When should SA’s inflation target be lowered?

In today’s blog post, I repost my Business Day article in which I argue that I argue that achieving a lower inflation target in South Africa would require help from government.

When should SA’s inflation target be lowered?

South Africa’s Reserve Bank Governor would like to see a lower inflation target. So would the National Treasury. But what should the target be and when should it be lowered? Google ‘inflation target South Africa’ and there are hardly any recent academic papers on these important questions.

The lack of academic research for South Africa makes it hard to assess what an ‘optimal’ inflation target might be. Let us start with theory. Because inflation distorts relative prices, maintaining a low inflation rate is likely to minimise resource misallocations caused by these distortions.

You ultimately see this reflected in economic growth. Our analysis shows that the relationship between inflation and economic growth in South Africa has been negative at all levels of inflation. Over the long term, higher inflation tends to be associated with a higher growth drag from inflation  distortions. This also implies that economic growth cannot be sustainably boosted by tolerating a higher rate of inflation.

Theory and international evidence supports this argument. Anthony Diercks’ ‘Reader’s Guide to Optimal Monetary Policy‘ shows that most academic studies suggest that the inflation rate that minimises welfare losses from inflation is near zero.

In practice, countries tend to choose inflation targets that are higher than that because inflation is measured imprecisely, and because economists tend to worry more about the damage long periods of deflation could do to confidence in the economy than about low and stable inflation.

South Africa’s inflation target of 3 to 6 percent, with a preference for medium-term inflation near the midpoint of 4.5%, is quite high compared to advanced economies and leading emerging market countries. Our high inflation is one reason why our exchange rate has tended to depreciate over time. This results in a deterioration in international competitiveness, contributing to making South Africa an increasingly expensive, low productivity economy. A lower inflation differential with our trading partners will reduce pressure on the currency, support the competitiveness of South Africa’s exporters and the buying power of our currency.

So why not immediately lower the target?

A major driver of inflation is people’s expectations of inflation. Inflation expectations affects wage demands and firm pricing decisions. If expectations are for inflation to remain high, the central bank would have to keep interest rates high to hammer inflations expectations lower. High interest rates weigh on economic activity and so imply a real cost to the economy.

The best time to reduce the inflation target would be a time when trend inflation is low. In recent years, the ideal opportunity was the lead-up to the COVID-19 pandemic, given that favourable supply shocks were responsible for containing inflation at the time.

At present, inflation expectations in South Africa are still near the top end of the Reserve Bank’s target range. Our measures of trend inflation remain above the midpoint of the inflation target and suggest that there is a high degree of inflation dispersion across price categories. Our estimate of underlying inflation pressure, for example, suggests that there has been more broad-based inflation pressure since the pandemic than implied by the ‘core’ measure that excludes some volatile components such as food and fuel prices that the Reserve Bank focuses on in its Monetary Policy Statements.

The Reserve Bank’s problem is that government-related inflation has consistently grown at well above the upper bound of the inflation target. Since 2009, inflation in electricity and administered categories have averaged almost 12% and 8% per year, respectively. The Reserve Bank cannot directly affect prices in such categories, so keeping interest rates high in response to such pressures imposes costs on parts of the economy where prices are more flexible.

A related consideration for the feasibility of lowering the inflation target is how the government’s fiscal stance is affecting the outlook for growth and inflation. Despite recently including a fiscal block in its model, the Reserve Bank remains tight lipped about its assessment of how rising debt is contributing to high interest rates. Like the IMF, our assessment is that, despite attempts to consolidate spending, the government’s fiscal stance has remained stimulatory at the margin. Our estimates also suggest that rising debt and an increase in government credit risk premia have contributed to higher borrowing costs. Lowering the inflation target would be expected to help bring down long term interest rates, but a worsening of government finances could move rates in the other direction.

Many market analysts expect the SARB to begin cutting its policy rate this year. However, should inflation not begin to fall as the Bank currently predicts, the policy rate would be below its estimate of the rate consistent with achievement of the current inflation target. Even if inflation were to briefly fall to below the mid-point, achieving a lower target in the current environment would likely require a delay in the start of its cutting cycle. How long the policy stance would need to remain restrictive would depend on whether households and firms believe the SARB is committed to doing whatever it takes to get inflation to the lower target and keep it there.

To make this possible without higher rates than currently predicted, a firm commitment from government to address the underlying causes of high structural inflation is needed. This would need to include determined efforts  to improve efficiencies in electricity production, addressing high administered price inflation, and a commitment to tying increases in public wages to productivity growth.

Dr Steenkamp is CEO of Codera Analytics and a research fellow with the economics department at Stellenbosch University.

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