The Reserve Bank’s dilemma — lowering inflation targets in a time of trouble

Last week the SA Reserve Bank’s Monetary Policy Committee (MPC) cut interest rates by 25 basis points, even though consumer price inflation had fallen to 2.8% in October, below the current inflation target band of between 3% and 6%.

Considering the scope for a further cut (and the bank’s prediction that inflation will remain below 4% for much of next year) questions were asked about whether the bank was really aiming for a lower inflation target, without being public about it.

The context for this is the admission by the National Treasury in its budget documents earlier this year that it was considering lowering the inflation target. It is well known that Reserve Bank Governor Lesetja Kganyago would like to do this. He is an inflationary “hawk”, committed to using tighter interest rates to lower inflation.

In response to the Treasury documents, Kganyago said aiming for a lower inflation target without being public about it would be pointless, because of the issue of inflation expectations. If people expect inflation to be high, they demand higher wages and charge higher prices. If they expect inflation to be low, they will moderate those demands.

At the same time, the current economic path is for lower inflation. However, as the MPC warned, there are still some inflationary issues to come, including electricity, food and insurance premium inflation

Last week SA’s energy regulator, Nersa, started its public consultation process to assess Eskom’s application for a 36% tariff increase. It will hear the traditional complaint from consumers that they cannot afford such a big increase, followed by Eskom’s traditional explanation that if it doesn’t get this hike, it cannot produce enough electricity.

However, it will probably not grapple with the bigger questions around electricity tariffs, including that the entire process has lost legitimacy.

Potential economic boost

Cutting interest rates dramatically would give a huge fillip to the national coalition.

It would ease some of the pressure on consumers and boost the economy. Coming after figures showing that jobs were created in the third quarter of the year, coalition members could claim the credit.

That would put pressure on MK and the EFF, who argue that their voters are only going to get poorer because of the coalition.

However, there are very real risks ahead. While the SA Reserve Bank may not want to publicly dwell on elections in other countries, there can be no doubt that the reelection of Donald Trump as US president poses significant risks for inflation here.

This is because of his promise to impose high tariffs, primarily on China and Mexico.

This is the reason that while shares in the US and Europe rose on his election, markets in emerging economies fell. These economies have the most to lose.

We run the risk of being caught up in a trade war between the US and China, which would see inflation rising across the world.

At the same time, the decision by the Kremlin last week to upgrade their nuclear doctrine to allow the use of nuclear weapons if Russia is attacked by conventional weapons supported by a nuclear power (this was in response to Ukraine launching US-made missiles into Russian territory for the first time) is a reminder of how geopolitical risks are still very high.

One of the reasons food prices in South Africa rose after the pandemic was because of Russia’s invasion of Ukraine. However, food prices did not rise here as quickly as they did in many other countries because the SA Reserve Bank raised rates earlier than most of the rest of the world.

Clearly, this is still a major issue for the central bank.

Lack of consultation

All of this makes the timing of the process of potentially changing the inflation target curious.

Kganyago said negotiations with the National Treasury on this issue had led to debates that had “become very rigorous”, which indicates that intense calculations are being made about the impact of a lower inflation target.

Make no mistake, this decision would be momentous. It has the potential to change South Africa’s inflation trajectory for generations; the price your grandchildren will pay for a loaf of non-carb bread will hinge on this.

While this will be hugely contested, on balance, for a country and an economy like ours, lower inflation would be a massive benefit. Keeping food prices low would help millions of people and protect the value of social grants and salaries.

Perhaps more important, price stability might well increase the legitimacy of the state. Failing states often include periods of hyperinflation (most famously Germany before Hitler and Zimbabwe under Mugabe).

Controlling inflation is one of the most important roles of the state (which is why the Constitution spells out that the role of the Reserve Bank is to protect the value of the currency). If it fulfils this role, it does not just help ordinary people live better lives, it also strengthens the state.

The importance of this decision means that it should not be made solely by a group of officials, most of whom are not elected.

As Professor Raymond Parsons has pointed out, when the current inflation mandate was set in the 1990s, it followed a process of consultation. (He should know, he was part of that process.)

This is not happening now.

It may be that a calculation has been made that opening this up to public discussion would lead to it being hopelessly politicised.

One can imagine the EFF and MK, and the trade union federations Cosatu and Saftu arguing against such a change, while the DA would support it, with the ANC being split down the middle (as always).

There is a risk that public consultation would lead to calls for the current inflation target to be moved upwards, which would mean your grandchildren would have to eat cheaper carb-heavy bread because they can’t afford the good stuff.

That said, lowering the target without consultation would mean the decision lacks legitimacy. And, because lowering the target would lead to higher interest rates for longer, there would be more public opposition to the bank’s decisions.

While the last few years have seen a pandemic and Russia’s invasion of Ukraine and thus higher inflation, the current economic situation, where inflation is coming down, provides a golden moment to change the target.

This opportunity should not be wasted. DM