Daniel Mminele: Normalising monetary policy in an uncertain world - the
outlook for monetary policy in South Africa
Address by Mr Daniel Mminele, Deputy Governor of the South African Reserve Bank, at the
Bank of America Merrill Lynch Fixed Income conference, Johannesburg, 28 November 2014.
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Introduction
Good morning ladies and gentlemen. Thank you to Bank of America Merrill Lynch for inviting
me to address you on the issue of monetary policy normalisation in an uncertain world. This
must be the single-most important issue that central banks around the world have been
grappling with for quite a while now.
We are now in the sixth year post the global financial crisis (GFC). Six years seems rather
instructive, because this is approximately the amount of time of that Reinhart and Rogoff
originally suggested it would take to recover from the financial crisis.1 There is now a fairly
strong consensus view among economists across the world that the US has paid its dues
and set itself up for a period of economic growth and subsequent monetary policy
normalisation.
In the case of the US, normalisation is generally taken to mean that the Federal Reserve
(Fed) will stabilise the size of their balance sheet, raise the Federal Funds rate and allow the
yield on US treasury bonds to move more freely. As a consequence of the US's favourable
interest rate and growth differentials vis-a-vis the rest of the world, the US dollar is likely to
continue to strengthen as capital flows back to higher yielding opportunities in the States.
Although normalisation and the consequent moves to higher policy and bond rates are
probably one of the most expected and anticipated consensus trades that the collective
market has ever anticipated, two things remain uncertain - namely timing and the degree of
adjustment, both in the US and elsewhere. In a normalising yield environment in the US,
most investors expect emerging market (EM) currencies to come under pressure -
particularly of those EMs running large (twin) deficits and vulnerable to capital flow reversals.
South Africa is unfortunately part of this latter group of countries.
If this is not challenging enough, we are also faced with stagflation - i.e. low growth and high
inflation. On the one hand US policy normalization suggests that we need to tighten policy,
but on the other hand raising rates carries the risk of weakening our own already weak
recovery. Consequently, the combination of an uncomfortably high current account and fiscal
deficits requires a pragmatic and balanced policy response that will contribute to a more
sustainable growth path for our economy.
In an effort to do justice to the topic I was asked to address today, I will try and assess how
we got into this unpleasant juncture, and what policy can do about it.
But let me first say a few words about monetary policy in major advanced economies and its
effect on South Africa, given just how important a swing factor this is for our policy
considerations.
Diverging policies global monetary policies
We know that the onset of the global financial crisis saw a synchronised response by central
banks across the world. There was a coordinated effort to loosen monetary policy to cushion
the world economy against what would probably have been a devastating collapse. These
accommodative policies have indeed succeeded in helping to protect against a protracted
global recession, and have also underpinned a global economic recovery. However, the pace
and extent of recovery has been uneven, which has resulted in diverging policies across the
major developed economies.
After a disappointing start to the year, the US economic performance has been better than
expected in recent quarters. The weather-related contraction of the first quarter was followed
by a strong rebound in growth in the second quarter, with the strong momentum maintained
into the third quarter. The economy is estimated to have grown at a better-than expected
3,9 per cent in the third quarter, with leading indicators such as the PMI pointing to strong
growth in the final quarter of the year. The job market has also improved considerably, with
the unemployment rate declining to 5,8 per cent in September, the lowest level since June
2008. In line with this stronger than expected performance of the economy, the Fed
concluded its quantitative easing programme in October and this has raised expectations of
a policy rate hike in mid-2015. The pace and timing of normalisation of policy rates, as
repeatedly stated by the Fed, will largely depend on the economic and inflationary
developments and the Fed's interpretation thereof. With a lot of slack still remaining in the
US labour market, one would expect the Fed to be cautious to not impede the recovery by
moving too soon and too aggressively. Inflationary pressures are also expected to remain
largely contained by a strong dollar and lower energy costs. The Fed will therefore face a
less difficult trade-off between above-target inflation and consolidating growth. As such, the
base case appears to one of a gradual normalisation of the Fed's policy rate.
The UK recovery also appears to be on track, with the economy growing 2,8 per cent in the
third quarter and the unemployment rate falling faster than expected, reaching 6 per cent at
the end of the third quarter. Although the Bank of England has maintained its asset
purchases at £375 billion and interest rates at 0.5 per cent, sentiments are slowly shifting
with some policymakers starting to vote for a policy rate hike. However, with the decline in
the inflation rate to below the 2 per cent target, faltering growth in Europe, and soured trading
and financial relations with Russia, a delay in policy normalisation appears likely.
In contrast to the positive developments in the US and the UK, growth in the euro area and
Japan has stalled, with policymakers in these countries indicating their willingness to take
strong remedial action to mitigate against a protracted recession and extremely low inflation.
The outlook for the euro area has deteriorated over the year, with growth forecasts by the
European Commission having been revised downwards in November, from 1,2 and
1,7 percent to 0,8 and 1,1 per cent for 2014 and 2015 respectively. More worrying has been
the shift of the weakness from the periphery to the core, notably France and Germany. The
euro zone is also battling with extremely low inflation, with CPI growing by a meagre 0,4 per
cent in October, uncomfortably close to deflation and far below the ECB's target of
close-tobut-below 2 per cent. The ECB has responded to these challenges by cutting its policy rate
further in September and introducing a new stimulus plan2 involving the purchase of
investment-grade asset backed securities issued by the non-financial private sector as well
as covered bonds of the financial sector. And we have had strong indications from policy
makers again during this week that should these measures prove to be insufficient, the
Governing council will consider in the first quarter of 2015 whether to embark on a sovereign
bond purchase programme.
Japan's economic performance has also disappointed, with the hike in the value-added tax
(VAT) partly to blame. Pre-emptive buying ahead of the VAT increase in the first quarter of
the year resulted in a positive performance, but this was followed by contractions in the
second and third quarters, pushing the Japanese economy back into recession. Furthermore,
although inflation is above the 2 percent target, this is largely due to the VAT increase and
inflation is expected to fall in the early months of 2015. In response to recessionary
conditions and still muted inflation, the Bank of Japan (BOJ) responded by raising its
monetary expansion programme in October by an additional ¥10-20 trillion to ¥80 trillion (an
equivalent of just under US$700 billion) per year.
Clearly, we are seeing a divergence of policy in the major advanced economies. This
suggests that central banks need to weigh the spill-over effects of tightening policy in the US
against accommodative policies in Europe and Japan in determining their own monetary
policy trajectories. Our sense is that the impact of US tightening will dominate, but that it
would be tempered somewhat by ECB and BOJ stimulus plans.
However, it is clear that global financial conditions have become less hospitable for countries
with large external financing requirements. This process has already delivered a bumpy ride
for South Africa, as it has for some other countries.
Impact of normalisation on South Africa
Like most emerging markets, South Africa benefited from the massive liquidity injection into
the global financial market following the Great Recession. Inflows of capital meant that the
current account deficit was comfortably financed, while it also resulted in significant
appreciation of the rand. This in turn helped to contain inflation, allowing room for
accommodative monetary policy over a fairly extended period. However, these trends started
to reverse in May 2013 in anticipation of US monetary policy normalisation, following
indications to that effect from the Fed. This saw a widespread depreciation of emerging
market currencies, which intensified with the actual implementation of the US Federal
Reserve's asset purchase tapering programme starting from January 2014.
The rand depreciated quite sharply in line with emerging market currencies, with the
weakness exacerbated by a widening current account deficit. The rand weakness contributed
to rising inflationary pressures, with inflation breaching the 6 per cent target in April and
reaching 6,6 per cent in May and June before retreating to 5,9 per cent in September and
October. The moderation in food and petrol prices contributed to lower inflation outcomes in
recent months. In particular, the abrupt and significant decline in international oil prices to
below US$80 per barrel in November has had a positive impact on the medium term inflation
outlook. The Bank's latest inflation forecast reflects an improved outlook, with headline
inflation now expected to average 6,1 per cent and 5,3 per cent in 2014 and 2015
respectively, compared with the previous forecast of 6,2 per cent and 5,7 percent. However,
there is a lot of uncertainty around the sustainability of the decline in oil prices, while the
exchange rate also continues to pose upside risks to the inflation outlook, as it still remains
vulnerable to changing perceptions about global monetary policy normalisation, and the large
current account deficit. As we have indicated previously, wage settlements that are de-linked
from inflation and underlying productivity trends also pose an upside risk to the inflation
outlook. Furthermore, the Bank remains concerned about the elevated level of core inflation
which remains close to the upper target level.
Domestic growth outlook also remains weak. The economy contracted by 1,6 per cent in the
first quarter and grew by a marginal 0,5 per cent in the second, with much of this weakness
due to prolonged strikes in the mining and manufacturing sectors amid already weak global
conditions. Growth improved to 1,4 per cent in the third quarter, however this was off a low
base. The Bank revised its growth outlook for 2014 downwards to 1,4 per cent, as
announced after our most recent MPC meeting last week, compared with 1,5 per cent
previously. The 2015 and 2016 projections were also downgraded from 2,8 per cent and
3,1 per cent respectively to 2,5 per cent and 2,9 per cent. Domestic growth prospects remain
constrained by short-term and long-term structural supply factors such as strike activity,
rising input costs and electricity shortages, as well as slowing consumer demand. Falling
commodity prices and weak economic conditions in the country's major trading partners also
add to this subdued outlook.
The combination of uncomfortably high current account and fiscal deficits (in the face of
global monetary policy normalisation), high inflationary pressures, and weak domestic growth
pose a challenge for both monetary and fiscal policy. These have required a balanced policy
response in an effort to ensure a sustainable growth path for our economy.
So how is South Africa doing?
Let me quote you a paragraph from last week's Economist magazine:
"It was great while it lasted. In a golden period from 2003 to 2010 .... economies
grew at an annual average rate of close to 5%, wages rose and unemployment
fell, ... people were lifted out of poverty and the middle class swelled.... But now
the growth spurt is over. What some worried would be a 'new normal' of
expansion of 3% a year is turning out to be far worse. The ...economy will on
average grow by only around 1.3% this year."3
No, in this case the Economist is not referring to South Africa - the quote is actually for the
Latin American region. But it is very much also our own story. Indeed, the ongoing emerging
market slowdown serves to remind us of the protracted nature of previous crisis episodes,
including the 1997-1998 Asian crisis and the 2008-09 world financial crisis. However, there
are limits to similarities among EMs, which may lead to differentiation when assessing
countries.
For example, South Africa's export performance relative to a number of peers remains poor -
irrespective of whether they are commodity exporters (Australia), or have also experienced
significant exchange rate depreciation (India, Turkey), or both (Brazil and Chile). The fact
that South Africa has grown its exports less than its peers, implies that the domestic
economy is suffering from something more than weak global demand and declining
commodity prices.
South Africa's weak performance is also visible in the country's declining share of world
exports, which declined from around 0.7% of world merchandise exports to 0.55% over the
last 10 years. Perplexingly, SA's portion of global exports has remained roughly stable since
2011, at about the level last attained at the height of the Great Recession, despite
pronounced currency depreciation over that entire period.
With global growth - particularly in the EU, our largest trading partner - under severe
pressure, we increasingly relied on the domestic non-tradeables sector to prop up domestic
growth as it would have been difficult to ramp up exports.
Unfortunately not all growth is equal. The quality of growth matters at least as much as the
quantity of growth, and there are reasons to believe SA's non-tradeable growth in the
postcrisis years has been of inferior quality. It has been driven by consumption, not investment,
which has been financed by debt, meaning it reduces future consumption and investment
capacity. Furthermore, the growth has been based on large quantities of imported inputs,
resulting in an unsustainable current account deficit.
Credit growth to the private sector appears sustainable and consistent with macroeconomic
fundamentals. Since the first quarter of 2011, credit extended to households increased by
22.3 per cent (or 4.9 percent when deflated with headline CPI), slightly less than the 6%
increase in GDP over the same period. Household credit has weakened quite significantly in
recent months, with growth slowing to an annual rate of 3,7 percent in September compared
to 7,5 percent in the same month last year. However, the moderate overall increase in credit
could be masking several unwelcome developments.
For instance, "good credit" extended for mortgages increased by much less than other
categories, notably instalment sale credit (mostly used for vehicle financing) and unsecured
credit. With credit extended to households shifting from relatively low interest (and lower
margin) mortgages to more profitable (higher margin) categories, it is not surprising that the
real value added in the financial sector also increased by a cumulative 9.5 percent since
2011q1 - on par with the real growth recorded in the retail sector. In fact the retail and
finance sectors together contributed almost 60 percent of GDP growth since 2011q1 -
significantly larger than their 37 percent share in GDP.
The growing size of the non-tradeables sector may also explain a weakening economy-wide
response to a weaker real exchange rate.
Potential growth has slowed
Another reason why South Africa has so far experienced a relatively weak recovery from the
2008-09 recession, relates to faltering potential growth. According to the OECD, "estimating
potential growth rates is always an imprecise exercise, and all the more so for a country
(such as SA) with such a high rate of inactivity and where the responsiveness of wage and
price inflation to changes in unemployment is low. In addition, in recent years the task has
been further complicated by uncertainty over the extent to which electricity supply limitations
have constrained potential output growth in South Africa".4
Replicating work by Borio, Disyatat, and Juselius (2013, 2014) at the Bank of International
Settlements (BIS), which incorporates financial cycle characteristics into the estimation,
some estimates suggest that South Africa's potential growth rate declined from 4 per cent in
2007 to around 21⁄2 per cent in 2013, compared to earlier estimates which suggested that
current potential growth rates was around 3 to 31⁄2 percent5. This development is not unique
to South Africa as several studies show that potential growth may have been over-estimated
in many emerging market economies.
Monetary policy response
The operating environment for South Africa's monetary policy has become increasingly
complex, with growth and inflation dynamics being influenced by a range of global and
domestic factors, which call for delicate trade-offs in terms of policy settings.
Recent developments suggest that the period of relatively low volatility has come to an end.
Market participants and policy makers now have to grapple with the possibility or risk that the
lift-off of rates in US may occur sooner than they anticipate, while in Japan and the Eurozone
more easing seems to be on the way, while risks assigned to geo-political risks, which the
market seems relatively relaxed about, may intensify. All these factors are likely to increase
volatility. Recent experience has shown us how sensitive our domestic market are to the
international backdrop. Against the background of South Africa's elevated current account
deficit, which is expected to only correct slowly, the risk of abrupt swings in capital flows
cannot be under-estimated.
This environment calls for continued vigilance from policy makers, and preparedness to
respond to the fast-changing economic and financial markets environment, and readiness to
act to changes one's monetary policy stance when deemed appropriate. It also calls for
ongoing dialogue, exchange of information and appropriately calibrated communication in
order to strengthen policy credibility. As you are aware, we embarked on a gradual,
datadependent, policy normalisation process at the beginning of this year, which will continue, but
will also take account of the unfolding situation as it affects the inflation trajectory and growth
dynamics. More recent developments on the inflation front have been encouraging and
resulted in an improved headline inflation forecast, which gave the MPC some flexibility in
the short-term, while it expressed concern about sticky core inflation, and reiterating that the
need to over time realign our real interest rates better with our emerging market peers
remains.
As indicated in our MPC statement last week, the timing of future interest rate increases will
be dependent on a range of factors, including the evolution of inflation expectations, the
timing and speed of normalisation of monetary policy in the US and the state of the domestic
economy.
As we have said before, while monetary policy should and in South Africa will play its role
within the confines of its mandate, a concerted effort is needed by other key role players in
agreeing and effectively implementing the necessary structural reforms that will deliver
higher trend growth.
Thank you.