DAAN STEENKAMP: Low trend inflation best time to cut target

The SA Reserve Bank governor would like to see a lower inflation target. So would the National Treasury. But what should that target be and when should it be lowered? Google “inflation target SA” and there are hardly any recent academic papers on these important questions.

The lack of academic research for SA makes it hard to assess what an “optimal” inflation target might be. Because inflation distorts relative prices, maintaining a low inflation rate is likely to minimise resource misallocations caused by these distortions.

It is ultimately reflected in economic growth. Our analysis shows that the relationship between inflation and economic growth in SA has been negative at all inflation levels. Over the long term, higher inflation tends to be associated with a higher growth drag from inflation distortions. This also implies that economic growth cannot be sustainably boosted by tolerating a higher inflation rate.

Theory and international evidence supports this argument. Anthony Diercks’ Reader's Guide to Optimal Monetary Policy shows that most academic studies suggest the inflation rate that minimises welfare losses from inflation is near zero.

In practice, countries tend to choose inflation targets that are higher than that because inflation is measured imprecisely, and because economists tend to worry more about the damage long periods of deflation could do to confidence in the economy than about low, stable inflation.

SA’s inflation target of 3%-6%, with a preference for medium-term inflation near the midpoint of 4.5%, is high compared with advanced economies and leading emerging market countries. Our high inflation is one reason our exchange rate has tended to depreciate over time. This causes a deterioration in international competitiveness, contributing to making SA an expensive, low productivity economy. A lower inflation differential with our trading partners will reduce pressure on the currency, and support the competitiveness of SA’s exporters and the buying power of our currency.

Favourable shocks

So why not immediately lower the target? A big driver of inflation is people’s expectations of inflation. This affects wage demands and firm pricing decisions. If expectations are for inflation to remain high, the central bank would have to keep interest rates high to hammer inflations expectations lower. High interest rates weigh on economic activity and so imply a real cost to the economy.

The best time to reduce the inflation target would be when trend inflation is low. In recent years the ideal opportunity was the lead-up to the Covid-19 pandemic, given that favourable supply shocks were responsible for containing inflation.

Now, inflation expectations in SA are still near the top end of the Reserve Bank’s target range. Our measures of trend inflation remain above the midpoint of the inflation target and suggest there is a high degree of inflation dispersion across price categories. 

Our estimate of underlying inflation pressure suggests there has been more broad-based inflation pressure since the pandemic than implied by the “core” measure that excludes some volatile components such as food and fuel prices, which the Reserve Bank focuses on in its monetary policy statements.

The Bank’s problem is that government-related inflation has consistently grown at well above the upper bound of the inflation target. Since 2009 inflation in electricity and other administered categories have averaged almost 12% and 8% per year respectively. The Reserve Bank cannot directly affect prices in such categories, so keeping interest rates high in response to such pressures imposes costs on parts of the economy in which prices are more flexible.

A related consideration for the feasibility of lowering the inflation target is how government’s fiscal stance is affecting the outlook for growth and inflation. Despite recently including a fiscal block in its model, the Reserve Bank remains tight-lipped about its assessment of how much rising debt is contributing to high interest rates. Like the IMF, our assessment is that despite attempts to consolidate spending, government’s fiscal stance has remained stimulatory at the margin.

Rising debt

Our estimates also suggest that rising debt and an increase in government credit risk premiums have contributed to higher borrowing costs. Lowering the inflation target would be expected to help reduce long-term interest rates, but a worsening of government finances could move rates in the other direction.

Many market analysts expect the Bank to begin cutting its policy rate this year. However, should inflation not start to fall as the Bank now predicts, the policy rate would be below its estimate of the rate consistent with achievement of the current inflation target.  Even if inflation were to briefly fall to below the midpoint, achieving a lower target in the current environment is likely to require a delay in the start of its cutting cycle. How long the policy stance would need to remain restrictive would depend on whether households and firms believe the Bank is committed to doing whatever it takes to get inflation to the lower target and keep it there. 

To make this possible without higher rates than now predicted, a firm commitment from government to address the underlying causes of high structural inflation is needed. This would need to include determined efforts to improve efficiencies in electricity production, addressing high administered price inflation, and a commitment to tying increases in public wages to productivity growth.

Steenkamp is CEO of Codera Analytics and a research fellow with the economics department at Stellenbosch University.