1. The task of monetary policy

The task of monetary policy is to maintain a stable financial environment that will be conducive for sustainable economic growth and development. There is fairly general consensus in the world of central banking about the goals and objectives of monetary policy, but there will always be differences of opinion on various possible alternative combinations of monetary policy instruments that could be used to achieve the ultimate goal, or on priorities that could be given to various intermediate targets within the overall objective.

There is also fairly general consensus that the extent of overall financial stability in a country should be measured by the rate of inflation (the "internal" value of the currency), or by changes in the exchange rate (the "external" value of the currency). Monetary policy therefore has the task to protect the value of the currency in the interest of sustainable economic growth, and a successful monetary policy will usually be reflected in a low rate of inflation and/or a stable exchange rate.

To achieve this objective, monetary policy must operate within a restricted and clearly defined financial environment wherein consistent, and, at times, temporary inconsistent, inter-relationships between various finan-cial aggregates must be understood and respected. To protect the value of the currency, monetary policy must assume a realistic approach to acceptable changes in aggregates such as the total and the various components of the money supply, bank credit extension to both the public and private sectors, the level of interest rates and the shape of the yield curve, the exchange rate and the official foreign reserves of the country.

For the sake of transparency, consistency and a better understanding of their actions, central banks often link monetary policy decisions to one selected core variable, such as the money supply or domestic credit extension (dce). This, however, does not mean that changes in the other financial aggregates can be ignored or are not of any relevance in the implementation of the total package of monetary policy.

In the case of South Africa, monetary policy decisions were linked for more than a decade to changes in the M3 money supply. This policy served the country well, especially as long as the domestic financial markets were relatively isolated from international markets, and international capital flows were determined mainly by non-economic considerations, and by exchange controls. In the circumstances, there existed a more stable relationship between changes in the money supply and total domestic expenditure, and therefore also between the money supply and inflation.

During the period of money supply targeting, the Reserve Bank obviously also had to take account of increases in total bank credit extension, of the level of interest rates, and of the amount of liquidity available at any time within the banking system. The Bank had to use the instruments at its disposal, such as minimum cash reserve requirements, conditions of discount window facilities, interest rates charged by the Bank on its loans, and open market operations, to ensure that its money supply guidelines would be achieved.

The Bank has recently moved away from the more formal money supply targeting approach, but must still endeavour to keep the rate of growth in M3, and the rate of growth in bank credit extension, within limits that will be consistent with the objective of protecting the value of the currency. Against the background of the liberalisation of the South African financial markets, and the gradual integration of South Africa in a very volatile global financial environment, it has, however, become extremely difficult to put meaningful quantitative values to the major financial aggregates that will produce the desired results for inflation.

The ultimate objective of monetary policy of course remains to protect the value of the currency. In some countries, central banks, together with governments, now target the rate of inflation directly, instead of setting guidelines for intermediate objectives such as the money supply or dce. South Africa should also gradually move towards a similar situation by liberalising its financial markets further and by the gradual integration of the South African financial system in the global markets.

In the absence of a pre-determined inflation target, the Reserve Bank aims at bringing the South African rate of inflation gradually more in line with the average rate of inflation in the economies of our major trading partners and international competitors.

2. A changed version of the monetary policy model

Recent changes introduced to monetary policy in South Africa recognised the changing environment in which the Reserve Bank must now operate, and took account of the fact that large international capital movements can easily disrupt trends in all the major financial aggregates, either temporarily or for a longer period of time. The main financial instruments must in this situation react quickly and sensitively to periodic changes in the underlying conditions in the financial markets in order to maintain or restore equilibrium in these markets. Interest rates, exchange rates and financial asset prices must be flexible, and must not be constrained by rigid monetary policy controls.

The repo system activated by the Reserve Bank on 1998-03-09 is intended to introduce greater flexibility into the financial market adjustment process in South Africa. As before, the influence of the Reserve Bank's intervention, or non-intervention, in the financial markets, will have an important influence on the level of interest rates in the country. In contrast to the previous discount window or overnight loan facility, the repo system makes Reserve Bank interventions more transparent, and continuously signals policy intentions through the regular disclosure of the amount of liquidity that the Bank is prepared to make available on a daily basis to banking institutions. This procedure makes the Reserve Bank's interest rate policy also more transparent. It is, after all, only by creating more or less money that the Reserve Bank can change the course of market determined interest rate trends.

The most important operational instrument used by the Reserve Bank to pursue its objective of protecting the value of the currency in the repo system may be perceived to be the amount of Reserve Bank funds that is provided at the daily repo tender. The supply of central bank liquidity will, however, have a direct effect on the repo rate, and therefore also on market interest rates in general. Interest rates therefore remain an important, if not the most important, operational instrument, also in the new system. The difficult questions that the Bank must consider at all times are: What rate of interest will be consistent with the Bank's final goal of protecting the value of the currency? How high must interest rates be to prevent excessive money creation through bank lending operations? What other inflationary pressures must be neutralised or counteracted by monetary policy?

In answering these questions, the Bank must always take into account that there exist relatively long time lags between monetary policy decisions and actions, and the rate of inflation. Today's relatively low rate of inflation was most probably determined by the monetary policies applied twelve to eighteen months ago, that is during the first half of 1997. And the policies applied today, will likewise determine next year's rate of inflation.

In the changed version of the monetary policy model, the inter-relationships between the various financial aggregates remain as important as they were before. The Bank must still ask itself, if not every day, at least very regularly, what level of interest rates will be required to induce a rate of increase in bank credit extension that will keep the money supply growth at a rate that will not add further stimulus to inflation.

In taking its decisions, the Reserve Bank must rely to an important extent on discretion. There is, unfortunately, no magic formula that will enable the central bank to apply monetary policy by rule. This always leaves almost all decisions taken by the Bank open to criticism. There are always pressure groups with a vested interest in low interest rates. There are, fortunately, also the less well-organised and less vociferous savers who have a vested interest in high interest rates. It is, after all, the function of interest rates to find equilibrium between the demand for and the supply of loanable funds. It can be perilous for central bankers to retain the level of interest rates in the longer term below the natural level as determined by underlying market forces.

3. Results achieved with monetary policy over the past year

The real test for the success of monetary policy lies in the results. Over the past twelve months, the rate of increase in consumer prices declined from 9,9 per cent in April 1997 to 5,4 per cent in March 1998. The rate of increase in the production price index slowed down from 9,6 per cent in March 1997 to 2,5 per cent in February this year.

The average weighted value of the rand against a basket of the currencies of South Africa's major trading partners depreciated by only 3,1 per cent from the end of December 1996 to the end of March 1998. In real terms, the exchange rate of the rand over the past fifteen months therefore remained very stable.

From the point of view of protecting the value of the currency, monetary policy has therefore been relatively successful. The Bank, however, remains somewhat concerned about the continuing high rates of increase in the money supply (+18,3 per cent over the twelve months up to February 1998), and in the total domestic credit extension by the banking sector (+14,2 per cent). Many reasons have been given for these relatively high rates of increase in the two very important financial aggregates, for example the almost explosive increases in turnover in all the financial markets in South Africa during the past few years.

The relatively large current increases in M3 and in dce are not the only reasons why monetary policy must remain cautious, and why interest rates should not be forced down artificially by any excessive injection of liquidity by the Reserve Bank. The developments in a number of East Asian countries over the past year provided a stark reminder, particularly to central banks in countries with emerging markets, about the need for maintaining well-disciplined macroeconomic financial policies at all times. The South African market in foreign exchange was, except for a few weeks, relatively unaffected by developments in East Asia. This endorsement by the markets of the South African fiscal and monetary policies of the past year provided encouragement for the retention of sound policies, and also enticed foreign investors to increase their holdings of South African securities.

During the first three months of this year, non-residents increased their holdings of South African equities and bonds by almost R25 billion. This enabled South African residents to increase their holdings of foreign securities by a substantial amount under the exchange control relaxations, and enabled the Reserve Bank to increase its foreign reserves by R4,3 billion during the first quarter of 1998. At the same time, the Bank's net oversold forward position in foreign currencies was reduced by US $3,5 billion.

4. Concluding remarks

The Reserve Bank is often criticised for its restrictive monetary policies, and particularly for its so-called "high-interest rate policy". Compared with 25 emerging markets covered regularly in the London Economist, there are eleven other countries in this group with more or less the same or even higher real interest rates than we have in South Africa, and thirteen with lower rates. Even with our current relatively low level of inflation, South African real rates of interest are very much in line with other emerging markets.

If South Africa wants to remain competitive in the capital markets of the world, we shall have to maintain the financial disciplines of the past few years. In the longer term, this will enable South Africa to attract more foreign capital from the international markets, to keep inflation under control, and, on the average, have a lower level of interest rates than would be the case with a shortsighted low interest rate policy at this stage, based on the creation of more money by the Reserve Bank. Such a policy will only lead to higher inflation, and therefore also higher nominal and real rates of interest.