segments of society have not changed much. For example,
following the 25 basis point increase in the repo rate in July, the Cosatu response was one of
"bitter disappointment", laying the blame for low growth at the door of "conservative monetary
and fiscal policies", despite a slightly negative real policy rate and a fiscal deficit of 4.5 per
cent of GDP.
Communication has another dimension that relates to transparency of policy decision-making
and forward guidance, which is more about future policy actions rather than communication
about what monetary policy can and cannot do. Although transparency and communication,
which is the corollary to accountability, is not unique to inflation targeting, there is no doubt
that it is integral to the framework and most countries, including South Africa, have made
great strides in increasing this aspect over the past two decades. Alan Blinder has
appropriately referred to this process as the "quiet revolution in central banking". But there
are disagreements around the limits of this transparency, particularly around the issue of
forward guidance. Although forward guidance, in the form of setting the path for policy rates,
predated the crisis, (in New Zealand, Sweden and Norway), as monetary policy reached the
zero lower bound in a number of the advanced economies forward guidance of some form
became more common-place, although the nature of the guidance often differs across
countries, and has been changing in the US and UK in particular.
The debate is now whether or not such guidance has been useful, and whether or not it
should continue once interest rates normalise. Although we have chosen not to give
guidance in the form of an explicit path, we have moved in the direction of being more open,
but prefer to provide a more generalised form of guidance, to act consistently and allow the
market to deduce the appropriate policy path. Along with a number of other features of
inflation targeting or monetary policy, central bank communication is likely to continue to
evolve particularly given the increased demand for greater public accountability.
Since the crisis there has been some questioning as to whether inflation targeting is enough
to ensure price and financial stability and should there be any adjustments to the framework
and policy mandates. In general, most conclusions are that some variant of inflation targeting
is appropriate, and that long run price stability should remain a key goal of monetary policy.
But beyond that there are disagreements.
In particular, there are concerns that the low inflation environment and the narrow focus on
inflation contributed to the financial crisis: that the period of low interest rate volatility lowered
perceived risks, and encouraged increased leverage and lending. Economists at the BIS, for
example, were warning that credit cycles tend to be longer than business cycles, and that
failure to focus on the former could lead to excessive leverage and the emergence of asset
price bubbles. The conventional response at the time, as typified in Chairman Greenspan's
Jackson Hole address in 2003, was that central banks could not recognise asset price
bubbles, and therefore should not lean against them, but should rather clean up after the
bubbles had popped (Bill White's so-called "lean or clean" debate).
It is now generally accepted that a narrow focus on inflation to the exclusion of asset prices is
not sufficient. However, a number of unresolved issues remain, one being whether or not
monetary policy should lean against asset prices. For example Claudio Borio at the Bank for
International Settlements, proposes extending the time horizon for monetary policy to take
the financial cycle into account. Alternatively, should interest rates remain focused on
monetary policy, and macroprudential tools be used to deal with asset price excesses? And if
macroprudential tools are used, should this be done by the central bank, or by a separate
agency? There are very different views still on this issue. A Brazilian proposal by da Silva
and Minella is to integrate a focus on credit gaps into the monetary policy framework. By
contrast John Taylor argues for a return to a rules-based approach rather than trying to
finetune sectors of the economy over the cycle while Lars Svennson highlights the output costs
of "leaning against the asset price winds" with monetary policy.
Our approach is one of separation of goals and instruments, that the repo rate will maintain
its traditional role as the main monetary policy instrument, while macroprudential tools will be
used for financial stability purposes. This toolkit is being developed, and the Bank closely
observes how different instruments are being used in varied circumstances by other central
banks. This does not mean, however, that interest rates could or should not be used in
combination with macroprudential tools should the need arise.
The Bank's experience during the pre-crisis period, when we did not have a focused
macroprudential approach, is instructive. During the period 2003-2006, the economy was
growing at rates above potential, with an average growth rate of around 5,5 per cent, at a
time when the potential growth rate was estimated to have been around 4 per cent. The
exchange rate was appreciating, partly in response to the commodity price cycle; annual
growth rates in credit extension were around 30 per cent; real household consumption
expenditure growth was around 9 per cent; and house price growth was in excess of 30 per
cent. Had we had a macroprudential focus, such a combination of settings would have been
a cause for concern, and may have elicited a policy response through higher interest rates.
However, over that period, inflation was steadily declining and threatening to fall below the
lower end of the target range when it reached a low of 3,1 per cent, which could have
required a further easing of monetary policy. There was perhaps a failure on our part to
recognise this as a broader financial stability risk, and to react either with a tighter monetary
policy stance, or with macroprudential tools. Similar settings would probably result in a
different response today, given our explicit financial stability mandate. How effective our
macroprudential policies will be in solving financial stability issues and dealing with situations
such as those described above is, however, still an open question.
The expansion of central bank mandates to include financial stability explicitly could have
implications for central bank independence. Central bank independence is not absolute,
however, and independence relates mostly to monetary policy at the operational level. The
inflation targeting framework lends itself well to the separation of instrument and goal
independence, in that generally central banks do not have goal independence (as the target
is usually, but not always, set by government), but, in order to prevent the so-called political
interest rate cycle, central banks have independence to pursue the mandate given to them.
But, as I have stressed on a number of occasions in the past, we are not independent of the
economy or society that we live in, and therefore we have to take a number of factors into
consideration when making decisions. However, compared to financial stability, monetary
policy decisions, while not easy, are more straightforward and better understood by the
public. These decisions generally involve the use of one tool (the interest rate), although
quantitative easing has complicated this argument, and there is a clear objective, even if
there is some weight on output variability in the Bank's objective function.
However, a financial stability mandate is more complicated. It generally involves government,
particularly when public funds are involved, in crisis resolution and the policy tools are more
directed at particular sectors, and therefore may be more politically sensitive as the
distributional impacts are more apparent than in the case of monetary policy. Furthermore,
challenges for communications are likely to arise if interest rates are used for both monetary
policy and financial stability purposes. And, as a recent IMF paper has argued, financial
stability is difficult to measure but crises are evident, so policy failures are observable, unlike
successes. To quote from the paper, "central banks would find it difficult, (even ex post) to
defend potentially unpopular measures, precisely because they succeeded in maintaining
financial stability." And any perceived failures on the financial stability front have the potential
to undermine monetary policy independence through a general loss of credibility of the
central bank.
A final issue is the debate around the optimal level of inflation. In particular, is the 2 per cent
inflation target norm in advanced economies too low? Olivier Blanchard at the IMF mooted
this in 2010, but the idea persists, and was recently raised again by Paul Krugman. The
argument relates to a fear of deflation, the dangers of a low inflation trap, and the economic
costs of deflation. But it does not undermine the basic tenet that long run price stability
remains at the core of central bank mandates. Rather, it appears to be a call for a moderate
upward adjustment to what would be regarded as the advanced economy norm for price
stability.
This debate, however, is not really that relevant in South Africa or many emerging market
economies where structural features, price setting behaviour and vulnerability to exogenous
shocks has generally required higher inflation targets. These structural features include
factors such as the weight of administered prices in the inflation basket, the weight of volatile
elements such as food, vulnerability to terms of trade changes, particularly in the case of
commodity producers, and the impact of exchange rate volatility on the exchange rate.
Although our inflation target of between 3 and 6 per cent is higher than the advanced
economy norm, this does not mean that there have not been times when there have been
calls to raise the inflation target, even from the current high level, in order to bring about a
looser monetary policy stance. Our current level of inflation and our target are not close to
the low inflation trap, and our view is that a higher inflation target would merely raise inflation
expectations, and actual inflation would then likely increase. The end result would be higher
nominal interest rates, and because of possible higher inflation variability and other risk
premia, we could end up with higher real interest rates as well.
In conclusion, inflation targeting is not as straight-forward as its name suggests. There are
many contentious issues, and the challenges facing emerging market economies are
different to those of the advanced economies. We are extremely fortunate to have a strong
line-up of international and local experts on this topic to provide us with their thinking on this
important policy question and to stimulate discussion. There is also keen interest and
participation in the conference, with a wide range of delegates, and I am sure you will all be
active participants in the discussions. I am particularly grateful to our international visitors
who have undertaken the long journey to be with us, and we hope that you will enjoy your
stay with us and will have time to gain an appreciation of our country beyond the confines of
the central bank and monetary policy.
Thank you.