Reshaping inflation targeting

Experienced societies prefer to keep inflation contained to a level where it doesn’t actively enter economic calculation, commonly identified as about 2% annually.

Once this level has been achieved, central banks tend to act as caretakers, trying to prevent their economies from overheating by performing above potential for too long.

Any society can experience bouts of high inflation following severe policy mistakes. The road back towards inconsequential inflation tends to be long, hard and costly, mostly measured in growth foregone.

South Africa started to gradually loose its inflation moorings in the course of the outperforming 1960s, after which political troubles in the 1970s and 1980s severely overtaxed the economy, resulting in deteriorating national finances and even higher inflation.

High tide was February 1986, when inflation reached 21%. Thereafter a long road back towards single digits commenced, partly bought by long bouts of economic underperformance.

For most of the 1990s, our central bank enjoyed full unprecedented independence, with total discretion about how to conduct its business, which was commonly understood to be to reduce inflation without paying an undue penalty in growth foregone.

In the process policy mistakes were made, at times costly ones, such as in 1998, while the new political dispensation after 1994 preferred to gain greater oversight over the central bank’s actions.

From the late 1990s, government bought into a new global fashion in monetary policy, that of targeting inflation, thereby favourably influencing expectations and in a less costly fashion over time return to low single-digit inflation.

With the rich OECD part of the world economy already having re-established low single-digit inflation, partially favoured by the globalization then underway, it could play anchor for other regions wanting to converge to its level of inflation.

All a small open economy like South Africa needed to do was to prevent domestic overheating and external currency shocks, and the open trade architecture would assure inflation convergence over time with the dominant trading partner (in our case Europe).

When midway in this process SARB policy discretion became more constrained through adopting a regime of inflation targeting, this in fact facilitated the process of inflation convergence by making policy objectives and its exercise more transparent, allowing market participants to adapt more easily to the expected changes ahead, in fact making it happen.

However, this entire process remained subject to two major rules.

Firstly, do not make major policy mistakes creating internal inflation shocks. Secondly, let nothing go wrong in the outside world, causing external inflation shocks.

The bigger such shocks, the more likely the economy would relapse to a higher inflation trajectory, well away from its convergence path to low single-digit inflation.

In our case, the relapse potential was akin to that of a rehabilitated drunk. Any whiff of alcohol can send him off the rails anew into bad binging, incurring enormous setbacks in his determination to stay off the stuff.

This inbred weakness was a matter of economic structure.

A large regional economy like the US has efficient markets populated by many participants, and co-opted into the even bigger globalization game, in which US labour unions have been mostly eroded away and even large businesses find themselves price takers.

In such a market system, indexing or passing on cost increases isn’t easy, to the point of being impossible. At the global level it is the closest the world can get to perfect competition.

In contrast, South Africa’s small economy still has inefficiencies from its protected insulated past.

Labour is either politically protected (public service) or can join strong private unions or its skills are in chronic short supply, giving them exceptional market power. At least half the labour force is so favoured.

The corporate playing field knows similar inefficiencies. Many of our economic sectors are dominated by a few large businesses that have the power to set prices. Large public corporations again enjoy considerable political protection in setting their mostly monopolistic prices.

When therefore inflation shocks occur, the ability of perpetuating second and third round pricing effects is considerable. An initial inflation shock, if sufficiently strong, can raise the average inflation level long enough for it to become embedded in pricing actions and so eventually in expectations, lingering on indefinitely.

Only massive growth sacrifice, foremost focused on unprotected economic participants bearing the brunt of any such an attempt, may erode such inflation momentum anew, with the protected elements in the economy following with a lag such an example.

This suggests inflation targeting is most effective in good times when things work out and inflation can steadily converge to a low global standard.

But when shocks interfere, is inflation targeting ultimately not able to prevent the breakout and the re-establishing of a higher inflation trajectory?

A relapse, in other words, cannot be prevented and can only at great cost be eroded anew. Just like any habitual drunk going off the rails will find the going stiff once sobering up and blearily surveying the scene.

Unfortunately, since 2007 we are in the midst of two massive inflation shocks, the one internal and self-inflicted and the other a combination of external commodity and currency effects and basically a case of double bad luck.

After having temporarily achieved a 20-year inflation low point of 3.5% in 2006, these recent shock events have launched us on a massive inflation binge.

Self-inflicted was the lack of public sector discipline in keeping administered prices and public sector wage rounds within the target norms. The Eskom experience was only the most conspicuous of these political failures.

But this creeping indiscipline came at a time when externally monstrous surprises were shaping in oil, food and to a lesser extent the Rand.

The combined force of these shocks have taken CPIX inflation back to 10.4%, and are good for at least a 13% peak in 2H2008. Unfortunately, this projection only incorporates already known facts about oil, food, Rand and Eskom tariffs.

Unknown is the extent to which the oil, food and Rand shocks still may mature in the period ahead. There has been talk of a quick halving of oil and food prices. But oil prices could also easily still as much as double in the next year or two. Food prices also retain upward potential on fundamental grounds. And the Rand could weaken further, given South Africa’s current account deficit of 9% of GDP, which any bout of global risk aversion would likely penalize heavily.

Thus we wait with baited breath what 2H2008 and 2009 will still bring, including potentially further shock-like progression in CPIX inflation towards 15%-18% territory before peaking out is finally achieved.

The good news must be that such run-up in inflation driven by commodity prices can quickly be reversed, if only such commodity prices could rise less fast. Any actual commodity price declines would accelerate the decline in inflation.

But already we know that the cumulative 27% Eskom tariff gain in 2008 won’t be a once-off, but will be repeated in coming years.

And now coming into view are the second-round effects which have a way of sustaining higher levels of inflation once achieved.

Wage demands are already running in 10%-15% territory, which is double two years ago, but still struggling to catch up with the fast-changing inflation reality. Dominant industry players are enforcing cost-related price increases on their clients, few of whom have the market power to resist.

It is true that if the commodity price reversal can happen soon enough, the falling inflation rate would in turn start to unwind these second-round forces.

But let’s not discount happiness before it has arrived.

The fact of the matter is that first-round and now second-round inflation shocks are in full bloom, still very much blossoming and trying to find their new levels.

This may not be a stable condition, but for the moment the pressure is towards higher inflation levels, and rapidly so. We are effectively back in double-digit inflation territory and may have further to go before peaking and then plateauing.

This reality has rapidly left the macro policymaker and his 3%-6% inflation target far behind in recent months.

It leaves him three options.

Firstly, to plead with government for its wards at least to toe the line, a plea that has so far fallen on deaf ears, given the political needs and realities of the moment.

Secondly, to thunder against all those stampeding second-round forces, threatening hellfire if they don’t hold the line at 3%-6%. This is not very effective, given the structural realities marking our market economy.

Finally, to bring to bear the interest rate instrument and incur growth sacrifice, forcing resource slack and intensifying competition, undoing pricing power.

The usefulness of having a high 5.5% growth rate in 2007 was mainly that there was quite a bit to sacrifice in the hope of achieving something in 2008.

Unfortunately, the forces arraigned against the SARB are overwhelmingly powerful, as enumerated. With inflation loose in a 13%-18% range this year and next, how can anyone expect to get the show back to 3%-6% shortly except for undiluted luck reversing the commodity price shocks and an appreciating Rand kicking in for good measure?

But short of such luck, we may as well recognize we are back in double-digit inflation territory of the very sticky kind for some time to come.

There presumably can be no thought of unlimited growth sacrifice, pushing the economy deep into recession at which point most private domestic players may be expected to capitulate and second-round inflation may diminish.

Still, it is possible that key macro policymakers are currently contemplating just such a strategy, as politically there isn’t much to be lost, with at most 12 months remaining.

This option cannot entirely be ruled out. But in the light of events it seems an unlikely outcome.

Instead, with Turkey leading the way two weeks ago, a precedent has been created where an emerging market country can shift the policy goalposts without getting liquidated (currency, asset markets), primarily because it turns out to be the sensible thing to do under very trying circumstances.

Growth sacrifice is welcomed by nobody when its ultimate cause is primarily a shift in the globalization balance unleashing a commodity price shock.

It may therefore be the highest time that the guessing game should turn towards asking when the policymakers will capitulate, and by how much?

Will they double or triple inflation targets or suspend them entirely for the time being? And would the Rand sink like a stone or comfortably float on that news?

It is inconceivable that political lethargy or simple fear to move (or Rand caution) yields no action of any kind these next twelve months, leaving the SARB with an active 3%-6% target in the presence of 13%-18% inflation.

Unless, that is, it is understood that the SARB will start paying lip service to the still existing target, like the Bank of England of late (under very different circumstances), but that could create an unreasonable quandary for an independent central bank, greatly taxing its credibility.

So, will we still raise rates two or three times, or even more, this year and next in the mindless pursuit of a steadily rising inflation rate, as especially foreign institutions and younger economists still seem to be proposing?

Or will we get an abrupt change of policy as the growth sacrifice finally comes into focus, forcing a change in the playing field?

It is a little difficult to miss the deepening growth sacrifice already in train, with car sales 20% down, housing in freefall and private fixed investment effectively having come to a standstill.

Something will probably give, possibly quite soon. Either we get real lucky on the external commodity price front, or the deepening growth sacrifice may finally cause a change in policy regarding inflation and interest rates in the short-term.

But don’t underestimate inertia pushing policy a little deeper into the quagmire first before the balance of forces finally reshapes reality. Another interest rate increase is therefore not off the table.

Just as George Bush apparently continues to rule nothing out, with nothing off the table when it comes to Iran these next six months. Imagine what that could do to oil.

Trying times indeed in which we desperately search for resolution high and low.

The interest rate peak is probably near, but not necessarily because inflation is about to peak and recede. Growth sacrifice will probably still deepen before it lightens up. As to the Rand, it faces downside exposure from these events, but these may not get unduly enacted, depending on the collective global judgement of our actions.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics