The implementation of South Africa’s inflation policy needs a more pragmatic approach by the National Treasury and the South African Reserve Bank and should be coupled to growth and employment targets for the country. Only then can we talk about the inflation targeting policy being good for the poor.
The South African Treasury team has been successful in turning around the country’s dismal public finance management by implementing a severe austerity programme — one which would make proponents of the Washington Consensus proud. In line with this conservatism the Treasury prescribed inflation targeting for the Reserve Bank in April 2000. The target was initially set at between 3% and 5% of the consumer price index (CPIX), excluding volatile items such as interest rates and municipal services.
The Reserve Bank argued that inflation targeting is good for the poor since it protects capital from being eroded by high inflation. Having witnessed one of the most successful structural adjustment programmes, which included the reduction of government debt as a percentage of the gross domestic product (GDP), the budget deficit as a percentage of the GDP and increased efficiency in the tax collection system, it was very hard to debunk the policy. The Reserve Bank welcomed inflation targeting and implemented it in the strictest and harshest terms — perhaps competing with its master.
The Reserve Bank recognised at the outset its imperfect control of inflation. However, it underestimated the importance of lags in the transmission mechanisms — like interest rates — the state of the economy and the future shocks to the economy.
The target had never been achieved until recently, when it was adjusted to 3% to 6% and made an annual rather than a rolling target. In a paper published in February last year, Corrine Ho and Robert McCauley presented a comprehensive review of inflation targeting in emerging economies. They found that of 43 emerging economies only 21 hit the target, the rest — which then included South Africa — missed by miles.
South Africa is an open economy. The Treasury believed that with the successful consolidation of fiscal finance, there was a need for convergence with the monetary policy. After some consultation it decided to exclude volatile items such as interest rates and some municipal charges from the inflation basket. Very little cognisance was taken of the dominance of the poor and those earning lower wages. For them, food is the biggest cost component in the consumption basket.
But somehow the advent of a low inflation rate environment accompanied by the low interest rate became the centre of the economic debate, despite the fact that the majority of South Africans have no access to credit.
The food shortages in the Southern African Development Community and the looming El Niño phenomenon in the latter part of 2001 led to a sudden increase in the price of maize, the staple food of many. At the same time the rand suddenly lost about 38% of its value against the dollar. This created an opportunity for greedy capitalists to increase prices of domestic goods, blaming the currency for their actions.
Fearing inflationary pressures owing to the depreciating currency against the euro and the dollar as well as rising food prices, the Reserve Bank increased rates in January 2002, arguing that it wanted to quell expected inflation in the coming months.
However, it was the Reserve Bank that had blundered when it changed a policy of buying dollars from the market from mid-1998 until October 2001 to rebuilding net reserves through the sale of state assets to non-residents and through foreign borrowings. The rand’s decline was a policy blunder and, the resulting burden should not have been inflicted on the poor and small and medium enterprises through interest rate increases. Further interest rate increases, ironically pursued to protect the poor from inflation, in fact benefited the rich who had money to save.
The Reserve Bank should not have acted, as there were extenuating reasons for the expected price increases. The Reserve Bank did not appreciate that the South African economy had integrated globally as an open macro-economy. In an open economy there are additional channels for the transmission of monetary policy — the meeting of inflation targets and the setting of interest rates.
The lack of pragmatism and overzealousnousness in the implementation of inflation targeting is also confirmed by the slowness in reducing interest rates when the rand recovered 60% of its value against the dollar. Interest rates only started declining in June last year, despite the fact that the rand had started gaining some of its strength at the beginning of 2002.
The lack of pragmatism by both the Treasury and the Reserve Bank has resulted in export-oriented sectors such as manufacturing and mining losing competitiveness. The poor business performances led to lower-than-anticipated revenue receipts, leaving the Treasury to do some juggling to balance its books. In an open economy, fiscal and monetary policy are integrated and therefore interest rates should have declined faster, and earlier, than has been the case.
The economy is estimated to have grown by just less than 2% last year, which is benign if we are to dent the 32% rate of unemployment. The Treasury lacks imagination in tackling this challenge. While its track record in terms of fiscal management is sound, the Treasury could have excelled by integrating output and employment in the inflation targeting adjustment given to the Reserve Bank. These factors are intertwined as the transmission mechanism relates to the interest rate, exchange rate and inflation.
Both the Treasury and the Reserve Bank can salvage the situation by continuing with a loose monetary policy and reducing interest rates by at least 2% this year. This would lead to the convergence of our interest rates with our peers — Mexico, Chile, Korea and others.
What could be better than a signal that South Africa has now completed its structural change and that lower interest rates and inflation are permanent features of the economy?
This would enable the government and the private sector to offer salary adjustments of just less than 4% for the current calendar year, ensuring that wage-setting is in line with the new structure of our economy.
Although we support inflation targeting, in a developing country where the majority are poor, growth and employment should be critical targets to be met not only by the Treasury but also by the Reserve Bank.
Lumkile Mondi is chief economist at the Industrial Development Corporation