The Reserve Bank’s quarterly projection model has emphasis on drivers of long-run inflation.
This column was first published in Business Day
Why do you hike rates when oil is falling, the rand is rallying, there is no pass-through from the recent weakness of the rand and there is no evidence of second-round effects from the April VAT increase?
This was the response of many foreign investors after the November monetary policy committee meeting and its 25-basis point rate hike.
Bemusingly, the sentiment above was apologetically caveated with a “we still know the SA Reserve Bank is one of the most credible central banks in the world, but ….”
The Bank is indeed one of the most credible central banks in terms of an inflation-targeting framework, a depth of research staff and forecast and publication transparency.
Its problem, however, is that the complexity of its quarterly projection model operation, and with it a view of a balance between various “gaps” in the economy — gaps of things like growth, the currency, inflation, the current account and finally interest rates, with equilibrium levels — has basically lifted off into the stratosphere.
Its problem stems fundamentally from differences in patience, and so, of time horizon. This seems to be compounded by a stubbornness to not listen to what the Bank actually says. This, in turn, gets caught up by a market focus on holding the quarterly projection model “to account” for short-run errors and assumption changes.
As a result, the market thinks that input assumptions shifting are an issue. Instead, the market needs to cut through all this and see the quarterly projection model and the Bank’s communications as being broadly constant and sticky.
The value of the model is to provide a broad understanding of the drivers of long-run inflation, shock analysis and an insight into where current policy sits on the accommodative/tight monetary spectrum.
Markets have really struggled to understand the fact that the monetary policy committee is, and always has been, focused very firmly on the long term when setting policy and considering inflation targeting. As such, markets get lost in debates over revisions to consumer price inflation forecasts in the first half of 2019 and not see the unchanging view on the end of the forecast horizon.
The Bank’s communication on this issue has been remarkably constant through the last six years. After the Marikana massacre in 2012, something clicked inside the Bank and a consistent mantra on some key issues came together and has been a constant thread.
One of the main streams of thought has been that the output gap is small — that potential growth is very low. The Bank was the first major institution to start to ring alarm bells about the fact that negative per capita income growth was structural rather than a short-term one-off, as so many people seemed to think at the time.
One of the other factors has been that even with low exchange rate pass-through, long-run inflation is going to be sticky at the top end of the target. As such, the Bank is targeting reducing the probability of inflation being outside the target in the long term, even if a simple modal baseline is that it will be within target.
This is why the monetary policy committee can hike rates even when the forecast shows inflation within target and even with a short-run forecast surprising to the downside.
The other issue that fails to garner enough attention is that while the price formation mechanism and inflation expectations in the country have been dampened in the short term, structurally they are not anchored correctly, and so long-run risks remain.
We are in a world of “fiddling”. The Reserve Bank is managing marginal risks as a risk-averse institution. The chance of an inflation “explosion” to, say 10%, is practically zero, and equally the dampening effect it is having on growth from hiking is small and only in the very short term. It therefore sees the hike as a worthwhile exercise, given the long-run inflation risks in a global world of tightening monetary conditions.
The Bank has already won a major victory in that it has not had to tighten policy in lockstep with the US Federal Reserve.
The Reserve Bank, which is looking at a time horizon that most people and particularly parts of the market struggle with, will stick to its guns. It would have these views with or without its model.
It needs to keep hammering home the existing message again and again, not because that message is new or hasn’t been clear, but because markets have such a short attention span and we are in a politically charged environment.
Other actors have the levers to deal with potential growth, but are doing precious little, which is not the Bank’s fault.
• Attard Montalto is head of capital markets research at Intellidex.