29 Mar Is the MPC an unnecessary constraint on economic growth?
As published by Business Day on 28 Mar, 2022 by Kyle Wales
The SA Reserve Bank’s mandate focuses on protecting the value of the currency in the interest of balanced and sustainable economic growth, and maintaining financial stability. This has been interpreted to mean keeping inflation within a 3%-6% band.
This narrow interpretation of its mandate places it at odds with other central banks around the world. Most notable among these is the US Federal Reserve, which has a dual mandate of maintaining price stability (keeping inflation low) as well as keeping the economy at full employment.
This has earned it credibility amongst inflation hawks but it has come with growth trade-offs which are unpalatable given the country’s slow growth trajectory.
There are two types of inflation. The first type is labelled “cost-push” inflation because aggregate demand remains the same but there is a decline in aggregate supply due to external factors that cause a rise in price levels. The second type is labelled “demand-pull” inflation because aggregate demand becomes greater than aggregate supply.
Clearly the world has seen a lot of inflation due to cost-push factors recently. Supply chain constraints as a result of the world emerging from the pandemic have had the effect of driving prices higher. Disruptions caused to global commodities markets caused by the Russia/Ukraine crisis are further exacerbating the problem.
The oil price has drifted to USD 110 per barrel. This not only pushes up the cost of transport for South African consumers but also impacts other items in the CPI Basket as well. The increase in the wheat price has also played a role as Ukraine and Russia account for 30% of global wheat exports between them.
Predictably, as a result of these and other factors, South Africa’s CPI stood at 5.7% y-o-y when it was last reported (just below its 6% upper bound), and the monetary policy committee raised repo rate by 25 bps on 24th of March.
However, unlike the US where we are seeing visible signs of overheating, South Africa sits atop a number of deflationary forces which makes the risk of demand-pull inflation almost zero, and using monetary policy tools to tame cost-push inflation is unlikely to be successful without inflicting harm to our economy.
The first of these deflationary forces is South Africa’s negative output gap. Today, many economies are larger than they were prior to Covid. The US’s economy, for example, surpassed its pre-pandemic size in 2021.
The same cannot be said for South Africa. Its economy at the end of 2021, according to the IMF, was still 2% smaller than it was at the end of 2019. As a result, the South African economy sits with excess capacity and this is deflationary because economic actors typically try to reduce prices as a mechanism to clear this excess.
The second of these deflationary forces is the increase in the prices of the cost-push factors, like oil and wheat, themselves. Similar to an increase in interest rates, they serve to withdraw liquidity from the economy. Interest rates withdraw liquidity from the economy by raising the cost of servicing debt. This in turn reduces aggregate demand. Increasing the price of items like oil and wheat also withdraws liquidity from the economy but it does so by increasing the price of the typical South African’s consumption basket, leaving them with less money to spend on other discretionary items. Why is it necessary for the MPC to withdraw additional liquidity from the economy in addition to this?
If we flip the problem on its head and looks at the problem from a “cost-push” perspective, we are also left scratching our heads. It is not possible for an economy which accounts for a mere 0.6% of global GDP to bring the oil and wheat markets to balance globally. Only a resolution of the Ukraine crisis will be able to do this and the role that South African can play to hasten this will be minimal.
While the MPC may be doing the things the narrow interpretation of its mandate requires it to do, it is coming at a substantial cost to the economy in terms of economic growth. If the MPC continues to approach monetary policy as it currently does, it will only add a further obstacle to South Africa’s economy exiting its low growth paradigm, and further impair the country’s attractiveness as an investment destination
The discussion around monetary policy has to evolve from “high inflation, therefore higher rates” to conceding that monetary policy is a multi-variable problem where inflation is only one of the factors that needs to be considered.