1. Intermediate objectives of monetary policy
The ultimate objective of macroeconomic policy in South Africa, as in most other countries of the world, is to promote a better standard of living for all the people of the country. A prime condition for the achievement of this objective at this stage would be to create more jobs and reduce total unemployment in the country as quickly as possible. The solution to the problem must also be sustainable and not only of a temporary nature that will at some later stage collapse to create even greater poverty and more hardships.
Monetary policy, as one of the more important components of overall macroeconomic policy, must obviously also serve this overriding objective of macroeconomic policy. And yet, monetary policy is seldom used directly for the creation of more jobs, or for the improvement of the living standards of the community. It is widely accepted that the contribution monetary policy should make to the achievement of the ultimate objective is an indirect one. Monetary policy has but a supporting role to play in the broader framework of overall macroeconomic policy. The ultimate goal assigned to monetary policy within the framework of overall economic policy is an intermediate one. The role of monetary policy must be to create a stable financial environment that will be conducive to economic growth, and that will make optimum or maximum economic growth possible. Financial stability on its own may not guarantee or even stimulate the development needed for the attainment of the ultimate goal, but without financial stability, sustainable economic growth will also not be attainable.
There may be differences of opinion on what kind or what degree of financial stability will serve the objective of maximum economic development best. For example, in the contemporary economic theory there is the ongoing debate on the importance of the so-called Philips curve trade-off between inflation and growth. There are many growth economists who believe that some inflation will be good for growth, but there are also the purist monetarists who insist that all inflation, even at a very low rate, will in the longer term be detrimental for growth.
There will also always be differences of opinion on how the monetary authorities should implement the various policy instruments at their disposal to achieve the objective of a stable financial environment. Should policy, for example, be pursued through a market-oriented system, or rather through direct controls over financial activities?
There will, finally, be differences of opinion on how financial stability should be defined. Must the central bank for example, strive to keep the internal value of the currency stable, that is to keep inflation low, or should it rather try to fix the external value, that is the exchange rate of the currency? In the short term, there may at times be apparent clashes between these two objectives, although in the longer term trends in the external and internal values of the currency of any country will tend to converge into a uniform rate of change.
The most important principle to agree to, however, is the notion that the function of monetary policy should be restricted to that of protecting the value of the currency, and of creating a stable financial environment that will support and promote optimum economic growth.
2. The role of monetary policy in South Africa
In both the South African Reserve Bank Act and the Constitution of the Republic of South Africa the Reserve Bank has been tasked with the function of protecting the value of the rand. No definition for an acceptable value of the rand has been provided by the legislature, neither has any norms or standards been provided for the measurement of the achievements of monetary policy.
This mandate for monetary policy was recently reconfirmed in the Government's Macroeconomic Strategy for Growth, Employment and Redistribution. In this important economic policy pronouncement of Government it was stated unequivocally that the Reserve Bank must maintain "monetary policies consistent with continued inflation reduction". It was also acknowledged that "To contain inflationary pressures requires concerted implementation of complimentary stabilisation measures: accelerated tariff liberalisations, sharper (budget) deficit reduction, tight monetary policy and, above all, productivity linked wage increases".
Against this background, the Reserve Bank's monetary policy model, designed by the De Kock Commission of Inquiry into the Monetary System and Monetary Policy in South Africa during the first half of the 1980's, has been linked mainly to the objective of reducing inflation to a lower level. The policy has been implemented with a fair amount of success - the average rate of inflation in South Africa was about 15 per cent per annum for almost two decades from 1974 to 1992. Over the past three years, that is from 1993 to 1995, the average rate of inflation had declined to about 9 per cent per year. This year will be the fourth one in succession that South Africa's average rate of inflation will be below 10 per cent.
For some economists, this may signify success. For others, and particularly doctrinaire monetarists, the goal of monetary policy should not stop short of zero inflation. For the pragmatists, some kind of objective criteria may be needed to determine whether the rate of inflation at a particular level should be accepted as tolerable. Allan Greenspan, Chairman of the Board of Governors of the Federal Reserve System of the United States, once said that the rate of inflation must be low enough not to have any material influence on the decisions of the community to save, to invest or to consume. In other words, people must not be concerned about the rate of inflation, or the expected rate of inflation, when these important economic decisions are taken at the micro-level.
In the case of South Africa, and particularly in the context of this country's re-integration in the global financial markets, a practical approach will be to accept as a minimum goal for monetary policy that the domestic rate of inflation should be brought in line with the average rate of inflation in the economies of our major trading partners, and major international competitors. Such a policy will in the longer-term maintain purchasing power parity between South Africa and the outside world.
Measured against the Greenspan directive, or against the purchasing power parity approach, South Africa does not deserve full score for its achievements with monetary policy, not even in the past three years when we succeeded in keeping the average rate of inflation in the single-digit range. One of the major disadvantages of a South African rate of inflation that remains out of line with the rate of inflation in other economies, is that it requires regular balancing adjustments in the external value of the currency, that is in the exchange rate of the rand.
Over the eight years from 1988 to 1995, the average annual depreciation in the nominal effective exchange rate of the rand was about 8 per cent. Over the same period, the average rate of inflation in South Africa was about 8 to 10 per cent above the average rate of inflation in the economies of our major trading partners. Over most of this period, the average nominal interest rate level on, for example long-term government bonds, was about 10 per cent above the level of comparable interest rates in the Unites States of America.
Markets tend over time to equalise yields, prices and the value of financial assets in different countries, even under the constraints of exchange controls and non-economic motivated international interferences such as boycotts, sanctions and disinvestment actions. The disadvantage is, however, that adjustment processes in the market place are inclined to take place in an irregular and sporadic way. Economic fundamentals such as inflation and purchasing power parity divergencies develop on a straight-line continuous basis - market adjustments such as exchange rate corrections are, however, more sporadic and take place on a stair-case basis. Markets are inclined to be slow in adjusting to fundamentals, but often in the short term overreact when justifiable and lagged adjustments are finally triggered by the forces of underlying fundamentals, and sometimes by non-economic events such as political changes.
Reforms in the international financial system over recent years, and in particular the abolition of the Bretton Woods System of fixed parities for exchange rates, the liberalisation of financial markets, the development of global electronic communication and trading networks and the integration of world financial markets, made the task of monetary authorities to maintain overall financial stability infinitely more difficult. Complete isolation of the domestic financial system from the outside world, for example with exchange controls, could perhaps make the task of central bankers easier, but will also exclude the economy from the savings resources of the rich and over-developed economies of the world. The removal of exchange controls without some harmonisation of domestic macro-economic policies, for example on inflation, will lead to greater financial instability, and not to a more stable financial environment as some people seem to believe.
3. Recent developments in the South African financial markets
Developments during 1996 in the market for foreign exchange exposed this new element of volatility in the South African financial system. The degree of overall financial stability established over the three years 1993 to 1995 was disturbed by a depreciation in the external value of the rand of more than 20 per cent from the end of 1995 up to the end of October 1996.
Although the Reserve Bank focuses the attention of its monetary policy objectives primarily on the protection of the internal value of the rand, there exists in the longer run, an irrefutable relationship between the external and the internal values of the currency. As indicated above, over the period 1988 to 1995, average changes in the exchange rate more or less corresponded with the inflation differential that existed between South Africa and its major trading partners over this period. This pattern, however, has now been broken by the substantial recent decline in the external value of the rand. The daunting question for monetary policy is whether the internal value of the rand will now, perhaps with some time lag, follow the external value, or whether we can on this occasion break this sequence and avoid inflation in 1997/98 following the depreciation of 1996. If not, there is a real danger that a new cycle of more inflation/more depreciation/more inflation could be reintroduced into South Africa which will defeat the defined objectives of monetary policy. Such a course will also frustrate achievement of the laudable objectives Government set for our country in its Macroeconomic Strategy for Growth, Employment and Redistribution.
The Reserve Bank had little immediate control over the exchange rate once it started to tumble in February 1996. The initial adjustment was triggered by an unfortunate combination of international financial market and domestic economic and political developments. After a period of unnatural strength in the exchange rate of the rand from May 1995 to January 1996, some depreciation of the rand could be justified on the basis of movements in economic fundamentals. As often happens in markets, however, there was an overreaction, fuelled by rumours, speculative transactions and unrealistic expectations of the immediate abolition of all remaining exchange controls. These rumours and speculations, combined with the real need for some exchange rate correction linked to trends in economic fundamentals, introduced great volatility in the market for foreign exchange, and led to an excessive depreciation of the rand in 1996.
In the longer term, as evidenced by the developments in the average rate of change in the exchange rate and the inflation differential over the eight years 1988 to 1995, economic fundamentals override rumours and speculations, provided sound domestic financial policies will be adhered to. In particular, interest rates which reflect the underlying monetary policies, will have to be maintained at a level high enough to force the necessary disciplines needed to restore stability, also to the external value of the rand. More so than at any other time during the past eight years, the monetary authorities will now have to use all the powers at their disposal to fight inflation in South Africa. In terms of the monetary policy model used by the Reserve Bank the answer to the depreciation of the rand, and the fears of continued depreciation, is a firm resolve to fight inflation, and to maintain financial stability in the domestic economy.
It becomes of even greater importance to bring inflation in line with the average rate of inflation in the economies of our major trading partners as we proceed on the road of the gradual removal of exchange controls. Without exchange controls, the external value of the rand will be exposed to even more pressures, and to greater volatility, unless this prime goal of lower inflation will also be achieved.
Over the past eight years, it was an important objective of the monetary authorities in South Africa to reduce the rate of inflation on a durable basis to below 10 per cent per annum. When this goal was reached in 1993 and was maintained throughout the next three years, some complacency set in. To be consistent within the framework of overall macroeconomic policy, the acceptance of a rate of inflation that still remained well above the ruling average rate of inflation in the economies of our major trading partners, requires the acceptance also of a gradual depreciation in the exchange rate of the rand, equal more or less over time to the inflation differential.
The inherent danger of this kind of a monetary policy approach that is prepared to continue to flirt with inflation when other countries have abandoned it, was proven by the events of the past year. Markets, particularly in the short term, do not always act rational. Once emotion takes over, as it did in the market for foreign exchange over the past eight months, disrupting volatility and overreactions become unavoidable.
In the longer term, South Africa will have to reduce its rate of inflation to a level that will no longer demand periodic adjustments in the exchange rate of the rand. What we have achieved with monetary policy over the past three years in protecting the value of the rand in difficult circumstances, was not good enough. The goal of overall financial stability requires a level for the decline in the internal value of the rand that will exclude the need for continuous small, or periodic large, depreciations in the external value of the rand.