31 March 2016
Without sufficient domestic saving, we need to rely on foreign investment to spur on development, eventually running into a balance-of-payments crisis.
A few weeks ago Stats SA reported a year-on-year increase in headline consumer price inflation (CPI) of 7.0% – a whole 100bps above the Reserve Bank’s upper limit of 6.0%. This is the highest inflation print since May 2009. Is there reason for alarm?
The chart below with headline CPI since 1969 provides some perspective. Even as recent as the past decade we’ve seen inflation peak at 12.4% – more than 600bps above the Reserve Bank’s upper limit! For nearly all of the 1980s inflation remained in double digits, breaching more than 20% in 1986. What is clear from the historical data is that SA is no stranger to protracted periods of high inflation.
SA inflation rose notably during the the 1970s and 1980s, but the same happened in most parts of the world due to a spate of oil price shocks. However, since the early 1980s our main trading partners experienced quite low levels of inflation, which over time led to lower imported inflation for SA. Initially, however, SA inflation remained high (for most of the 1980s) due to a substantially higher growth in broad money supply in SA than in its trading partners. In the light of the sanctions against the country and a multitude of exchange controls, SA needed a monetary policy (relatively low interest rates) that would stimulate economic activity in the short term. Only from the 1990s as sanctions were lifted and the economy gradually liberated, did inflation start to decline.
Since the 1990s, inflation targeting was used more and more in SA, but in an informal and eclectic way. While price stability was pursued, the time period over which this would be achieved was not specified. It was only in the 2000 Budget that formal inflation targeting was introduced. Why the change to a formal framework?
Other than removing uncertainty among the public, formal inflation targeting also improves the coordination between monetary policy and other economic policies followed by government. SA is one of a few countries in the world that stipulated the independence of its central bank in its Constitution. But the Reserve Bank and the Minister of Finance must consult one another regularly and while the Minister of Finance announces the level of the inflation target, a committee consisting of both Reserve Bank and National Treasury members facilitates the process.
One of the features of an inflation-targeting framework is the greater degree of transparency it brings to monetary policy. Within a formal framework, targeting a set band, such as our 3% to 6% headline CPI, gives credibility to monetary policy and tempers the increases in wages and other operational costs, as well as the price setting by businesses, thereby curbing inflation. The time horizon over which a target is set could also affect its credibility. In SA, one could reasonably expect a change in interest rates to take between 18 and 24 months to fully affect inflation. A multi-year target approach is therefore used in SA.
Strict inflation targeting and the accompanying interest rate hikes – as we’ve witnessed recently – are often criticised for stunting economic growth. While higher interest rates do curb consumer spending and business expansion, which dampens growth, most economists agree that monetary policy cannot contribute directly to economic growth and job creation over the long term. Inflation targeting is, however, very necessary to create price stability, a requirement for long-term economic growth, and is here to stay.