1. The main objective of monetary policy

It is generally accepted in the world today that the main task of central banks should be to achieve and maintain price stability. Price stability on its own may not guarantee a higher level of economic growth, but it is a prerequisite for sustainable economic development over the longer term. The meaning of price stability, or a pre-defined goal for an acceptable rate of inflation, is seldom provided by governments in their directives to central banks.

In the case of South Africa, the South African Reserve Bank Act only prescribes that the Reserve Bank shall "protect the value of the rand", without any indication of how this should be pursued, what measure of success must be achieved, to what extent the value of the rand must be protected, or how the results will be measured. In terms of the Constitution of the Republic of South Africa, the Reserve Bank shall pursue this objective independently of government interference, provided regular consultation shall take place with the Minister of Finance.

These provisions of the Act and the Constitution determine the objective of monetary policy in South Africa and do not leave the central bank with the freedom to determine its own goals, but require of the Bank to decide for itself on the strategy it will follow, and the instruments it will use in the pursuance of the prescribed goal, namely to protect the value of the rand. They also leave the Bank with some discretion to interpret the commission it received from Parliament, and to decide for itself with what vigour and determination it will apply the instruments at its disposal for pursuing the goal of price stability.

2. Different monetary policy strategies

Although the objective of protecting the value of the currency is fairly common for monetary policy in the more developed economies of the world today, central banks do not all follow the same strategy to achieve the objective.

Inflation is a rather complex phenomenon of the market economy and all inflationary pressures cannot directly or indirectly be controlled by central banks. All central banks, however, share one common responsibility, and that is to create money. Money, or rather the excessive creation of money, is not always at the root of inflation, but is almost indispensable for sustaining inflation over a long period of time. It is therefore generally accepted that, as a minimum, central banks should restrict the rate of increase in the money supply should they want to achieve the objective of protecting the value of the currency. Many central banks therefore accept this intermediate objective of controlling the money supply as the best contribution they can make towards the protection of the value of the currency, and therefore to economic growth and development. At least the central bank is then targeting an objective over which it has some control.

Using the money supply as an intermediate objective for monetary policy has met with some success in certain countries, such as Germany, Switzerland and South Africa. Some other countries abandoned money supply targets at a stage when they no longer found a reliable relation between changes in the money supply and inflation, mainly because of the introduction of many substitutes for money in the national payment systems, for example electronic transfers, credit cards and, one of the latest innovations, "smart" cards. Canada is one of the countries that abandoned the money supply as an anchor for its monetary policy already somewhere in the early eighties.

Other intermediate targets are sometimes used by central banks, for example, a fixed or stable exchange rate, the level of interest rates or the volume of credit extension by banking institutions. In a more recent development, however, a few central banks have introduced a new monetary policy strategy based on the direct targeting of the rate of inflation. Canada was one of the pioneers in this new approach when early in 1991 the Bank of Canada and the Government of Canada jointly announced targets for reducing the rate of inflation on the way to price stability. The first guidepost was set for the end of 1992 (22 months after the announcement) and provided for a rate of increase in the consumer price index within a band of 2 to 4 per cent.

Canada has been relatively successful with its programme of direct inflation targeting. Today, similar policies are being followed by a number of countries, for example, New Zealand (already introduced in 1990, that is, a year before Canada), Finland, Sweden, Israel and the United Kingdom.

3. Inflation targets in South Africa

It is a common feature of countries with predeter-mined and pre-announced inflation targets, that governments and central banks take joint responsibility for the targets. In Canada, for example, targets are jointly announced by the Governor of the Bank of Canada and the Minister of Finance. In New Zealand, the goals are defined in terms of formal Policy Targets Agreements entered into from time to time between the Governor of the Reserve Bank of New Zealand and the Minister of Finance. In some countries, inflation targets are determined in terms of even more comprehensive accords that will also include organised commerce and industry, and labour movements.

In South Africa, where many political, social and economic structural reforms are now in progress, it will not at this stage be easy to reach a degree of consensus that will make it possible to decide on a definition of acceptable price stability. The South African Reserve Bank is therefore pursuing its instruction from Parliament to protect the value of the rand to the best of its ability by setting annual guidelines for an acceptable rate of increase in the M3 money supply. Monetary policy decisions are triggered by deviations in the actual growth of the money supply from these guidelines. For 1996, for example, the guidelines were set as 6 to 10 per cent for the rate of growth in M3 from the fourth quarter of 1995 up to the fourth quarter of 1996. Changes in the money supply at rates above 10 per cent will require a restrictive monetary policy; changes between 6 to 10 per cent a more neutral approach; and changes below 6 per cent an expansionary monetary policy.

Implicit in these guidelines are also objectives for the rate of inflation. Roughly speaking, if the Reserve Bank is of opinion that the real growth rate in the South African economy in 1996 will be about 4 per cent, a 10 per cent growth in the money supply will accommodate real growth plus inflation of about 6 per cent, unless there will occur at the same time a major change in the velocity of circulation of the money supply. The Reserve Bank's objective is indeed to bring inflation down gradually to a level that will be more or less in line with the average rate of inflation in the economies of our major trading partners. This, in the present global environment, will require inflation of not more than about 4 per cent per annum. As long as the South African rate of inflation is in excess of the rate of inflation in the economies of our trading partners, South Africa's relative competitiveness will be eroded, and there will be continuous pressure on the exchange rate of the rand to depreciate.

4. The present situation

Over the past few years, South Africa succeeded in bringing the rate of inflation gradually down from over 15 per cent in 1991 to 8,7 per cent last year. Over the twelve months up to March 1996, the increase in the consumer price index was only 6,3 per cent. It would seem as if South Africa was now firmly on its way to reach that first objective of bringing our rate of inflation more or less in line with the average of our trading partners.

One important contributing factor to the success of the last few years has been a relatively stable exchange rate of the rand. In both 1993 and 1994, the average weighted value of the rand, measured against a basket of the currencies of our major trading partners, depreciated by about 8 ½ per cent, and in 1995 by only 3 ½ per cent. The effective depreciation of 3 ½ per cent in nominal terms last year was less than the difference between the rate of inflation in South Africa and the average rate of inflation in the other countries. Adjusted for the inflation differential, the exchange rate of the rand in real terms changed very little in 1993 and 1994, but appreciated by about 4 per cent in 1995.

The recent turmoil in the foreign exchange market and an effective depreciation of the rand of 15 per cent in the first four months of 1996 has created a new situation. Inflation has come under a new threat, and the task of the Reserve Bank to protect the value of the rand now faces a new challenge. Can we keep inflation in check and continue to move gradually towards our longer term goal of reducing the South African rate of inflation to the same low level of our major trading partners?

5. The consequences of the depreciation of the rand

South Africa imports about 25 per cent of all the goods and services it uses in the country, and exports over 20 per cent of its total domestic production. Changes in the exchange rate of the rand of the magnitude we have experienced recently will therefore have an important effect on the future course of the economy.

The depreciation can have serious consequences for inflation. Economists predict that the effect on overall inflation could range from a 2 to 3 percentage points rise in the level of inflation over the next year. These estimates are, however, based on the direct or immediate effect of the price rises that will flow from a depreciation of about 15 per cent. The forecast is therefore based on a static analysis that does not take into account what the dynamic process of continuous economic change will do to prices in general, or to the level of inflation. The forecast also does not take into account possible corrective actions that might be introduced deliberately by the monetary authorities.

There is, in the more dynamic process, a danger that the indirect or subsequent effects of the depreciation can in the longer term lead to an escalation in the rate of inflation. An increase in the price of petrol, for example, will have an impact on the prices of many other goods and services that contain an element of transport in the final cost of delivery to the consumer.

There is, however, also a possibility that the proximate effects of the depreciation can, in the dynamic process, be reduced by a decline in the prices, or in the rate of increase of the prices, of domestically produced goods and services, particularly those goods and services that do not include an important import content in the final production cost. In Canada in late 1991, and continuing through most of 1992, the Canadian dollar depreciated by 13 per cent on an effective basis, and yet the rate of inflation declined from about 5 per cent in the middle of 1991 to 2,1 per cent over the twelve months up to December 1992.

Not all price changes are bad for the economy, and an anti-inflation policy must be flexible enough to accommodate relative price adjustments that contain important signals for change, for example, in total domestic expenditure and/or in its composition. The depreciation of the rand can, for example, turn out to be beneficial for the South African balance of payments if a greater part of domestic production can now be diverted to exports, and even more so if domestic production can be increased, both for export and for domestic consumption. This will, in the dynamic process of economic change, only be possible if overall inflation can be constrained, and if production costs per unit of production will not rise. Otherwise, the competitive advantage for South African producers created by the depreciation will be of short duration.

This makes South Africa's anti-inflation policy now even more urgent and more important than before the depreciation took place. It must be a firm policy commitment now at most to accommodate some part of the proximate price effects of the depreciation, but surely not to support potential second-round effects. Indeed, as far as possible, South Africa must continue to pursue its inflation target over time to reduce the inflation in this country to a level that will be more in line with the average level of inflation in the economies of our major trading partners.

The Reserve Bank is determined to bring its part in this effort. Success will be easier to achieve if the following macro-economic objectives can also be met at the same time:

Total domestic expenditure must be constrained, not only that of the private sector, but also expenditure by government. Some domestic production must now be shifted to exports, away from domestic consumption.

Unwarrantable increases in the cost of production must be avoided in the present situation, even more so than before. In particular, wage and salary increases should, at the most, reflect rises in productivity, and should not raise the unit cost of production, otherwise a perpetual wage-price-depreciation spiral can easily put South Africa back on the road of high inflation and low economic growth.

Producers that may benefit more directly from the depreciation in the form of increased rand export proceeds, should share these benefits with local consumers by reducing the prices of their products (where they also produce for the domestic market).

The depreciation of the rand came at a time when there were early warning signals of an imminent turn-around, after three years of expansion, in the business cycle. If properly used, the depreciation can serve as a timely injection of a preventative medicine, or as a stimulus for continued growth. If not, it can turn out to be a dangerous injection of anabolic steroids that will weaken the economic fibre of South Africa even further, and eventually lead to lower growth and more unemployment.

The challenge is now for South Africa to turn this depreciation into a beneficial event, as Canada did in 1991/92. This will require, however, austerity and financial disciplines, particularly on expenditure by the public and the private sectors in South Africa, as Canada did in 1991/92. It will, in particular, require of the Reserve Bank to stick to its objective over time to reduce the rate of inflation to a level that will be more or less in line with the average rate of inflation in the economies of our major trading partners. The time horison may have shifted -- the objective remains the same.