We though about writing a post about tomorrow’s MPC meeting and the interest rate decision, but Cees Bruggemans already has an excellent post out. We are posting it here but you should visit his site and register for the email comments.
A shockable summer, by Cees Bruggemans
This summer, we got shocked (though not electrocuted) three times in quick succession: the Nene firing, the New Year financial Chinese fireworks, vicious drought. It sunk the Rand, and has by implication spiked inflation projections. Are interest rates next, or will it all remain a lot more subdued than imagined?
Headline inflation will move higher in the coming year, as much as 0.5% more than expected prior to Nene, gyrating in a 6%-7.5% range, wandering well off the reservation for most of the year. But supply-side shock spiked, not driven by excess demand. Indeed, demand growth will erode some more, worsening the imbalance between fading growth and lifting inflation. SARB is expected to meet this head on, but will it?
We have a free-floating currency system, meaning market capital flows decide the level of the Rand. SARB is not in the business of attempting to manipulate the currency by loading interest rates. The forces on the loose are too big for that.
In an inflation targeting regime with a dual mandate, interest rate policy is focused on simultaneously managing two macro gaps that may come into being, namely an inflation gap and an output gap, for better or worse (in other words overshooting or undershooting their respective targets).
The medium target for output is to be in line what the economy can potentially produce without inclining either to more inflation or disinflation. The medium term target for inflation is given to the SARB by government fiat, in our case a 3%-6% range (rather than an exact number).
In normal times (remember them fondly), an overheating economy may invite accelerated price increases, like at a public auction seeking better returns where there is much interest. In bad times, an cooling economy may arrest price momentum. In the one case two positive gaps needed to be reined in, in the latter case two negative gaps needing to be undone, in both cases using interest rate changes to achieve these outcomes in the medium term (2-3 year time horizons).
But these are clearly not normal times, with economic output waning, and in places going through the floor (iron ore, car sales) while inflation is spiking lively (mainly food, Rand and energy driven). Two gaps alright, big ones too, but in opposing directions. How to solve both simultaneously.
The one gap (output) requires cutting interest rates (supposedly), the other (inflation) boosting them, except that the economic weakness and the higher inflation spikes are mostly supply driven, not demand caused. In other words, shaped by forces not necessarily amenable to interest rate discipline or support.
But then what is left?
Medium-term inflation expectations can be kept in check, alternatively they can start becoming lively, dragging their anchors. And once they start dragging they can acquire a life of their own, taking off without the benefit of initiating price shocks.
These are second-order effects, and the most feared by a central bank. For once this expectation shaping process becomes unhinged, losing its bearings, one man’s price increase becomes another man’s increased demand for price compensation.
The economically strong can defend themselves in such a battle by rising their “prices” (wage, fee, product pricing demands) faster than their costs. The weak can’t. So if on fixed income, or without negotiable skills or talents, an accelerating inflation will sink those that are defenseless. If enough in number, they can become politically destabilizing. In a society like ours, that is like dynamiting rivers when fishing.
And thus the modern focus on keeping those expectations contained, for the cost of mastering them after they have broken out is unacceptably high.
If this is the playing field, how loose and fast are the players at present with their inflation expectations? Things are certainly hotting up. The ease with which price increases and wage demands in double-digit territory are obtained, either by raw force or stealth, is growing. SARB has tried to stay ahead of the curve, without inducing undue cost (interest rate) premiums.
And not done too badly. Only 125 points of rate increases over two years so far, while the Rand has weakened markedly, but inflation and the expectations derived from it have been volatile but not unduly out of control. Unlike earlier cycles when SARB wouldn’t stop until having hiked 400 or 500 points (but inflation also way off the reservation by then).
It is a difficult question, with output and inflation gaps going in opposite directions, what a central bank is to do? Play Solomon and do nothing, straddling the divide?
Two last observations.
SARB has more than 15 mostly successful years behind it in which its credibility has grown and vested. It hasn’t been necessary for a long time to turn into an inflation nutter and kill off an unwanted runaway chain event.
Also, the SARB’s main macro partner (Treasury managing things fiscal) may not always have followed a policy stance supportive of SARB efforts. But next month’s budget could turn into quite a disciplinary effort and supportive of SARB broader aims, in which case fiscal might start to do the heavy lifting regarding our expectations.
Both observations possibly a reason to rethink the monetary stance? Not of course turning soft in the head, but becoming more supportive rather than leading the disciplining charge? If so, did we see the change in seasons coming? Or ignored its possibility completely?
This may make coming Thursday’s Monetary Policy Committee’s weighty pronouncements extra interesting, looking for evidence as to which way our combined macro winds will be blowing shortly.
Bruggemans & Associates, Consulting Economists