South African Reserve Bank. Picture: MARTIN RHODES
South African Reserve Bank. Picture: MARTIN RHODES

In the wake of a series of articles criticising the SA Reserve Bank’s response to the current crisis, the Bank governor went on road shows that included a lecture at Wits University in part to defend his policy position. He argued that full-blown quantitative easing (QE) would not only be inflationary, but also end up bankrupting the Bank.

The governor explained in technical detail the mechanics behind his reasoning. He asserted that if the Bank commenced with large-scale QE purchases with positive rates, sterilisation would have to be done at a high cost to the Bank. On the other hand, the excess reserves created as a consequence of QE would push the reference rate down and thus force the repo rate too low, which would be inflationary. There is no free lunch, he warned.

The governor further challenged South African QE proponents, this author being one of the earliest and most visible, saying we “have not appreciated the inescapability of this choice”. I reject his thesis and argue that his assertions and lecture are not based on modern macroeconomic science and practice.

The East Asian economic miracle came about through the active use of central bank balance sheet approach to monetary policy.

First, the governor is correct in saying that excessive reserves can bid down the overnight rate to the remuneration floor or zero, resulting in the policy rate (repo) trending downwards. In this respect, without the Bank’s intervention the overnight rate becomes the repo rate, and it thus loses control of monetary policy. It is also correct that this process is tantamount to the easing of interest rates.

But to impute the immediate occurrence of inflation on the basis of low rates occasioned by these liquid management operations is highly erroneous. Inflation developments are not intrinsic to the liquid management operations done by a central bank. It is the resultant final spending (aggregate demand) enabled by accommodative rates over a sustained period that cause inflation. But none of the proponents of QE has suggested that we need permanent QE.

Furthermore, even if there were to be many months of QE the occurrence of inflation would depend on how sensitive aggregate demand is to interest rate movements. It is common cause that spending directed towards the productive sector is least inflationary.

What is more, the disinflationary pressures caused by the hysteresis following the 2007/2008 crisis and the endless bouts of fiscal consolidations have dampened any near-term prospect of inflation. Couple this with the high capacity underutilisation, high unemployment, low credit and low oil prices, and add the disinflationary effects of the coronavirus pandemic. Inflation is distant.

But even if there were to be indications of demand-pull inflation on the horizon, appropriate tools or signals could be deployed. In addition, and more importantly, by justifying the refusal to deploy large-scale QE on the basis that excess reserves may lead to inflation and related costs, the governor has opened himself up to those with technical nous on this matter. Here is how this is technically surmountable.

The Reserve Bank can simply delink or divorce the quantity of money (reserves) from the interest rate target (overnight) and thus also from the policy rate. This rather innocuous technical approach has far-reaching implications.

The divorce accords the Bank unprecedented freedoms. It allows the Bank to set the policy rate as per the normal monetary policy concerns, unencumbered by the concerns of setting of the quantity of reserves. In other words, any quantity of reserves will be consistent with many differing levels of interest rates, just as the same interest rate will obtain with differing levels of reserves. In short, the Bank can set and maintain a repo rate independent of the quantity of reserves.

What are the implications? Commercial banks' excess reserves would be remunerated at the policy rate. Another profitability advantage to banks would be the elimination of reserve tax, but so too will be the removal of the opportunity cost of holding excess reserve balances with the central bank. This besides the efficiency and the financial system stabilisation that come with it.

But what is profoundly significant for SA is the enjoyment of developmental central banking associated with this approach. The delinking is associated with the active use of a Reserve Bank’s balance sheet. The East Asian economic miracle came about through the active use of central bank balance sheet approach to monetary policy.

These mechanics are also consistent with the macroeconomic model that gave rise to the phrase QE. Under this model, as I have repeatedly argued here and elsewhere, the use of the central bank balance sheet becomes the primary monetary policy tool, not the SA Reserve Bank’s passive interest rate policy. The balance sheet policy can be implemented without regard to the level of interest rates. It is also for this insight that the need for rates to be zero or near zero to implement QE is a myth, as I have argued before.

This delinking approach is technically known as the “decoupling of interest rates from reserves (money)". While this technical rendition of banking and monetary systems, and therefore macro-monetary science, has not yet entered the mainstream textbooks and macroeconomic analysis, it has been canonical for a while and is practised by many major and serious reserve banks today. It has long been known by most heterodox economists.

This divorce also settles the unfounded concern about the cost of the sterilisation of reserves that would otherwise take place after the large bond purchases. Sterilisation is where gilt purchases by the Reserve Bank are offset by withdrawals.

As a matter of record, the fearmongering by the governor about the Bank’s bankruptcy requires addressing. Even though central banks are, from an accounting perspective, structured just like commercial banks, potential losses that may not be absorbed by capital cannot render reserve banks inoperative or even raise additional capital from Treasury, as would be the case with a commercial bank. The International Monetary Fund (IMF), Bank of England and others agree.

As creator of the national currency the Bank will always meet any liability in its domestic currency. There are many reserve banks that are now operating comfortably with negative capital levels.

Elsewhere, Prof Chris Malikane has shown that even using the current interest policy, instead of the Bank going bankrupt as a consequence of sterilisation it would in fact be strengthened. On technical grounds, therefore, there can be no excuse for failing to deploy large-scale QE and related unconventional tools now.

The Bank’s interest rate policy has failed and will forever fail. The contradistinction between the balance sheet policy (real monetary policy) and interest rate policy is evident in the East Asia economic miracle and (South) Africa’s IMF/World Bank approaches.

So a free lunch is not what proponents of QE have proposed; rather it is the sitting and doing nothing, or the barest minimum, when the rest of the world's central banks have spared no tool in tackling what is the greatest economic fallout in centuries.

• Nkosi is executive director of Firstsource Money and founding executive board member of London-based Monetary Reform International.

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