After the inflation target was breached, the Reserve Bank was widely seen as justified in increasing interest rates early in June for the fifth time in a year. The question is less whether it should have done so, but whether we have chosen the correct inflation target.
With the Reserve Bank implementing contractionary monetary policy and the national treasury effectively implementing contractionary fiscal policy with its growing fiscal surplus, the economy is starting to slow. Passenger vehicle sales, which act as an early warning signal on the health of the economy, are down 20% since their peak last year.
While the main reason for the growing fiscal surplus — inadequate delivery by government departments — is, for the most part, out of the hands of the national treasury, the tightening of monetary policy is a conscious effort by the Reserve Bank to slow the economy and thereby fulfil its inflation-targeting mandate.
The successes of inflation-targeting frameworks have been lauded internationally and it is perhaps not the framework but the range of the target that should be reconsidered. This might indeed open a can of macroeconomic worms, but given that the price of contractionary macroeconomic policies will be much needed economic growth, the debate is certainly an important one to have.
The academic economic literature is clear that very high levels of inflation are detrimental to economic growth. Inflation above 40% is associated with reduced economic growth. Below such “crisis” levels of inflation, different studies have found different turning points at which inflation has a detrimental effect on long-run growth.
For emerging economies the turning points vary from 10% to 20%, depending on the stage of development the economy is in. While the exact turning point, within the 10% to 20% band, is hard to pinpoint, a target of 3% to 6% is well below the required level to avoid the detrimental effects of inflation. It is hard, therefore, to justify sacrificing economic growth as we are doing now.
It is important to note that some recent studies have found that the causation between inflation and economic growth is hard to identify and others do not find any meaningful relationship at all. Thus keeping inflation at very low levels might have no benefits at all for developing countries.
Moreover, the detrimental effects of inadequate education, poor governance and inadequate healthcare on growth have often been identified as more pressing concerns for growth in developing countries. The Reserve Bank’s focus on its target is clear. In its latest statement at Monetary Policy Committee on June 7, the Reserve Bank said: “The Monetary Policy Committee cannot ignore the possible impact of this breach on inflation expectations.”
The focus is on what the breach of the target does to inflationary expectations, which begs the question: should the target have such an important focus? Surely the optimal level of inflation for the current stage of our economic development is more important? Especially since inflationary pressures are not being caused by underlying economicgrowth, but by oil and food prices on which interest rates have no effect.
Réjane Woodroffe is chief economist at Metropolitan Asset Managers