An address by Lesetja Kganyago,
Governor of the South African Reserve Bank
University of Pretoria, Pretoria
12 August 2020
In the shadow of COVID:
lessons from 20 years of inflation targeting
Good afternoon, ladies and gentlemen.
This speech is about 20 years of inflation targeting.
For two decades, we have been part of a great international experiment in getting
monetary policy right. Inflation targeting has delivered a long period of price stability,
comparable to the best years of the post-War Bretton Woods system, and should be
considered a success for South Africa and for many other countries.
To understand how we got to where we are now, looking back at 20 years of inflation
targeting, we can start further back: with a speech from 1979, titled 'The anguish of
central banking', by Arthur Burns, who was Chair of the US Federal Reserve for most
of the 1970s.
This was a period of high inflation, in the US and globally. Burns asked why inflation
was 'proving so stubborn', and why central bankers were failing to stop it. He offered
a remarkable confession: that the Fed could have stopped this inflation at any time,
but didn't because it lacked the will to do so.1 To quote from the speech directly:
Inflation came to be widely viewed as a temporary phenomenon - or, provided it remained mild,
as an acceptable condition. 'Maximum' or 'full' employment, after all, had become the nation's
major economic goal - not stability of the price level. That inflation ultimately brings on
recession and otherwise nullifies many of the benefits sought through social legislation was
largely ignored.2
During Burns' tenure at the Fed, inflation averaged nearly 7% in the US, well above
the 2% levels of the preceding two decades.3 Indeed, the decade ended in tears, with
high inflation giving way to falling investment and growth, and eventually a sharp and
persistent increase in unemployment, which took years to resolve.
How easily could we have made the same mistakes! We could have said that - with
high unemployment, and such great economic demands after apartheid - it was just
not possible to control inflation. And then we would have ended up with no social
benefits - no more growth, no extra jobs - but with high and stubborn inflation instead,
just as it did for Burns.
But the story of South African central banking, in the democratic era, is not one of
regret. The 1980s and early 1990s made it very clear that high inflation creates
uncertainty, destroys savings, and undermines growth. The growth/inflation trade-off
doesn't work. We realised that inflation targeting, as a transparent and accountable
policy framework, provided our best shot at price stability with growth.
In fact, the inflation-targeting era has been one of lower inflation and lower interest
rates than prevailed previously. Following our mandate, inflation has been kept under
control.4 Even now, at this very difficult time for the economy, we can see the inflation-
Please see Arthur Burns, 30 September 1979, 'The anguish of central banking', available at
http://www.perjacobsson.org/lectures/1979.pdf, p. 15.
2
Ibid, p. 13.
3
Precisely, CPI inflation averaged 6.5% during Burns' tenure as Fed Chair (February 1970 -
March 1978). For the 1970s as a whole, inflation averaged 7.1%. For the 1960s, it was 2.3%. For
the 1950s, it was 2.1%. (Data from the St Louis Fed FRED database.)
4
For this period, inflation has averaged 5.9%. The volatility of growth, inflation and interest rates has
also been lower. Specifically, for the periods 1970-2000 and 2000-2020, the standard deviation of
growth has declined from 4.3 to 2.6, the standard deviation of inflation has fallen from 3.9 to 2.4, and
the standard deviation of interest rates (the lowest SARB lending rate) has gone from 4.9 to 2.5. The
pattern of lower volatility following the introduction of inflation targeting also holds when contrasting
1980-2000 with 2000-2020 (i.e. two 20-year windows).
targeting framework functioning properly, delivering historically low interest rates in
the context of low inflation.
What are the chances, 20 years from now, that we will still have price stability and low
interest rates? Will we be agonising, 20 years from now, over how we lost control of
inflation?
Today, there is a new generation coming of age, in very difficult circumstances. They
have many questions - about the economy in general, and about how monetary policy
fits into the picture. Some of the questions are asked in a fiery tone, and I think that
young people are right to be angry. Not only have they been unlucky, reaching
adulthood during one of the worst economic disasters in modern history. They are also
now discovering that, over the past 10 years, South Africa has been accumulating debt
at a rapid pace, faster than any big emerging market except Argentina. So, while the
economy struggles to grow, and job creation remains elusive despite the spending,
there is a heavy burden of debt for future generations to carry.
Justified though this anger is, we need to channel that energy into positive action. We
also need to guard against making policy mistakes that could sink us into deeper
trouble.
Perhaps, in the audience here today, there are future macroeconomic policymakers,
future reserve bank governors and finance ministers. There are surely many people
who will be leaders in this country, in one role or another. This speech is primarily for
you. You will decide much of our economic future, through your choices and the ideas
behind them. We are giving you many problems, but at least we have achieved price
stability. It will be up to you to keep it. Here are some lessons we have learned to help
you do that.
The first lesson has to do with Arthur Burns' problem, which is about losing track of
your mission and living to regret it. Perhaps the most common criticism of inflation
targeting, over the past two decades, has been that South Africa needs a more growth-
friendly monetary policy. Burns, however, learned the hard way that there is no
permanent gain to growth from short-run increases in inflation.
While we would all like South Africa to reach permanently high growth, this is beyond
the powers of a central bank. As we have often communicated, most of our growth
problems should be addressed through structural reforms and confidence-boosting
measures. To give just one example, the central bank cannot stop electricity load-
shedding with interest rates.
The South African Reserve Bank (SARB) can be held accountable for achieving low
and stable inflation. But economic growth requires collaborative effort. It is simply not
within the power of one institution to deliver. It is a team sport. It needs contributions
from education, from the development finance institutions, from the private sector, and
from many other players.
Our emphasis on growth as a team sport, however, does not crowd out our concern
for the specific growth problem we can address, which is weak demand. Right now,
demand has been badly damaged by the coronavirus lockdowns. In technical terms,
we think the output gap is deeply negative. This feeds into our policy stance: we have
slashed interest rates to support aggregate demand and the spending power of South
Africans. In doing this, we are supporting that part of growth in the near term which we
can influence.
We have become clearer about this in recent years, as part of adopting the Quarterly
Projection Model (QPM) as the main forecasting tool for the Monetary Policy
Committee (MPC) back in 2017. The QPM sets out a proposed path for interest rates,
which it gets from a so-called 'Taylor rule'. That rule responds to the output gap as
well as inflation. Indeed, because the output gap also affects the inflation rate, the rule
responds to weak growth twice. The output gap gives us a measure of slack - and
that gap, in turn, has an impact on inflation.
Would it make sense to add growth or employment to the mandate of the SARB,
alongside the price stability mandate?5 I doubt this would change policy much. After
all, we already include growth in our models and decision making - through the output
gap, a comprehensive measure of economic slack.6 The problem is that formally
adding an extra mandate, in the context of our propensity to stagflation, could
encourage policy mistakes and weaken credibility.
South Africa's growth and employment problems are bigger than monetary policy.7
For instance, even when the economy was booming, unemployment stayed above
20%. As with growth, the bedrock of this problem is structural, not cyclical. In this case,
it's the legacy of Bantustans, apartheid education, and the failure to fix those problems.
Our labour markets have also historically raised the cost of hiring people even when
the economy is weak and people are losing jobs. This cost inflation has further
undermined job creation even when growth picks up.
For these kinds of structural reasons, an employment mandate is unlikely to be
effective. More likely, we would find ourselves in Arthur Burns' shoes: we would not
get unemployment permanently lower, but we would be stuck with higher inflation,
making our growth and jobs challenges even worse.
We want to be crystal-clear that we won't make that mistake. With inflation well
anchored, moves to lower interest rates should get us more real growth than inflation.
And this is exactly where we are now.
But doesn't everyone have low inflation now? Isn't this due to the coronavirus, not
monetary policy? This brings me to the second common argument we have heard,
which is that lower inflation has been a global phenomenon, not an accomplishment
of inflation targeting.
There's no doubt that global factors affect inflation. Globalisation and low-cost
manufacturing have made many goods cheaper. The recent collapse in oil prices has
been a big disinflationary shock.
But we also have good evidence that countries with independent, inflation-targeting
central banks have lower and less volatile inflation.8 And we can see that there are
still countries with high inflation rates, despite low global inflation. The easy examples
of this are the hyperinflation cases, like Venezuela and Zimbabwe.
But there are less extreme cases that show the value of sensible monetary policy.
Consider Turkey, a middle-income country like South Africa. In June this year, Turkish
inflation was 12.6%. In South Africa, it was 2.2%. Both these economies had low
growth, of less than 1%, before COVID-19 hit. Both countries have experienced big
currency depreciations this year. Both are major importers of oil, and have benefitted
from its price collapse. So why are their inflation rates so different?
The point here is that the independence of the central bank matters, with the
experience of other emerging and developing economies bearing testimony to this.9
Since 2015, Turkey's inflation rate has averaged 11.6% against a target of 5%. For
the same period, South African inflation has been within our 3-6% target range,
averaging 5%.
Examples like this make it crystal-clear that low inflation is not just a worldwide fact
that countries can have 'for free'. If individual countries don't make an effort, they can
easily get stuck with high inflation.
The third argument is that inflation targeting is a rich-country policy, inappropriate for
an emerging market like South Africa. In fact, inflation targeting has been adopted
widely by emerging markets. This makes sense, as many of us have learned from
bitter experience that tolerating inflation isn't developmental - it just creates instability.
It is worth noting that there are more developing-country inflation targetters, about
25, compared to 11 among the advanced economies.10 And while New Zealand gets
the credit for being first to implement inflation targeting, the second country was an
emerging market: Chile.11 Differences between advanced and emerging economies
tend to be reflected in target designs that are not 'one size fits all'. Most rich countries
have found they like a 2% target, but emerging markets have used other sizes, often
3% or 4%.
More recently, critics of monetary policy here in South Africa have flipped by
180 degrees. The SARB was originally accused of wrongly importing a first-world
policy to South Africa. But now we are told to follow major advanced economies and
launch a big Quantitative Easing (QE) programme. So much for the claim that rich-
country policies don't work in developing countries!
This brings me to the next part of my speech, which is about new challenges to inflation
targeting.
In South Africa, there is a surprising amount of interest in QE. From being arcane
jargon, many people have suddenly developed passionate views about it, and it gets
lots of media interest. Given all this, let me summarise where we are in this
conversation.
As I explained in a recent speech at Wits University, QE will become appropriate when
interest rates are at the zero lower bound and there is deflation risk. While inflation
has eased and created space for lower rates, I am not aware of any professional
analyst who projects deflation in South Africa. Our own SARB forecasts are in line with
this consensus.
Nonetheless, should deflation take root, we would be prepared to deploy the tools at
our disposal, as appropriate, to achieve our mandate. Our inflation-targeting
framework would help us make that decision, and would underpin the credibility of any
steps we might need to take.
In the current circumstances, however, we think that a QE programme doesn't make
much sense for South Africa. Some advocates of QE argue that it is a free way of
financing government deficits. This is not true. The funds created to buy bonds would
flow into the interbank money market, lowering the cost of funding. This cost of funding
is in fact the repurchase rate (repo rate), which is our main monetary policy tool. To
ensure that the repo rate stays where the MPC wants it, despite the extra funds in the
system, we would have to borrow those funds back ourselves, which could be costly.
To repeat: QE would not be 'free money'.
Nonetheless, there are still claims that QE could work because the SARB could buy
long-term bonds at a high interest rate, in the region of 9%, and then pay sterilisation
costs equal to the repo rate, at 3.5% currently, and profit from the spread. Borrow at
3.5% and lend at 9% - what a great business model! Fortunately, the SARB is driven
by public interest and not by profit. And, clearly, there are some risks embedded in
this pricing, or private buyers who do look for profits would have eaten this 'free lunch'
already. In fact, if we intervened to bring down long yields, we would be transferring
risk back to the public balance sheet, while also removing incentives for new lending
to the public sector.
One of South Africa's fiscal advantages is that the average maturity of government
debt is unusually long relative to its peers. At the start of this year, it was a bit over
12 years. The whole point of borrowing long-term like this, even though it costs a bit
more, is to share risk with investors. This means that when things like the coronavirus
and credit rating downgrades happen, bond prices fall and borrowing costs go up -
but this debt need not be rolled over at higher interest rates, because government has
already received the funds, long-term, at the old interest rates. The risk is shared.
Should the SARB start doing QE, however, by buying bonds on the secondary market,
then investors could shift risk back onto the public sector's balance sheet, at a higher
price. In other words, it would be a private sector bailout, arranged by the SARB.
Worse, QE would reduce the incentives for new investors to come and buy long-term
sovereign debt, because there would not be enough yield or compensation for the
longer-term risks now visible.
What happens with QE, instead, is that public borrowing switches to the short-end of
the curve. As the central bank buys longer-term bonds, it also sells, to the private
sector, short-term instruments in their place, with the net result that the only new debt
the private sector ends up with is that short-term debt. Given that our short-term
instruments, like SARB debentures, are much like Treasury bills, it turns out that QE
is much less exciting than it looks. Not only can National Treasury effectively make its
own QE by funding itself through Treasury bills, but it is actually doing so.12 Its pre-
crisis borrowing strategy was astute: it left room in the short-end of the yield curve to
borrow in an emergency. Lower inflation and a lower repo rate have made that
borrowing cheaper than it otherwise would have been. In these circumstances, it's not
at all clear what a SARB QE programme would add.
Rather than trying to supplant private investors or taking away the risk of investing, we
have focused on liquidity. Specifically, we have been buying bonds in the secondary
market, at different maturities, in the context of a sudden stop in global capital flows.
As the central bank, we have unique powers to provide liquidity, and we have used
them to restore market functioning. These interventions have been helpful so far.
Yields have fallen. We didn't set out to lower yields, specifically, but it turns out that
market dysfunction was part of the reason why yields were so high.
Putting all the pieces together, this monetary-fiscal mix allows more spending in the
context of a major emergency. We are helping by setting low interest rates, and by
ensuring that the government bond market remains liquid. National Treasury is able
to sell its debt to investors. This approach is going to deliver a historically high level of
government spending this year, even adjusting for population growth and inflation, and
excluding interest costs.13 National Treasury is not cutting spending in the middle of a
crisis; they are raising it, to the highest levels on record.
However, we also need to think about the next few years. National Treasury is already
planning to run deficits of 14.6% of gross domestic product (GDP) this year, 9.3% of
GDP next year, and 7.7% the year after that.14 In this context, high long-term interest
rates are a critically important signal about what savings are available. We should be
listening to this message, not trying to temporarily suppress it through SARB
interventions, which really just switch long-term debt for short-term debt.
We are in very difficult circumstances, but QE isn't the answer. We need to focus on
real solutions.
Our discussion of QE takes me to the final part of my speech, which is about new
challenges to the inflation-targeting paradigm.
As Mervyn King has noted, all previous monetary policy paradigms have fallen, sooner
or later.15 The current one will also be replaced, eventually, by one that works better
for future circumstances. What might change?
In many of the advanced economies, inflation targeting is facing large challenges.
below
Inflation has been their inflation targets for many years now. Policy rates have
been stuck at zero. And instruments like QE and forward guidance have not been
powerful enough to solve this problem. It is now hard to explain why the Bank of Japan,
or the European Central Bank, has been unable to push inflation to targeted levels of
around 2% despite aggressive monetary policies.
At this stage, there is little consensus on the answers, and even less on policy
solutions.
There are two basic sets of explanations for why inflation has stayed so low in
advanced economies, and why central banks have been unable to lift it.
One set emphasises factors beyond the control of central banks, such as changes in
labour markets or demographics. For instance, in an aging society, people want to
save, and they don't want to take risks, so demand is limited and interest rates are
low.16 This explanation works well for places like Japan.
Another kind of explanation puts the emphasis on debt. Where borrowers have too
much debt, even small interest rate increases have large effects on demand, while
large rate cuts do little to boost it further. As one paper in this literature puts it, the
'black hole' of debt is inescapable, pulling down inflation and interest rates
permanently.17 An alternative version is that low interest rates encourage financial
risk-taking, which leads to crisis, depressing the economy, lowering inflation, and
generating even lower interest rates.18
In these cases, too loose monetary policy eventually causes very high debt levels that
smother economic growth, or it ends up causing financial crises.
I don't think South Africa has these problems yet. Right now, we don't have the high
inflation and high interest rates of the past, but we also don't have the zero rates and
close-to-zero inflation of the rich countries. The inflation-targeting paradigm is working
pretty well.
Given all the challenges facing South Africa, we should recognise that monetary policy
is the last place where we should consider risky changes. We have a well-established
inflation-targeting framework, which is delivering low interest rates and low inflation.
This is the most functional part of the macroeconomic framework.
Unfortunately, getting monetary policy right isn't going to be enough. South Africa's
debt situation is critical. And our rebound from lockdown is looking weak compared
with other countries.19 As a country, we need to find a path back to fiscal sustainability
and growth. We can borrow from new creditors; we can shift our debt towards short-
term borrowing; we can move things around different balance sheets - but this is not
a recovery strategy; it is just a way to buy time. If public sector borrowing were the way
to achieve sustained growth, the last 10 years of debt accumulation should have been
enough. The real task now is restoring our fiscal credibility and implementing structural
reforms so the economy has a way to become more efficient and grow.
In many ways, as a country, we seem to be depressed, unable to get out of bed. Yes,
it's winter, and it's cold. But we can't live like this. Spring is coming, and inflation and
interest rates are low. We need to focus on the opportunities, get up, and get to work.
Thank you.