Inflated fantasies

SOUTH Africa's inflation targeting framework and the reserve bank's constitutional mandate should remain unchanged (see the next issue of Finweek). But that doesn't mean one can't be cynical about the fallacies surrounding monetary policy.

The first thing to feel cynical about is the importance - or, sometimes, lack thereof - attached to the gross domestic product (GDP) in the policy decision-making process.

Let's go back about a year ago. Bank governor Tito Mboweni was dismissive at a conference when someone from the audience asked him at what level of GDP he would regard interest rates as having risen high enough. Mboweni came back with a rapid-fire response: "The real question is 'at what level of the inflation rate'?"

Mboweni also said at the same conference that critics of the bank's inflation targeting policy were "rubbing us the wrong way". The two responses suggest a callous disregard for the importance of economic growth (GDP) in monetary policy decision. In the first half of 2008, despite Mboweni's protestations to the contrary, he was a so-called inflation nutter.

This term was apparently first used by Bank of England governor Mervyn King to describe central bankers who pursue inflation objectives with no thought of the consequences for economic growth.

Mboweni in the first half of 2008 played the inflation nutter to a T. Despite warnings that GDP - that is, national income - was being severely negatively affected, he raised interest rates by a further one percentage point to 15.5%, bringing the cumulative rate increase since June 2006 to 5.5 percentage points.

Choppy waters

Many thought he could have left rates unchanged in the first half of 2008 before starting to cut when the global economy began tanking.

Now, Mboweni is singing a completely different tune. The fact that inflation has remained sticky at high levels and will average a relatively high 5.4% in the last quarter of next year hasn't put the brakes on an aggressive campaign of interest rate cuts.

He has snipped rates by 3.5 percentage points, bringing the prime overdraft rate to 12%. Mboweni has emphasised the weak state of the SA economy - which he blames on global conditions - as a reason for chopping rates.

Of course, it's a fact that the overly strict monetary policy implemented by Mboweni in the upward cycle of interest rates is also to blame for weakness in the local economy. Household consumption expenditure - which accounts for two-thirds of the economy - has been in recession, and latest retail sales show conditions remain bad.

Mboweni must take some of the blame for the weak local economy. He paid too little attention to GDP when he should have realised that his actions would have severe consequences. Now he is trying to undo the damage; but if he had been less enthusiastic in the upward cycle he could have been less dramatic in the downward cycle, making for more stability.

Targeting unrealistic expectations

The key issue is that Mboweni didn't realise that fighting high commodities prices - oil and food - with all guns blazing would destroy domestic demand and would do a lot of damage to GDP. It's time for him to acknowledge that he should have realised the limits to inflation targeting and that he behaved like an inflation nutter.

The other thing one can be cynical about is the concept that inflation targeting will anchor the public's inflation expectations around the target. In the never-never land that economists live in, setting the target will cause people to expect inflation to be 6% and - hey presto! - inflation will be 6%.

Guess what? The target has had little impact on the expectations of trade unions, who negotiate wages and hence have a direct effect on prices. The Bureau for Economic Research's last inflation expectations survey shows trade unions expect inflation to be 10.1% in the first quarter of 2010.

Rand Merchant Bank economist Kay Walsh has done some research showing that inflation expectations are a good predictor of services inflation. Her research suggests that services inflation could remain elevated for longer than anticipated. Services now have a bigger weighting in the target basket, so that isn't good news.

Inflation targeting is still seen by the markets as international best practice, which is why SA should stick with it. But that doesn't mean that it isn't open to a lot of cynicism.

- Fin24.com