It Pays to Keep the (Inflation Targeting) Faith A Financial Market Perspective

1. It Pays to Keep the(Inflation Targeting) FaithA Financial Market Perspective Gordon Smith 20 September 2002

2. Motivation For This Presentation • An inflation target is a monetary policy objective which formalizes the primary function of a constitutionally independent central bank to maintain price stability as a core policy deliverable • The technical parameters of the target were determined by expertise in the National Treasury accountable to a democratically elected parliament as an appropriate macroeconomicpolicy • From both political and fiscal perspectives, it is therefore imperative to underscore that opposition to SA’s adoption of an IT monetary policy regime is tenable on technical and not political grounds The purpose of this presentation is to clarify our understanding of the benefits of an IT monetary policy regime for South Africa in the context of a 400bp rise in interest rates so far this year

3. SARB Caught Between a Rock... • A good example of pervasive anti-inflation targeting populism is evident in this quote from the Business Day’s “Cartoon city” Editorial, Monday 16 September 2002: “…With interest rates now having been ticked up by Reserve Bank governor Tito Mboweni for the fourth time in eight months, the kind of growth required to make even the most modest pitch at jobs growth…is a mere pipe dream. The rates hikes will squeeze the indebted…middle classes. They will devastate the poor”.

4. And a Hard Place… 6/9 & 9/12 Month Forward Rate Agreement (One Year Ago to Today) • At height of Dec. Rand crisis, MM curve was pricing in a +450bps rise in inter-bank funding rates, with the implicit view that Repo rate would reflect this liquidity condition • Moreover, since the deterioration in world food and oil prices since July, the MM has again been pricing in higher rates sooner rather than later as the curve inverts Source: Bloomberg

5. Key Questions Facing an IT Regime • Why lower inflation? Inflation convergence is a prerequisite for successful integration with global trading partners • Why use inflation targeting? Other monetary policy regimes* have not been as successful. No IT regime since 1990 has yet been abandoned • How does IT work? Policy must be forward looking rather than reactive. Reference rate must be set to ensure monetary conditions support target. If inflation expected to deviate from target, a policy adjustment should be implemented as soon as possible • How does EM reality deviate from “ideal” conditions? In myriad ways, but past experience of inflation inertia is more costly. Requires resolve in face of currency routs, excessive wage growth and fiscal laxity * Fixed money growth rule; Fixed/Crawling Peg exchange rates; MCI rule

6. Benefits of a Successful IT Regime • Policy transparency & consistency offered by IT boosts confidence between economic contractors that there will be a moderation in inflation uncertainty and thus volatility (i.e. risk) • International evidence, especially from the “Dollar Bloc” countries, suggests that an anti-inflation credibility can still be maintained even given negative effects of unforeseen currency events • Where exogenous shocks are not uncommon (typical for small, open economies) and the history of inflation targeting is short, incumbency risk of giving up on IT is high - as is now apparent in SA • In simple terms, being able to price out inflation risk from the yield curve reduces the risk free rate on new productive investment, raises prospective returns and boosts economic and job growth prospects • For the fiscus there is a double benefit of widening and deepening the tax base while easing the costs of public debt, thus reducing the primary budget surplus

7. Assessing SARB Policy Performance... Monetary Conditions Index* • Using the Bank of Canada’s MCI approach, monetary tightening response of the SARB was exceptionally rapid after the Rand’s accelerated depreciation in Dec. 2001 • Indeed, SARB changed monetary policy from a relatively easy to relatively tight stance within a 6M period. Still, the question remains whether this has been enough? Source : I-Net Bridge * Bank of Canada Methodology(1-Month bps chg in official rate plus 1-Month % chg in TWI)

8. The Theory: Inflation & the MPTM* • * = Monetary Policy Transmission Mechanism • In the theory of inflation, the response of monetary policy can be theoretically judged in terms of whether a price shock (either inflation or deflation) is either “accommodated” or “not accommodated” • Given forward looking characteristics of inflation targeting, it is incumbent on SARB NOT to accommodate a monetary expansion, typically due to one of the following developments: 1. Rapid currency depreciation/devaluation 2. Remuneration growth greater than productivity gains 3. Excessive budget deficit financing 4. Or, as is often the case, any combination of the above three

9. The Theory: Inflation & the MPTM Cont. NOT ACCOMMODATING THE PRICE SHOCK: • Stage 1: After price shock, the real value of money supply shrinks and real interest rates rise. The demand for money falls, pricing power of companies wanes and the exchange rate tends to appreciate • Stage 2: As prices fall, the real stock of money rises and real rates reverse. As credit demand rises, income growth resumes and pricing power improves. But since the shock is over there is no lasting effect. ACCOMMODATING THE PRICE SHOCK: • A price shock occurs; the real money supply should shrink but the central bank accommodates inflationary pressure by allowing nominal money supply to rise through credit creation • As a result real rates do not rise and pricing power of producers and consumers is maintained. This allows second round effects to take hold. Prices rise further and an iterative inflation problem ensues

10. Initial (Exogenous?) Price Shocks... The Economist Food Index in Rands Rand Oil Price (Per BBL) • Sources of recent external or exogenous shocks include rapid rises in (world) oil/food prices and sharp fall in Rand exchange rates. Latter needs to be assessed before concluding as exogenous. Source for all charts: I-Net Bridge

11. …Were Accommodated in 2001/2 Real & Nominal M3 Growth (% YOY) and Real Prime Rate (%) Nominal M3 Growth(LHS) Real M3 Growth(RHS) • Accommodation of rapid rise in nominal and real M3 growth in 2001 and so far in 2002 is evident in falling real prime lending rate throughout this period • Indeed, to strict monetarists this accommodation was partially responsible for creating an excess supply of Rand and thus a direct contributor to weakening unit in 2H 2001 Source: I-Net Bridge Real Prime Rate(LHS)

12. …But Not Accommodated in 1998 Real & Nominal M3 Growth (% YOY) and Real Prime Rate (%) Nominal M3 Growth(LHS) Real M3 Growth(RHS) • One key reason why the 1998 currency shock did no harm medium-term inflation prospects is because policy responded by raising real rates quickly Source: I-Net Bridge Real Prime Rate(LHS)

13. Did SARB Do “Too Little Too Late”? Slope of SA’s Yield Curve (bps) & Headline Inflation (%) Slope of SA’s Yield Curve (bps) [R153 - 3M NCD] Headline Inflation(RHS) • If further inflation rises highlight policy as “still behind the curve”, we may not be at the peak of the current tightening cycle • Indeed, despite the vociferous rhetoric of aggrieved editors, this is still the outcome discounted in an ever more sharply inverted yield curve Source for all charts: I-Net Bridge SA’s Yield Curve(LHS)

14. 14 CPIX CPI 12 10 8 6 4 2 Forecast 0 1998 1999 2000 2001 2002 2003 Our CPI & CPIX Forecast Profile CPI & CPIX (% YOY) • For the record, Deutsche Bank remains hopeful that even as the CPIX target is missed for this year and next, inflation should be in target - just - by end-2003. Source: I-Net Bridge

15. Our Key Conclusions... • Evidence suggests that the “great inflation” of 2002 was in part caused by monetary expansion in 2001. This dislodges a spurious claim that cost-push inflation cannot be partly addressed by monetary policy. • Indeed, the longer there is monetary accommodation, the greater the risk that the source of inflation becomes embedded and self-perpetuating. There is already some evidence of a wage/price spiral. • If one accepts that the SARB remains committed to the inflation target - albeit belatedly - then one has to expect higher real rates. This implies a risk of another rise in Repo rate or at least a delay in easing. • While this may prejudice short-term growth, especially as a competitive currency has been somewhat diluted by real appreciation this year, there is no long-term trade-off between growth and inflation

16. View on Current IT Policy Debate • Since the aim of the IT regime is to help to complete SA’s transition to low inflation, if SA sets “easy” targets of say 7% for the next five years, there is little if any practical point to this monetary policy • There also seems little point in excluding half the index, as has been suggested by some commentators! As a macroeconomic measure, the index needs to be meaningful to the broad population for buy-in. In this sense CPIX(Mu) is a “democratic target” • and one can also argue SARB would lose early indicator • The envisaged speed of SA’s inflation transition under an IT regime may have been ambitious but, should the target be altered, it is critical that the ultimate aim is still to reduce CPIX to 4%, or the mid-point of the 2004 3-5% target range.

17. View on Current IT Policy Debate Cont. • One suggestion we would have is that the target range might be extended to account for higher risks predicated on SA’s susceptibility to external shocks • However, in this adaptation, the explicit IT policy aim would be to achieve the midpoint of the target, with the wider range on either side reflecting the greater forecast risk • We believe that missing the target but reaffirming the aim is preferable to shifting the goalposts: if the latter happens, it may entrench a perception that could happen again, since SARB has not had time to establish credibility • Government needs to play its part too. So far, while the National Treasury has set the target, the actions of other ministries, notably on wages and administered prices, have undermined it • Over time, this would imply a commitment to public sector efficiency increments, including parastatal restructuring