T T Mboweni: Monetary policy and inflation
Address by Mr T T Mboweni, Governor of the South African Reserve Bank, at the Bureau for
Economic Research Annual Conference, Cape Town, 7 November 2002.
The references for the speech can be found on the website of the South African Reserve Bank.
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1. Introduction
There has been a widespread shift among central banks toward a more focused approach regarding
inflation since the early 1990s. Countries have increasingly been granting independence to their
central banks with a first policy priority being low inflation. There is general consensus that high
inflation is associated with bad economic performance and there is recognition by central bankers that
policies aimed at systematically exploiting the short-run output/inflation trade-off to increase output
beyond potential are in the long-run always ineffective and self-defeating.
There seems to be continued uncertainty in some circles as to the Reserve Bank's primary objective. I
have mentioned the Bank's primary objective many times before but it seems to need regular
restatement. According to the Constitution "the primary objective of the Bank shall be to protect the
value of the currency of the Republic in the interest of balanced and sustainable economic growth". By
working towards keeping domestic inflation low, stable, and predictable, the Bank contributes towards
solid, sustainable economic growth and a higher standard of living for the community. The autonomy
and objectives of the Bank are entrenched in the Constitution that specifies that the Bank, in pursuit of
its primary objective, must perform its functions independently and without fear, favour or prejudice.
The Bank has interpreted this constitutional reason for its existence to mean that it must always strive
to achieve and maintain price stability in South Africa. In the pursuance of this objective, the Bank
assumes responsibility for, firstly, formulating and implementing monetary policy in such a way that the
primary objective will be achieved in the interest of the whole community that it serves. Secondly,
ensuring that the South African money and banking system as a whole is sound, meets the
requirements of the community and keeps abreast of developments in international finance. Thirdly,
assisting the South African government, as well as other members of the economic community of
Southern Africa, in the formulation and implementation of macroeconomic policy. And fourthly,
informing the South African community and all interested stakeholders abroad about monetary policy
specifically, and the South African economic situation in general.
In order to avoid global financial crises and the risk of contagion, the international community has been
working hard to promote good macroeconomic policies, sound financial systems, and enhanced
disclosure so that market discipline can work constructively. To this end, the Reserve Bank
participates in the work of the Bank for International Settlements, where central bankers from around
the world collaborate in research, and in developing international codes and best practices. The bank
also participates in the Financial Stability Forum, an international body that brings together central
bankers, regulators, and government officials to address financial stability concerns. It is another
example of the Bank's forward-looking efforts to ensure that we are sufficiently prepared to withstand
financial shocks should they occur. The Bank also makes available senior personnel for International
Monetary Fund missions to work in other countries.
Although the functions of the Bank have changed and expanded over time, the formulation and
implementation of domestic monetary policy remains one of the cornerstones of its activities. Over the
years the Bank has applied various monetary policy frameworks. From February 2000 an inflation
targeting framework was adopted. The adoption of this target formally entrusted a single monetary
policy objective to the Bank, namely, price stability. Fully-fledged inflation targeting is based on
important pillars that include an institutional commitment to price stability, instrument independence,
an absence of other nominal anchors, policy transparency and accountability and specifies that fiscal
dominance will not be applied. The success of inflation targeting depends strongly on central bank
credibility that is derived from the market's belief in the Reserve Bank's resolve and ability to meet the
inflation target.
South Africa adopted formal inflation targeting for three main reasons. In the first place, it was
necessary to find the most credible and transparent monetary policy framework. This came after a
period when money aggregate targets had at first proved less closely connected to the inflation rate
than expected and the subsequent eclectic monetary policy framework had, among others, proved
less transparent than hoped for. Secondly, there was a desire to balance the Bank's independence
with more specific accountability. And thirdly, there was a desire to reduce the social and economic
costs of high inflation by reducing the inflation expectations of both financial markets and agents in the
real economy.
In February 2000 it was announced that the Reserve Bank had to achieve an average rate of increase
in the CPIX measure of inflation of between 3 and 6 per cent for the year 2002. The CPIX measure
was chosen to ensure a wide coverage of consumer items, but without the mortgage interest
component that would perversely fall as the Reserve Bank relaxed monetary policy, and vice versa.
This inflation target measure was chosen because of the fact that it is the measure that most closely
approximates a cost of living index for the wider community. In October 2001 it was announced that
the target range would remain unchanged for 2003, and was set at an annual average of 3 to 5 per
cent for 2004 and 2005.
In the Medium-Term Budget Policy Statement on 29 October 2002 the Minister of Finance indicated
that current conditions warranted a reconsideration of the targets. With the approval of Cabinet the
target range of 3 to 5 per cent for the year 2004 was accordingly revised to 3 to 6 per cent. Once
inflation has returned to the 3 to 6 per cent range, the authorities will consider introducing a lower
target again.
2. The importance of the inflation forecast
Monetary policy decisions are made on the basis of current and expected developments in a number
of variables. These variables are also the main drivers of the Bank's econometric models and the
forecasts obtained from these models contribute to the monetary policy decision-making process. The
Bank's suite of forecasting models has become an important cornerstone in assessing the prospects
for inflation and growth in the economy. The models have enabled the Bank to assess more effectively
the risks associated with the predicted outcomes of several variables. The forecasts alone do not
indicate how the monetary policy stance should be changed but they are a key source of information
for the MPC.
The MPC uses a fan chart to assess the risks inherent in the forecast and to communicate to the
public the uncertainties that lie ahead (the Bank publishes the fan chart in the six-monthly Monetary
Policy Review). The fan chart allows the MPC to focus its discussions on the potential upside and
downside of risks lying ahead and more particularly on the possible effect of these risks on inflation.
The fan chart clearly illustrates the large degree of uncertainty to which an inflation forecast is subject
but also gives an indication of the probability of a particular outcome.
3. Assessment of inflation targeting in South Africa
South Africa could not escape the combined inflationary consequences of rising international crude oil
prices over the past two years and a sharp depreciation in the exchange value of the currency in the
latter part of 2001. Despite these developments, monetary policy has been characterised by more
measured and timeous adjustments to the monetary policy stance and greater interest rate stability
since the introduction of the inflation-targeting monetary policy framework in South Africa.
In assessing the performance of South Africa's monetary policy framework one could first of all ask
what advantages or potential benefits were foreseen in adopting inflation targeting.
The advantages that were envisaged were that inflation targeting would help to focus monetary policy
through pre-commitment by making the objective of monetary policy clear from the outset. It would
provide an anchor for expectations of future inflation to influence price and wage setting thereby
improving planning in the private and public sectors. Inflation targeting would form part of a formalised,
publicly announced, and co-ordinated effort to contain inflation in pursuit of sustainable economic
growth and development. And finally, inflation targeting would enhance the accountability and
transparency of the central bank to the public.
The first important question is whether these advantages have materialised and, more particularly,
whether there is any significant evidence of an improvement in inflation performance. If there has been
an improvement in inflation performance the next important question is whether this has been
achieved at the cost of greater output volatility or not. Ideally one would like to see both a decline in
inflation volatility and a decline in output volatility.
It is important to remember that interest rate changes are only fully reflected in inflation 12 to
24 months after an adjustment in policy. Furthermore, exogenous shocks complicate a comparative
analysis over relatively short periods of time so that a period of at least three to four years would have
to transpire from date of first adopting the new framework in order to be able to make a clearer
assessment of the effectiveness of the new framework. A few select observations regarding some of
the more tangible advantages that have been derived from the new framework in South Africa can
nevertheless be made at this stage.
Inflation targeting has significantly strengthened the Reserve Bank's mandate to focus on price
stability. Monetary policy transparency, accountability and communication have been mutually
reinforced with inflation targeting. In previous policy regimes there was no explicit benchmark against
which the performance of the Bank could be judged objectively. In the inflation-targeting framework, a
specific target range is set for a particular price index to be achieved within a specific time frame.
Inflation targeting has also been accompanied by major improvements in the Bank's communication
with the public and markets and there has been a significant upgrade in monetary policy transparency.
Some examples in this regard are the biannual Monetary Policy Review, the monetary policy
statements and the national and regional Monetary Policy Forums. The Monetary Policy Review
analyses inflation developments and the factors that impact on inflation. It also provides an
assessment of recent monetary policy developments and a discussion of the inflation outlook as well
as the Reserve Bank's inflation forecast. The monetary policy forums have become increasingly
popular as they provide an opportunity for two-way dialogue on monetary policy. I also appear
periodically before Parliament.
The fact that the inflation target is decided upon by the Cabinet has served to ensure the correct
monetary and fiscal policy mix from the outset. It means that the Cabinet in effect agrees that if fiscal
policy is changed, monetary policy would probably also have to change in order to offset any stimulus
(or restraint) flowing from fiscal policy. Inflation targeting has in effect introduced a pre-commitment
strategy and probably explains why countries that have adopted this particular approach to inflation
targeting are less often characterised by public disagreements between the respective fiscal and
monetary authorities. Interestingly, every single country that has adopted an inflation-targeting
framework has up to the present continued to adhere to it.
In South Africa the inflation target has strengthened forward-looking inflation expectations in most
sectors of the economy and therefore contributed to a weakening of the weight of past inflation.
Although some commentators remain stubbornly backward-looking and more than a few journalists
initially continued to predict the monetary policy stance on the back of the most recent CPIX or PPI
data, inflation expectations dampened significantly with the new policy strategy and CPIX inflation fell
from a peak of over 8 per cent in August 2000 to below 6 per cent in October 2001. Some economists
and a number of journalists had continued to focus on the "unrealistically" narrow and low inflation
target of the Reserve Bank but at the same time had stressed the need for unions to moderate wage
demands to avoid increases in unemployment. This in itself contributed to a more forward-looking
approach to wage outcomes in general and, throughout much of last year, wage moderation and
productivity gains served as important cushions that absorbed some of the inflationary impact of the
currency depreciation.
A number of critics of the new framework have argued that inflation targeting is an untested
framework, as no major adverse shocks have put strain on the achievement of low and stable inflation
in many inflation-targeting countries. This is incorrect as many inflation-targeting countries are small
open economies that have been subject to severe shocks in the aftermath of the 1997 Asian crisis.
The combined adverse financial and terms-of-trade shocks suffered by Australia, Chile, Israel and
New Zealand, among others, led to major exchange rate depreciations in these countries which
significantly tested the attainment of their inflation targets. Although inflation in these countries initially
accelerated again in the aftermath of currency depreciation, they weathered this storm successfully
and recorded less-than-expected pass-through from exchange rate depreciation to inflation.
The inflation-targeting policy framework provides a fair measure of flexibility for the Bank. As in other
countries that target inflation, the policy allows for some discretion in the case of serious supply
shocks to avoid costly losses in terms of output and jobs. In this regard Svensson writes: "In practice
... [central banks] avoid causing this instability to other variables than the CPI, by adopting a more
gradualist approach. They do not attempt to take inflation back to target as fast as possible. Instead
they ... set monetary conditions such that the inflation projection hits the target at a longer horizon than
the shortest possible ... in this sense ... inflation-targeting central banks have made the choice to
pursue flexible rather than strict inflation targeting." Svensson, E.O. 1997. Inflation targeting in an
open economy: strict or flexible inflation targeting? Discussion Paper Series, G97/8. Reserve Bank of
New Zealand, November.
4. The growth and inflation outlook for South Africa
During the past two years the world economy has experienced its most significant slowdown since the
early 1990s. Although the South African economy proved to be relatively resilient last year, in the
aftermath of September 11 and in the months leading up to December it was hard to find much
optimism among professional economists, business people, investors and ordinary consumers.
Fortunately, on the growth front things have turned out better than expected. Real GDP growth for the
year 2001 was just over 2 per cent and even if this is less than is required for robust job creation and
per capita income growth, it is certainly significantly higher than the growth registered by our most
important trading partners and many other economies that had been affected far more severely by the
slowdown in the world economy. Moreover, many professional forecasters now expect at least a
moderate recovery in the world economy through the end of the year and beyond, while growth in the
2 to 3 per cent range is widely forecasted for the South African economy this year.
South Africa's near-term growth prospects are encouraging and official estimates for the first two
quarters of this year exceeded expectations. Preliminary indicators for a number of sectors, for
example agriculture, manufacturing, electricity, construction and services, look relatively promising for
the second half of 2003. Both the leading and coincident business cycle indicators have in recent
months provided an encouraging outlook on the back of the strengthening performance of component
indices. The exchange rate developments should also continue to provide a major boost in activity to
the export and import-substitution sectors and these sectors should receive a further boost by the
anticipated upturn in global activity and an associated strengthening in commodity prices. Export
performance remains a pivotal aggregate to engender more robust growth this year and the strength
of this contribution to growth will depend on the pace of recovery in the world economy.
The budget for 2002/03 envisages a slightly more expansionary stance and an increase in the budget
deficit to GDP ratio. It allows room for additional spending on targeted social welfare services,
including HIV/Aids prevention and treatment, and on economic infrastructure. In addition, lower taxes
have provided tax relief mainly for low and middle-income earners and have brought personal and
company tax rates closer together. The fiscal and monetary policy mix therefore augurs well for better
economic performance this year.
The economy nevertheless remains vulnerable to concerns about South Africa's longer-term growth
prospects and high priority must continue to be given to structural reforms that can make substantive
progress in lowering unemployment and raising living standards. In particular, we continue to face the
challenges of high unemployment, a low savings level and a high HIV/Aids infection rate.
It is therefore of paramount importance that we address the daunting challenge of ensuring that South
Africa's rich natural and human resources are employed for the benefit of all, promoting overall and
strategic human resources development, improving social conditions, and alleviating poverty.
The South African authorities are persevering with structural reform efforts that are essential for higher
sustainable growth and employment and have identified a number of key areas of policy concern, such
as the trade regime, competition policy, privatisation and public expenditure policies.
Despite these concerns, South Africa's credit rating has improved by 2 points in the latest country
credit ratings. One of the reasons is that South Africa is generally seen as getting things right and a
process of differentiating South Africa from bad performers seems to be underway. It is important that
we continue to build on this increasingly favourable rating and further distinguish ourselves from
countries that have discredited themselves in the eyes of the international investment community. This
will not only call for lower and more stable inflation in the years ahead, but we must also continue to
ensure domestic financial stability by continuing to strengthen the infrastructure for the domestic
banking system and financial markets. This means focusing on aspects such as further enhancing
astute supervision of banks and other financial institutions, ensuring that all the proper market rules
are in place, bedding down the appropriate legal framework, accounting and auditing standards as
well as a reliable system of credit information on individual borrowers.
Turning to inflation prospects, there had been no indication during the first half of last year of any
impending upward movement in inflation. South Africa, in line with most of its trading partners, had
experienced a slowdown in economic growth during the first half of 2001, but both fiscal and current
account performance was strong and inflation was falling. There had been sustained fiscal rectitude
and very strong revenue growth with the resultant favourable budget deficit to GDP outcome for fiscal
2001/02. As a result of improved macroeconomic performance and prospects in general, South Africa
earned investment grade status on its external sovereign debt from Moody's in November 2001 while
default risk spreads on South Africa's external sovereign debt narrowed by some 130 basis points
during the course of the year.
Given the fact that we are in an inflation-targeting framework, the Reserve Bank therefore does not
have any intermediate targets or guidelines as was the case before the year 2000.
The four measured and timely increases in short-term interest rates so far this year to counter the
inflation spiral were entirely appropriate but inflation expectations have nevertheless continued to
harden somewhat. The presence of some excess capacity in the economy should however help limit
price pressures, but much also depends on movements in unit labour costs. It is still too early to
assess the eventual second round inflation outcomes of recent unit labour cost developments in South
Africa although it is apparent that the 2002 inflation target might not be attained. The findings of the
most recent survey of inflationary expectations reflect the changed expectations of respondents. The
indexation of wages in a number of important pay settlements also raises concerns about the eventual
second-round effects of recent large price increases and the Bank will, as always, vigilantly monitor
the situation in the months ahead.
I emphasised in a recent speech that interest rate decisions by the MPC are conditioned by prevailing
demand pressures, currency and labour cost movements and other indicators of inflationary
conditions. In view of the relatively long transmission lags between interest rate changes and inflation,
it is important that corrective measures are timeous and measured without seriously jeopardising the
economy's growth performance. Flexible inflation targeting implies that the Bank should avoid severe
corrective action to bring inflation in 2003 or any of the subsequent years to within the target range at
significant cost to the real economy. At the same time, however, the Bank must ensure that any
second-round inflationary pressures that would jeopardise the target for 2003 and beyond are
contained. The recovery currently underway in the economy also appears to be sufficiently strong to
have weathered the impact on output of the timeous and measured interest rate increases during
2002.
5. Conclusion
We hold the view that South Africa's economic prosperity will be enhanced by a price stability
approach to monetary policy and that the inflation-targeting framework is the most appropriate to
achieve this objective. Economists and policy makers alike have debated the merits of inflation
targeting at length and the experience in other inflation-targeting countries suggests that we can
expect that South Africa's monetary policy framework will continue to evolve. Although some
economists think that a monetary policy based on price stability will compromise economic growth,
many governments and central banks internationally have come to recognise that inflation destroys an
economy's potential since there is no long-run trade-off between inflation and unemployment. The
monetary authorities in South Africa share the latter view and will continue to make decisions based
on international best practice. They are furthermore committed to further improve the process of
monetary policymaking on the basis of continued research and experience.