An address by Daniel Mminele,
Deputy Governor of the South African Reserve Bank,
at the Central Banking Seminar of the Federal Reserve Bank of New York
New York
16 October 2017
Economic and monetary policy developments in South Africa
Introduction
Ladies and gentlemen, good afternoon.
It is my great pleasure to address this distinguished audience of fellow central
bankers as we gather here in New York City to compare the current economic and
financial developments across the major regions and to discuss the conduct of
monetary policy in a world that finds itself in a transition.
For many of the previous years, as we gathered for the annual meetings of the
International Monetary Fund and the World Bank, we had to discuss the reasons for
the continued disappointing performance of global growth, and the most appropriate
role that monetary policy could play in contributing to remedying the shortfalls.
This year, I am pleased to say, the outlook is finally looking somewhat promising:
global economic growth, especially in the advanced economies, is gathering some
momentum, is generally stronger than most observers expected a year ago, and
looks sustainable, even if medium-term risks, which need tackling to safeguard these
encouraging developments, cannot be ignored.
As much as these developments are welcomed by the emerging economies, some
of which have struggled with sub-par growth in recent years, there are some
accompanying challenges. For example, stronger economic growth will continue to
reduce the degree of economic slack in the advanced economies, calling for ongoing
monetary policy normalization and, eventually, higher real interest rates across the
world. For the emerging economies that have become used to elevated capital
inflows of late, this may force unpopular policy adjustments.
My remarks today will focus on the South African experience and how our monetary
policy is negotiating the present challenges of low growth, inflation risks, and a
benign yet uncertain global environment.
The dilemma of slowing growth and stubborn inflation
In its conduct of monetary policy, the South African Reserve Bank (SARB) has faced
a growing dilemma in recent years: that of slowing economic growth coupled with
inflation that is stubbornly rigid above the midpoint of its 3-6% target range.
Following the short-lived rebound in the aftermath of the global financial crisis, which
the economy‟s growth
saw real GDP1 expand by about 3% in both 2010 and 2011,
rate has gradually slowed, reaching a low of 0.3% in 2016. The average growth of
1.6% in the past five years is a far cry from the 4.7% seen in the five years leading
up to the 2008/09 recession. Our forecasts currently see real GDP registering growth
of only 0.6% in 2017 before recovering moderately to a similarly weak 1.2% in 2018
and 1.5% in 2019.
Yet inflation has not shown a typical response. From a low of 3% in late 2010, the
year-on-year rate of increase in the consumer price index (CPI) has mostly hovered
SARB‟s
around the upper end of the 3-6% target band, breaching it on the upside on
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five occasions the last time between September 2016 and March this year. Even if
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we look at the core rate of inflation which excludes the volatile food, non-alcoholic
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beverages, fuel, and electricity components the picture is quite similar. From a low
of 3.6% year on year in the early months of 2011, core inflation rose for most of the
following five years, only declining since the beginning of this year.
Why has this happened? To a large extent, the answer lies in the structural nature of
the economic slowdown. A self-reinforcing cycle of poor private-sector confidence,
coupled with subdued business investment and infrastructure bottlenecks (in
particular in the electricity sector), has led to a gradual but sustained deterioration in
the potential rate of economic growth. From the 3-4% range seen for most of the
SARB‟s
2000s, the estimate of potential growth has slowed to no more than 1.1% for
this year, with only a mild pickup expected in the next two years. Consequently,
while we estimate that actual GDP is currently about 1.7% below potential, this
output gap explains only a minor part of the poor growth performance of recent
years.
Yet, even the presence of an output gap for most of the past eight years has not had
a major impact on inflation. Indeed, our internal models suggest that the degree of
slack in the economy has a lesser impact on the formation of price trends than other
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factors do, for instance exchange rate developments which, incidentally, have
been unfavourable over the past few years. Several other factors are frequently cited
to explain this relative lack of responsiveness, including rigidities in the wage
formation process, insufficient competition in many sectors of the economy, and the
adaptive and backward-looking nature of inflation expectations.
Recent improvements in the inflation outcome and inflation outlook
Admittedly, the last three quarters have seen an encouraging improvement on the
inflation front, despite the stickiness above the midpoint of the target band. The
headline rate of inflation, which peaked at 6.7% in December 2016, fell to 4.6% in
July 2017. Part of this slowdown reflects the more benign developments on the food
and energy fronts. Helped by a strong rebound in grain production following the
2015/16 drought, which sharply reduced the prices of cereals, food inflation has
fallen to 5.7% from a high of 11.8% last December. Fuel inflation is still off its early-
year highs, while the modest gain in electricity prices in July 2017 has improved the
overall year-on-year CPI comparison.
However, not all of the inflation slowdown is attributable to these transitory factors.
Encouragingly, after a long upward drift, core inflation fell from a peak of 5.9% last
December to 4.6% in July. Furthermore, this moderation was stronger than both the
market consensus and the SARB expectations at the start of the year, as evidenced
by the regular downward adjustments to our inflation projections. True: a large part
of the deceleration in core inflation occurred in the goods sector, especially in those
subsectors where import penetration is elevated, and these subsectors clearly
benefitted from a recovery in the rand from early 2016 to March 2017 (an
improvement of 37% in nominal, trade-weighted terms). Yet the magnitude of that
slowdown in inflation, just like the absence of upside price pressures in the services
sector (in particular in housing and insurance), surprised most observers.
The marked improvement in the inflation forecast, as well as the significant
deterioration in the growth outlook coupled with an assessment by the Monetary
Policy Committee (MPC) of the risks to the inflation outlook being more or less
balanced, gave the MPC room for a moderate reduction in the repurchase rate of 25
basis points to 6.75% at its July meeting.
The current rates of inflation are not expected to fully persist, in large part because
reflect the lagged impact of last year‟s rand recovery, which has already
they still
SARB‟s
partly reversed. Indeed, the latest projections see inflation rising back to
5.3% by the third quarter of 2018 and stabilising around these levels over the
MPC‟s
remainder of the forecast period. By the time of the September meeting, while
the inflation outlook was more or less unchanged and the growth outlook had
improved moderately, the risks to the inflation outlook were assessed to be
somewhat on the upside, resulting in the MPC opting to keep rates unchanged at
that meeting.
Risks to the more benign environment
While the overall situation looks more benign when compared to previous periods,
this should not allow a sense of complacency to creep in. The exchange rate of the
rand, whose recovery over the past year has been key to the decline in inflation,
remains volatile but does not display any major deviation, at present, from what our
internal models suggest as fair valuation. Yet the risks to the rand are probably
skewed towards renewed depreciation, for both internal and external reasons.
On the internal front, factors such as the combination of political and policy
uncertainty, growing fiscal challenges of addressing growth-induced revenue
shortfalls, the continuing upward drift in the debt-to-GDP ratio as well as growing
funding needs for state-owned enterprises could all add to currency vulnerability.
Global market developments could also easily compound the rand‟s vulnerability. So
far this year, the combination of low global market volatility, relatively flat government
bond yield curves, and compressed risk premiums across a broad range of financial
assets has largely sheltered South African assets from domestic causes of volatility.
Net portfolio inflows into the local bond market have remained positive, and even in
instances where domestic developments did put local assets under pressure, such
tension proved short-lived. Yet the recent upward correction in interest rate
expectations in several advanced economies, including the US2 and the UK3, serves
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as a warning that even a gradual pace of monetary policy normalization after years
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of very loose global monetary conditions may not be without adverse
consequences for emerging market currencies such as the rand.
Other factors present upside risks to inflation over the coming two years. On the
exchange rate front, we must also remember that the 2016 and early 2017
appreciation was greatly helped by a recovery in South Africa‟s
terms of trade.4 But
the recent developments in commodity prices, including the stronger prices of crude
oil and the downward correction in the prices of iron ore, indicate that this
improvement could partly reverse. The possibility remains for a larger electricity tariff
SARB‟s
increase in 2018 than the 8% assumed in the forecast. In addition, in the
longer run, the implementation of minimum wage legislation could put upward
pressure on labour costs, even though the size and timing of that impact is not yet
fully understood.
Monetary policy's
unclear margin of manoeuvre
Amid such elevated uncertainties, and despite the subdued nature of domestic
demand, it is not clear how much space exists, if at all, for additional policy rate cuts
by the MPC in the coming quarters. However, this does not mean that the SARB
does not take the weakness of real economic growth into consideration. It certainly
SARB‟s
does. Indeed, estimates by the Quarterly Projection Model (QPM) of a
Taylor rule based on the historical policy rate path show that the output gap has
played a role in determining that policy rate.5
Furthermore, the policy stance is, at present, probably not far from what can be
perceived as „neutral‟. According to estimates from the above-mentioned QPM
model, the current real interest rate is not far from its equilibrium, or „neutral‟, level.
this „neutral‟ level
Admittedly, estimates of are fraught with high uncertainty, in South
Africa and elsewhere. Nonetheless, such calculations suggest that the SARB does
not have the kind of „room to ease‟ it had when policy was unambiguously tight, for
instance at the start of the 2008/09 recession.
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Arguably, because of the existence of an output gap, monetary policy could under
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normal circumstances be allowed to loosen somewhat, with a real interest rate that
is moderately below its „neutral‟ level. This bias must, however, be weighed against
both the upside risks to inflation (which I have already highlighted) and the
stubbornly high level of inflation expectations. While expectations are currently less
volatile, and probably less adaptive than in the early years of the inflation-targeting
regime, they remain above the midpoint of the target range and uncomfortably close
to its upper end. The consequence is a relatively large risk of persistent above-target
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inflation in the event of an inflationary shock to the economy and it is the mandate
of the MPC to mitigate such a risk.
As indicated earlier, in light of the balance of risks to the outlook and to the current
policy stance, the MPC decided to keep the policy rate unchanged at its September
meeting. This does not prejudge any future moves. Rather, because of the elevated
level of uncertainty we are currently facing, the MPC feels a particularly strong need
to reassess the balance of risks at every meeting. Consequently, monetary policy
decisions, now more than ever, have to be data-dependent.
The most recent decision of the MPC appeared to surprise domestic money markets
somewhat, as they had come to discount a 25 basis points rate cut in the wake of
the July move. We prefer not to surprise markets. In fact, we see policy transparency
and consistency as crucial in ensuring an effective transmission of rate decisions to
the economy.
Yet in a fluid environment, where even small changes in the balance of risks can tip
the policy scales one way or another, it is not possible to systematically come up
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with fully predictable policy decisions just as it is not possible, in such an
environment, for the MPC to give the kind of forward guidance that some call for. If
SARB‟s
anything, domestic financial market indicators seem to broadly echo the
view that the uncertain environment is forcing a cautious approach to policy. Thus,
forward rate agreements only discount a short and shallow easing cycle while the
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yield curve is positively sloped a sign that investors are cognisant of the upside
risks to inflation, and therefore to policy rates, in the medium to long term.
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Conclusion the continued relevance of the inflation target range
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The challenges that South Africa has had to face over the past few years in
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particular the combination of slow growth and relatively high inflation may have led
some observers to question whether the current inflation target range remains
relevant for the country at this stage. In my view, raising or even contemplating
abandoning the inflation target band would be a misguided approach. Both economic
theory and historical experience show that whenever the price and wage formation
process is rigid and price expectations are adaptive rather than well anchored, the
cost of negative shocks tends to be higher and longer-lasting in real economic terms.
South Africa‟s own experience of the
most recent global financial crisis, which saw
the country suffer a relatively high number of job losses, illustrates the merit of such
a strong and credible price anchor.
In fact, many emerging economies, including those at a similar level of development
as South Africa, have enjoyed both stronger economic growth as well as lower and
more stable inflation since introducing inflation targets. This observation has
continued to apply since the global financial crisis. Equally, the adoption of a different
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anchor for example the exchange rate would be very difficult for South Africa as
we are a commodity exporter and therefore regularly exposed to large terms-of-trade
fluctuations.
The truth of the matter is this: low and stable inflation is the best contribution that
monetary policy can make towards stronger and more sustainable economic growth
and poverty reduction. As the saying goes: "Facts do not cease to exist because
they are ignored."
There is no better way to contribute to the socio-economic well-being of a nation
than to protect the cost of living of its citizens. In his speech titled „Whip inflation
now‟, US President Gerald Ford warned that inflation would „destroy our country, our
homes, our liberties, our property, and finally our national pride‟.
As the SARB, we remain committed to formulating and implementing monetary
policy aimed at controlling inflation at low levels, in line with the independence that
the Constitution guarantees us, while remaining relevant to the context in which we
operate.
Thank you.