Don’t fight with the Fed; accept there will be policy uncertainty - SA Reserve Bank governor

16 Apr 2023

Though central banks are under fire for potentially overtightening, SA Reserve Bank Governor Lesetja Kganyago told an international audience that humility surrounding assessing inflation forces and comfort with the prospect of a mild recession were advisable in an environment where inflation dynamics defy easy analysis

Ever since the Global Financial Crisis (GFC) in 2008, it’s felt like the fate of the world has rested in the hands of the central banks — and now they are coming under increasing criticism for potentially overplaying their hand and putting the global economy at risk.

The latest US inflation data confirm what we already know: that headline inflation is coming down but that higher interest rates have had very little impact on core inflation, which excludes energy and food prices, for the past four months.

SA Reserve Bank Governor Lesetja Kganyago weighed in on the challenges and blind spots central banks face at this point at the Peterson Institute for International Economics Macro Week 2023 conference this week, recommending that central banks remain humble in their assessment of changing inflation dynamics and how higher interest rates are passing through to the real economy.

Worries about the impact of the four-plus percentage point rate hikes that have been implemented in the advanced economies, and South Africa too, have heightened in the wake of the turbulence in the US regional banking sector and Société Générale’s surprise state-assisted takeover by UBS.

Attention has also turned to the sharp drop-off in money supply, as reflected in the circulation of cash and cash-like assets, since December, which is the steepest drop since the 1930s. There are also mounting concerns that a credit crunch may emerge, with banks tightening their lending standards as their focus shifts to bolstering their capital reserves in an environment of a slowing global economy.

Criticism of Fed policy decisions

One of the Federal Reserve’s most vocal critics has been the chief economic adviser at Allianz, Mohamed El-Erian, who, in a recent column titled The Fed’s Credibility Problem, says that there are good reasons to be concerned about Fed policy decisions and the adverse effects they are having on other countries.

He considers that the US central bank has “mishandled” its interest rate hiking cycle, stumbled in its supervision of banks, and fuelled, rather than calmed, market volatility “on several occasions”.

He points to research by Harvard University that found market volatility to be three times higher during Fed Chair Jerome Powell’s press conferences than any of his predecessors, with investors then reversing their initial reactions after the conferences.

Investors are no longer aligning their decisions with those of the Fed, as they did in the past when they tended to adhere to the 1970s adage “Don’t fight the Fed”. Thus, the rate expectations that are being priced into markets are now diverging considerably from the Fed’s dot plot.

For instance, after the Fed announced a 25-basis point hike in the Fed Funds rate at its March meeting, the gap widened to as much as a full percentage point.

Says El-Erian: “That is a remarkably large gap for the central bank at the centre of the global financial system. Markets continue to go against everything they have heard and read from the Fed by pricing in a rate cut as early as June.”

In essence, investors believe the Fed will be under pressure to take its foot off the accelerator in the second half of the year because of growing evidence of how rate hikes already implemented are adversely affecting the economy and financial stability.

Kganyago acknowledges that “the possibility of overtightening is clearly real” but believes that central banks “can rectify their stance more quickly than in the event where they ‘under-tighten’”.

There is certainly room for empathy for central banks right now. It’s uncharted territory for them. They face the twin challenges of unwinding decades of ultra-easy monetary policy, fighting inflation and navigating a seismic shift in the macroeconomy amid harsh geopolitical forces.

Like government attempts to manage the health and economic fallouts from the Covid pandemic, one day, with the benefit of hindsight, it will seem blindingly obvious how central banks should have responded, but until then, they will need to navigate the extremely complex interaction of the short to medium-term cyclical factors driving inflation and longer-term structural forces underlying price-setting behaviour.

Kganyago believes these profoundly changing inflationary dynamics suggest that we need to “unlearn some of the lessons about cyclical policy from the GFC period”.

He describes the stimulus that central banks kept in place well after economies had reopened from the Covid crisis as a policy error. Demand was massive and supply problems created bottlenecks, which set in motion the steep increase in inflation rates worldwide.

Looking forward, Kganyago says the most difficult inflationary forces central banks need to identify, measure, and adjust for are climate change, geopolitics, demographics and labour markets, technology and trade. These relative price adjustments defy easy analysis and create forecasting uncertainty that makes it difficult to see how effective policy is likely to be and how the central banks need to react, he says. Thus, he sees these structural unknowns as “the weakest link in central bank analytical and policy frameworks”.

Kganyago’s recommendation is that central banks and market participants, it seems, need to accept there will be policy uncertainty — something that, he believes, comes easier to emerging markets — and become more comfortable with the prospect of minor recession “instead of prolonged periods of weak growth that bedevil larger emerging economies like mine”.

In its March minutes, the Fed did acknowledge there would likely be a mild recession in the US later this year, but that growth would rebound in the following two years. The fact that recession was anticipated to strike in the first half of the year highlights just how difficult it is to predict global economic outcomes over the next few years.

Thus, humility, acceptance of policy uncertainty and comfort with, rather than avoidance of, mild recession are wise recommendations from our SA Reserve Bank governor, as he addresses a global audience. DM/BM

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Criticism of Fed policy decisions