The Reserve Bank should have announced another 50 basis point reduction in the repo rate after the meeting of its monetary policy committee recently.
After making a strong case for a benign inflation outlook and indicating that inflation was likely to stay within the 3% to 6% boundaries of the target range over the next two years, the committee did an about-face. Instead of concluding that this was a perfect time to see how low rates could go, it came to the astonishing conclusion that “leaving the rate unchanged at 7,5% would be consistent with CPIX inflation remaining within the target range”.
The bank’s decision to leave the repo rate at 7,5% when CPIX (consumer inflation less mortgages) is at the bottom end of its 3% to 6% inflation target range indicates it is out of step with the view that job creation is South Africa’s most important policy goal.
Based on South Africa’s financial history, the current repo level of 7,5 % appears low. But relative to the low rates set in all parts of the world since the 2000 crash, a 7,5 % interest rate with 1% inflation is about the highest real interest rate of any country.
Bank rates in developed countries currently average about 2%. In developing countries with inflation rates comparable to South Africa they average about 3% to 4%. In only seven other developing countries is the bank rate currently above 7%. But these countries face an average inflation rate above 10% and are, therefore, in fact pursuing very expansionary monetary policies with negative real interest rates.
With probably the world’s highest unemployment rate, South Africa now has the dubious honour of imposing the world’s highest real rate of interest!
Economists now recognise interest rates are no longer an endogenously market-determined variable that equilibrates saving and investment, or the supply and demand for loanable funds.
The repo or bank rate is set exogenously by central banks as their chief monetary policy instrument. Other short-term rates are held at the same level after adjusting for all liquidity, maturity and marketability differentials by bank arbitrage. Long-term rates are determined by market expectations of future short-term rates of future central bank rate-setting behaviour.
No doubt Reserve Bank Governor Tito Mboweni appreciates the huge virtues of low interest rates in stimulating aggregate demand and achieving higher employment levels. But he rarely praises them. They are:
A direct increase in investment spending, by reducing the cut-off rate of return required on investment projects.
A direct increase in the market value of all capital assets by reducing the rate at which future expected income streams are discounted.
A huge increase in capital gain income for all wealth owners by raising asset prices.
Demand stimulation for newly produced capital assets by raising the discounted market value of existing assets.
A lower interest burden of all debtor units, in particular the central government, by reducing interest rates on past debts.
Help to all households in affording housing assets of greater capital value by reducing the carrying costs of debt.
An enormous increase in the expected return on all physical assets that generate rental income, generating a housing boom by reducing the required rate of asset appreciation needed to offset the interest cost of bonds.
Direct reduction in the exchange rate, and so export growth stimulation, by reducing the interest rate differential over foreign rates.
Central banks do not have the ability to attain their inflation targets by directly reducing price and wage inflation. All they can do is raise the bank rate and restrict the growth of aggregate demand.
This operates effectively to reduce inflation when inflation is caused by excess demand. But when inflation is cost inflation — as it is in South Africa and most other developing countries — the primary effect of higher rates is to reduce the level of aggregate demand and output, and increase unemployment levels.
Inflation-rate targeting has been extremely successful in developed economies. Central banks keep interest rates high and aggregate demand growth low, and so maintain slack economies with high unemployment rates — what Marx termed “the reserve army of the unemployed”.
This policy succeeds by grinding down the bargaining power of labour and making it increasingly difficult for unions to negotiate higher wages. In South Africa, industry bargaining councils are under growing pressure to show more flexibility in granting exemptions by the Labour Ministry in extending of wage agreements to rural areas.
Mboweni is right to be concerned about rising unit labour costs. It is not sufficiently widely recognised that wage moderation is the essential prerequisite for price stability. At the end of the day, real wages cannot grow more rapidly than the average rate of labour productivity, currently averaging about 2% to 3% in South Africa, if unit labour costs are to remain constant.
Local unions are seriously mistaken if they believe they can permanently negotiate real wage increases in excess of average labour productivity growth through tough collective bargaining under a pro-labour government. The result of higher money wages will simply be higher price inflation.
With strong market power in labour markets, unions can bargain successfully for, say, 10% increases. But as long as business has market power in product markets, it can protect mark-ups and pass on all increases in unit labour costs as higher product prices. The result is real wage growth of 3%, or lower, and an inflation rate of 7% to 8%, or higher. This is aggravated by central bank inflation targeting, which by raising rates pushes the economy into deeper stagflation.
Even when union leaders understand that wage moderation and 2% to 3% wage increases are essential for price stability, they are unable to negotiate for 2% to 3% wage increases for their members when inflation is running at 5% to 9%, and other unions are successfully bargaining for 10% wage increases. They would be tarred and feathered by their membership before being voted out of office.
The only way out of this dilemma is by negotiating a social contract in the National Economic, Development and Labour Council between the government, business and labour.
Labour must agree to moderate its wage demands and settle for increases equal to the average rate of labour productivity growth in the previous year, say 2-3%.
Business must agree to keep its mark-ups constant, so prices remain a constant proportion of unit costs.
The Reserve Bank must agree to reduce the repo rate to, say, 2%. As short-term interest rates would then be about 2%, the National Treasury could then increase its spending on capital goods and public works, and run a budget deficit of about 10% of gross domestic product.
Finally, there is the serious problem of rand instability and over-valuation. The root of the problem is the use of the domestic currency in international trade, where its value cannot be established by fiat, as domestically. Foreign agents must be bribed to hold rands in their portfolios.
It is widely recognised that for South Africa’s long-term survival, it is absolutely imperative to raise employment growth. This is only possible with a low interest rate policy, which under current Reserve Bank leadership appears beyond reach.
Basil John Moore is professor extraordinary of economics at Stellenbosch University