1. The task of monetary policy
The South African Reserve Bank has been tasked with the responsibility to protect the value of the South African currency. Although this is a very clear mandate, there is almost always pressure on the Reserve Bank to pursue other objectives, for example to stimulate or uphold the real demand for goods and services, to provide more money for the purpose of creating more jobs, to provide funding for excessive public sector expenditure, to reduce interest rates to a lower level, etc. These other objectives must apparently at times be pursued by the Reserve Bank irrespective of the implications it may have for the value of the currency. Should, however, inflation rise as a consequence of the diversions, the same critics will again hold the Reserve Bank responsible for not fulfilling its assignment.
Although the mandate is clear, it is not always easy to decide what monetary policy measures are required to achieve the objective. There are, firstly, unavoidable time lags involved in the dynamic process of economic development. Changes in interest rates today will, for example, normally only affect changes in the money supply something like six months later, whereas changes in the money supply will only gradually work through to total spending, and total spending may or may not affect prices in the longer term.
There are, secondly, no fixed or even stable relationships between the various financial aggregates, or between developments in real economic activity and in the financial aggregates. Ratios based on historical data can be very misleading for future developments, particularly in a situation where major structural changes are taking place at the same time, as we now experience in South Africa.
There is, thirdly, a major element of subjective discretion involved in monetary policy because it is about the uncertain future, and about unpredictable changes in the value of the currency. Taking account of the unavoidable time lags involved, monetary policy cannot wait for inflation to rise before it acts, because it will then always be too late.
What we do today, is not about today's inflation, but about what may happen to inflation next year. It is therefore a fallacy to argue that because inflation is low today, monetary policy must now be relaxed. The Reserve Bank must be guided by the underlying forces that operate at this stage but will show their real effects on inflation only next year.
There are finally many forces at work that contribute to inflationary pressures in the economy. The more and the stronger these forces become, the more difficult it is for the Reserve Bank to pursue its objectives and to achieve its goal of financial stability. Those with a vested interest in the underlying operations cannot always understand why the Reserve Bank is often such a spoilsport and remains reluctant to accommodate their needs by just printing more money. They are also the people who normally do not understand why inflation increases, and then look for a scapegoat in inefficient monetary policy.
The Reserve Bank must remain unassailable to these pressures, and must resist the crave for short-term expediency, and short-term popularity that will in the longer term lead to lower growth, more unemployment and greater poverty. The directive to the Reserve Bank to protect the value of the currency is therefore not a short-term one, but a medium and longer term task. The contribution expected of the Reserve Bank towards growth and economic development is to maintain overall financial stability, that is, to keep inflation low.
It is for this reason that central banks should not pursue short-term gains, if any, that can be achieved from the so-called trade-off assumed to exist between inflation and growth. The Phillips curve trade-off is becoming a myth that may have worked many years ago, but is no longer regarded as of any importance. Just recently, Professor Robert E. Lucas of the University of Chicago was awarded with the one million US dollars Nobel Prize for Economics in recognition of the work he has done on the role of rational expectations in economic policy making. In the announcement of the reward, the Royal Swedish Academy of Sciences paid the following tribute to Professor Lucas:
"In a study published in 1972, Lucas used the rational expectations hypothesis to provide the first theoretically satisfactory explanation for why the Phillips curve could be sloping in the run (but must) be vertical in the long run. In other words, regardless of how it is pursued, stabilization policy cannot systematically affect long-run employment ... Lucas demonstrated that any endeavour, based on such policy, to exploit the Phillips curve and permanently increase employment would be futile and only give rise to higher inflation. This is because agents in the model adjust their expectations and hence price and wage formation to the new expected policy".
It is time for many South Africans to catch up with the new world of rational expectations, particularly now that South Africa is being reintegrated in the world economy, and the perceptions of well-informed and sophisticated market participants in and outside of South Africa are continuously subjecting the monetary and fiscal policies applied by all countries to the closest scrutiny. Even if some of us still do not accept or believe in this new world of rational expectations, we cannot be part of the global economy, and be exempted from the rules of the game at the same time.
2. Macroeconomic background
Restricting the functions of the Reserve Bank to the protection of the value of the currency, and therefore to developments in macroeconomic financial aggregates, does not mean that the Bank has no interest in the real economy. On the contrary, many of the inflationary pressures that will sooner or later challenge the ability of the Reserve Bank to adhere to its mission, emanate from real economic activity.
Aggregate national account statistics of recent developments in the South African economy can be very misleading. Although total gross domestic production slowed down, indicating seasonally adjusted annualised growth rates of only about 1 per cent in the first two quarters of 1995, the underlying economy remained much stronger. Excluding the primary sector, the growth in the real value added by the secondary and tertiary sectors accelerated from an annualised rate of 3½ per cent in the first quarter of 1995 to 4½ per cent in the second quarter. This growth was supported strongly by a surge of 5½ per cent in total gross domestic expenditure in the second quarter, mainly because of a very strong rise of more than 8 per cent in gross domestic fixed investment. The rate of increase in real private sector fixed investment rose from an annualised level of 9½ per cent in the first quarter of 1995 to approximately 13½ per cent in the second quarter.
These impressive growth rates may not be sufficient to absorb the huge backlog of unemployed people in the country; they may also not be high enough to generate sufficient income for the financing of all the desired public sector expenditure; they may not enable all businessmen in the country to make all the profits they would like to make.
They do, however, lead to strains and frictions in the economy that cannot be ignored, particularly not when deciding on monetary policy for the immediate future. All indications from financial aggregates are that the buoyant conditions in the economy are continuing, and may even be gaining momentum. Stimulated by a rising level of public sector expenditure, the strains and frictions could easily lead to higher inflation, particularly if the rising pressures are accommodated by the creation of more money. It is an illusion to believe that the limited growth potential of the economy can be lifted by the creation of more money.
The most important stress in the current process of economic development is created by the strong rise in imports, resulting in a rising deficit in the current account of the balance of payments. In the second quarter of 1995, the seasonally adjusted annualised rate of the current account deficit increased to R12,5 billion, equal to about 3 per cent of gross domestic product. This may not be regarded as too high for a developing economy -- the Mexican crisis of last year centred around a current account deficit of more than 7 per cent of gross domestic product. There are nevertheless some ominous warnings in this rising current account deficit.
After all, the widening of the current account gap is in itself a reflection of underlying inflationary impulses that, if not checked with restrictive monetary and fiscal policy, will eventually force a depreciation of the exchange rate, and will be converted into open inflation. Depreciation in an overstressed economy will almost always lead to higher inflation.
It is true that a substantial net capital inflow at this stage makes the growing current account deficit tolerable. This is indeed the most important change in the South African economy over the past eighteen months -- the growth potential of the economy has effectively been lifted to a higher level because of the turnaround in the capital account of the balance of payments from persistent net outflows to a rather large net inflow. Our own experiences of the past, however, and the experience of many other countries, learn that, in the longer term, a country should not rely too much or for too long on capital inflows for sustaining domestic growth.
Developments in the South African economy over the past two years also exposed the shortage of domestic saving and resulted in an undesirable excessive increase in the demand for bank credit. The rate of increase in total bank credit extended to the private sector gradually rose from 5,7 per cent over the twelve months up to May 1993 to 19,5 per cent in April 1995. Since then, it levelled out and indeed recently showed some signs of retracting. Over the twelve months ending in August 1995, total bank credit extended to the private sector nevertheless still increased by 18,6 per cent, which is far above the current rate of inflation, and reflects a high rate of increase in the real value of the outstanding amount of bank credit.
The excessive rate of increase in bank credit extension led to the unacceptably high rate of increase in the money supply, which holds the ominous threat of higher inflation somewhere downstream. At the end of 1993, the M3 money supply was rising at a rate of less than 7 per cent over successive twelve months' periods, but then gradually rose to a level of between 15 and 16 per cent towards the second half of 1994. It has now been fluctuating around this higher level for about a year, with little evidence of receding again to within the guidelines for an acceptable rate of growth of between 6 and 10 per cent indicated by the Reserve Bank at the beginning of 1995.
There is also evidence of a higher rate of increase in average wages and salaries which rose at rates below 10 per cent towards the end of 1993 and the beginning of 1994, before accelerating to about 11 per cent in the first quarter of 1995. These increases are not matched by recent welcome small rises in labour productivity, and lead to a further rise in nominal and real unit labour costs of production.
From the evidence of the financial data available to the Reserve Bank, the deduction must be made that current levels of expansion in the South African economy, and particularly in the total demand for goods and services, are putting severe pressures on available resources. This is further reflected in emerging pressures on fiscal policy, particularly at the level of regional governments where budget provisions seem to be inadequate for the financing of total committed expenditure.
3. Implications for monetary policy
At this stage the Reserve Bank is therefore confronted by:-
a strong demand for bank credit to finance a rising real demand for investment and consumption emanating from both the private and the public sectors;
an unacceptably high rate of increase in the total money supply, which, through the multiplier effect of secondary spending, could easily lead to higher inflation somewhere downstream;
a growing deficit in the current account of the balance of payments which must be monitored closely with the necessary circumspection; and
an unhealthy large deficit on the public sector budget, with many rumours of overshooting of budget targets, particularly at the level of second and third tier government.
In these circumstances, monetary policy must remain cautious. It is true that the current level of interest rates are perceived to be high, historically and in comparison with the present level of interest rates in many other countries. So are the level of bank credit extension and the rate of increase in the money supply. The apparent inflexibility of the demand for bank credit to higher interest rates can be explained by two reasons. Firstly, there are the normal time lags already referred to between changes in interest rates and changes in the demand for credit. And, secondly, there is the effect of rational expectations -- borrowers are in general not affected by the rate of inflation of the past year in their decisions to borrow more funds, but by their expectations on the future rate of inflation. Is it perhaps true that most South Africans still expect inflation to remain in the double digit range in future? If so, it will require a persistent restrictive monetary policy to tame inflation.
There is a general misconception in the South Africa media that the real rate of interest is simply the difference between the rate of inflation over the past year, deducted from the nominal interest rates applicable to loans for the next year. This is, of course, not comparing apples with apples. It is unfortunately not possible to quantify the expected rate of inflation over the next year to calculate the true level of the real rate of interest. For monetary policy purposes, the result or the effect of the disciplines of interest rates in this situation becomes more important. The level of interest rates may be perceived to be high, but as long as the demand for credit remains excessive and bank credit extension and the money supply continue to increase at rates that threaten the financial stability of the economy, the Reserve Bank can certainly not take the initiative to reduce interest rates. This will be against the instructions given to the Bank by Parliament.
4. A longer term perspective of monetary policy
The theme of this Conference is "Heading towards 2000". In conclusion, a few remarks on the longer term prospects for monetary policy may be appropriate. In this context, it must be accepted that the ups and downs of the trade cycle will remain part of the South African market-oriented economy. It is the task of the Reserve Bank to maintain financial stability, that is to protect the value of the rand, both in phases of economic expansion and contraction. In the longer term, the objective of monetary policy should be to support optimum sustainable economic growth, which will require financial stability at all times. Financial stability is no guarantee for sustainable growth, but is surely an essential precondition.
Reading potential future macroeconomic developments in South Africa correctly, monetary policy will have no easy task. In summary, the task of the Reserve Bank will have to strive for financial stability in the context of a political, social and economic environment that will persistently make unrealistic demands on the limited available economic resources of the country. Monetary policy will have the unenviable task of leaning against the wind all the time, and the Reserve Bank will have little opportunity for popular policies. In the medium and longer term, there will be little need for demand stimulation, but it will be essential to create an investment friendly environment that will support the continuing expansion of the production capacity of the economy. Low rates of interest, justified by low inflation and a restricted rate of growth in the money supply, will have to be an important element of such an environment. And yet, there will be a persistent pressure on the Reserve Bank to create more money, which will only serve to stimulate inflation and force higher interest rates.
At the same time, monetary policy will be challenged by the integration of the South African economy in the global markets for goods, services and financial assets. This will not only require the gradual elimination of remaining foreign exchange and trade controls, but also a sharpening of instruments applied and strategies implemented in the execution of monetary policy. Interest rates and the exchange rate will have to play an increasing role in finding equilibrium and restoring financial stability in times of temporary diversions. More and more, the Reserve Bank will be blamed for allowing and supporting the natural disciplines of the market economy to force all South Africans to live within their means, or to produce the means they demand of the economy.
The resolve of the Reserve Bank to maintain financial stability will be tested severely by extreme pressures from all sectors of the economy. The success of monetary policy will not be measured by the popularity of the Reserve Bank, but by the stability of the value of the rand.