RAYMOND PARSONS: A fixed 3% inflation target could be necessary — or a bridge too far

Over its 104 years of existence the SA Reserve Bank has built a fine record of achievement as a major role-player in SA’s policy framework. The Bank has been a key custodian of macroeconomic stability, and supportive of actions that minimise SA’s country risk premium.

In pursuit of its basic anti-inflation constitutional mandate, since 2000 the Reserve Bank has implemented an inflation target band of 3%-6% with a significant degree of success — the SA economy has benefited from lower and less volatile inflation.

However, with the accumulated experience of inflation targeting both in SA and globally over several decades, it is opportune now to review the inflation targeting regime and, if necessary, adapt the approach.

Since 2017 the Bank has in any event opted for the 4.5% midpoint of the existing band, but governor Lesetja Kganyago has for some time advocated a lower fixed target of 3% as being more appropriate if SA is to remain globally competitive.

The advantages as well as associated risks of a change have therefore been the subject of intensified joint technical research by the Bank and the Treasury. However, getting this right is a challenge for policymakers.

In the latest Reserve Bank monetary policy committee statement of May 29 Kganyago again strongly reiterated that, for external and internal reasons, SA’s inflation target is “too high and too wide”.

With inflation presently slowing down in SA, he sees an opportunity to “lock in” lower inflation at low cost. The Bank is therefore of the view that the 3% scenario is more attractive than the present 4.5% one, and that the time has arrived for inflationary expectations to move to a lower level.

Reserve Bank researchers have emphasised that SA’s inflation target range has become an outlier compared with other emerging markets.

However, the trade-off between inflation targeting and economic growth is a complex one. In various countries anchoring inflation expectations (when inflation targeting is used) is done in different ways — by adopting point targets, by having tolerances around a point target, or by specifying target ranges such as in SA.

Overall, there is no consensus in the academic literature as to whether a point or a band target is always the best option, as national economic circumstances differ.

One recent European Central Bank study found that target ranges or (in some cases) tolerance bands, outperformed the other types. In other words, the band targets were missed less frequently by central banks.

However, the outcomes partially depended on the economic context of the country concerned, and no target type was found to consistently outperform all others. After all, central banks can hit their target for the wrong reasons, as well as miss the target for the right ones.

Another Swedish central bank study on the preferred target type concluded that a “dovish” central bank would find a band target more attractive, whereas a “hawkish” one would prefer a point target.

The technical work done by the Bank and Treasury on the proposed change to the inflation target framework is wide-ranging, thorough and persuasive. Nonetheless, an important reality test for a new inflation targeting regime is to enjoy as much support as possible among key stakeholders, such as business and labour, whose decisions shape inflationary expectations.

The significant role of inflationary expectations has been a constant theme in Reserve Bank modelling and deliberations, including in the motivation for the new 3% target. The inflation target range in 2000 was finalised through a consultative process with key players. Subsequent global research has also emphasised the need to mobilise support from major stakeholders, including governments.

The strategic importance of government of national unity (GNU) “buy-in” therefore rests on several factors. These include the persistent negative role of administered prices, ranging from Eskom and Transnet tariffs to municipal rates. The Bank’s previous study of how administered prices in SA complicate its anti-inflation task needs to gain more traction now.

The Bank research is optimistic that a decline in headline inflation will lower administrative price inflation, especially if reforms are introduced to improve efficiency in regulated sectors. This nevertheless may be “a big ask”.

The Reserve Bank has indicated that a move to a 3% inflation target means “growth will be somewhat lower at first, but the economy will do better later”. The short run cost is seen as eclipsed by permanent gains. Indeed, the Bank’s view is that a highly credible commitment to “disinflate” quickly should actually have little economic effect.

The GNU cabinet will need to decide how this fits with its medium-term GDP growth target of 3%, at a time when most growth forecasts for 2025 are now barely 1%. The official policy “optics” are therefore strongly focused on a far higher job-rich growth rate over the next couple of years.

Another variable that would need to be successfully managed in a changed inflation target regime is the extent to which elevated policy uncertainty — both globally and domestically — could pose a tangible risk to a lower, but fixed, inflation target.

A target band provides the flexibility needed where, for an economy still undergoing major structural changes, the linkages to economic transmission mechanisms are far more uncertain. The danger is that the more specific the target, the more likely it is to be missed amid uncertain structural change in an increasingly volatile global economy.

Politics and policy-making seldom follow the neat contours crafted by economic technicians. Finance minister Enoch Godongwana has said political support for fiscal and monetary policy reforms, such as a fiscal rule or a lower inflation target, must be built before they can be implemented.

There is nonetheless no reason “sufficient consensus” cannot be found to implement a key positive change in the inflation targeting regime that could give SA the best of both worlds. There is policy space for more than one new formula.

The choice of a new inflation path and target for SA therefore ultimately requires careful design, good communication and wide buy-in. It must remain focused and achievable.

We know SA needs low and stable inflation for a number of well-known reasons, not least of all to remain globally competitive. A lower but flexible inflation target is an important tool for the Reserve Bank to achieve that goal.

There is an old economics saying that macroeconomic stability is not everything, but without it a country has very little.

• Parsons is a professor at the North West University Business School.