Reserve Bank vindicated
The critics are wrong; the Bank is no ‘inflation nutter’
Critics have been pushing hard for the Reserve Bank’s mandate to be broadened to make it consider growth and employment concerns directly, not just inflation. But according to new ground-breaking research, the Bank already does so.
The Bank is a flexible, forward-looking inflation targeter that gives considerable attention to labour market conditions when deciding the path of interest rates, according to an empirical study undertaken by Laurence Harris, a professor of economics in the School of Finance & Management at SOAS, University of London, and former National Treasury economist Shannon Bold.
The revelation that the Bank is responsive to changes in unemployment — not just the path of inflation — is likely to strengthen its hand in the ongoing, highly politicised dispute over its ownership and mandate.
The research was conducted under the auspices of the Southern Africa — Towards Inclusive Economic Development (SA-TIED) programme, which seeks to support economic policymaking in Southern Africa by conceiving and producing original research.
The programme is a collaboration between the UN University World Institute for Development Economics Research, the Treasury, the department of trade & industry and many other governmental and research organisations in SA.
The researchers set out to assess the extent to which monetary policy in SA has been responsive to inflation as well as other variables, including changes in output and unemployment.
"The issue is important for SA’s choice of macroeconomic strategy," they say in their working paper. "At various times since the introduction of inflation targeting, political and technical debates have included prominent criticisms of inflation targeting or the interest rate policies resulting from it."
They cite Cosatu, for example, which has long urged the Bank to abandon a narrow focus on inflation targeting because it considers it an inappropriate policy for a country at SA’s stage of development.
More recently, the ANC resolved at its 2017 national conference that the Bank should operate a "flexible" monetary policy regime that was responsive to GDP growth and unemployment, not just inflation. It was unclear whether this implied a mandate change or not.
Under inflation targeting, South Africa’s monetary policy has had a forward-looking inflation target that is pursued flexibly in the light of labour market conditionsShannon Bold & Laurence Harris
The issue again made headlines last month when ANC secretary-general Ace Magashule said the party’s national executive committee had agreed to force a dual mandate on the Bank. President Cyril Ramaphosa subsequently asserted that the party would not change the central bank’s mandate or nationalise it because this was "simply not prudent" given the current economic and fiscal situation.
On June 20 during his state of the nation address, Ramaphosa reaffirmed the existing constitutional wording of the Bank’s mandate — to protect the value of the currency (keep inflation low and steady) in the interest of balanced and sustainable growth.
One of the dangers in changing the Bank’s constitutional mandate, Harris explains in an interview with the FM, is that it "is a foundation principle rather than a narrow instruction" and its maintenance is thus seen as a sign of the country’s "trustworthiness".
"Forex markets, money and capital markets, react to changes in signals that have been elevated to such status," he says. "A change of the mandate would be such a major political event that it would undoubtedly weaken trust in SA’s commitment to macroeconomic stability with consequent revisions of risk premiums and adjustments in investment positions."
In their paper, the researchers set out to uncover the extent to which the Bank’s policy rate decisions, since the adoption of inflation targeting in 2000, have followed a Taylor rule, responding partly to changes in the output gap, unemployment, or labour market slack in the economy while maintaining focus on the inflation target.
Taylor’s rule, devised by Stanford economist John Taylor in 1993, is a guideline for how a central bank like the US Federal Reserve (which has a dual mandate) should alter interest rates in response to changes in economic conditions to achieve both its goals of maximising employment and keeping inflation low and stable.
The rule states that the real short-term interest rate should be determined according to three variables: where actual inflation is relative to the central bank’s target, how far actual output is from "full capacity" output (or how far actual employment is from full employment), and the neutral or sustainable level of the short-term interest rate.
The rule recommends tighter monetary policy when inflation is above its target or when the economy is above its full employment level, and vice versa. Though the Fed doesn’t explicitly follow a Taylor rule, various studies show that such a rule adequately describes how monetary policy has been conducted in the US in the past.
Accordingly, if SA’s central bank was running a simple, rigid inflation-targeting regime in which policy was adjusted to correct for current deviations in inflation only, its interest rate decisions would not fit closely to the path described by a Taylor rule.
Though previous research on monetary policy in SA has found that a Taylor rule provides a good fit for the inflation-targeting period, using this approach to study the specific effects of unemployment changes on monetary policy in SA has not been carried out before.
Using a classic Taylor rule, the researchers found that a significant negative statistical relationship exists between the unemployment gap (the deviation of the official unemployment rate from an assumed natural rate of 25%) and the repo rate.
This suggests that as unemployment rises above its natural rate, the Bank responds by lowering interest rates to stimulate the economy to produce more and employ more workers. However, in doing so the Bank still places a greater weight on expected inflation than on unemployment, in line with its mandate prioritising price stability.
These findings would appear to vindicate the Bank, which has stated repeatedly that it’s not an "inflation nutter" that acts to keep headline inflation within the 3%-6% target band at all costs. Rather, it implements monetary policy flexibly, taking into account changes in the real economy.
What it means
New study shows Reserve Bank is responsive to unemployment
Harris agrees that criticism of the Bank as an inflexible inflation nutter has been misplaced. "Absolutely, yes," he says. "These estimates robustly support the idea that the Reserve Bank has used inflation targeting with considerable regard to labour market conditions."
He concludes that there is no reason to change the Bank’s mandate. "One reason is that the argument the governor regularly makes is correct, that control of inflation is necessary for supporting GDP and growth. The other — which is the conclusion of this paper — is that the Reserve Bank’s successful targeting of inflation has been achieved by operating flexibly in a way that takes labour market conditions into account."
Moreover, a political decision to change the mandate would not be a single act but the start of "a drawn-out, contested process" with further effects upon macroeconomic stability and risk premiums, he warns. Also, a change of mandate would change the context of SA’s highly centralised wage bargaining and price-setting systems, and likely add to inflationary pressures in those frameworks.
"The Reserve Bank’s inflation targeting has been operated flexibly and yielded important benefits," Harris concludes. "SA’s low growth, high unemployment and inequality require changes in the structure of the economy and cannot be overcome by changes in monetary policy. A revision of the Reserve Bank’s mandate is unnecessary and pressure for it simply diverts attention from the task of achieving fundamental economic changes."
Another of the paper’s key findings is that the Bank’s policy rate decisions respond to expected inflation rather than current inflation. In this respect, the expectations of businesspeople and trade unions with regard to the path of future inflation are found to have been more significant than those of economists and other analysts.
This could be because these two groups are price setters in the economy, either directly through the prices of the goods and services they provide, or indirectly through the wage increases they demand.
"This is an important consideration for policy, especially in anchoring expectations of those groups that weigh more heavily in the Bank’s interest rate decisions," the researchers say.
In a separate analysis using a modified Taylor rule, the researchers used the deviation of SA’s labour force participation rate (LFPR) from its long-run average of 57% as a proxy for the output gap (the gap between actual GDP and SA’s maximum potential GDP).
They found to their surprise that the Bank gives almost the same weight to deviations in the LFPR as it does to inflation. However, Harris downplays the LFPR results for a host of technical reasons, saying their robustness, economic and statistical significance do not warrant any policy conclusions being drawn.