When Stones Were Soft

1. When Stones Were Soft

So goes a SiSwati saying. When stones harden, clearly it calls for a different way of doing things. That time is now; in fact, stones hardened a while ago, but policy makers and politicians have a way of always staying behind the curve. The dire growth and unemployment situation in South Africa require a change of approach: call it a change of strategy, a change of policy, or a new way of doing things, but make a change.

As you will see below, the US Federal Reserve understands this very well. And, though I may dislike him and disagree with his politics and beliefs in general, so does US President Donald Trump.

2. Monetary Policy and its Impact on Growth and Unemployment

2.1 Macroeconomic Policy Objectives

The macroeconomic policy objectives of governments are typically the attainment of full employment, a stable price level, high and sustained economic growth, and a healthy balance of payments. Though this might be the case, different governments do not put equal emphasis on the various policy objectives; one or more objectives might be given priority over others, and these priorities may be revised from time to time in response to economic and/or socio-political pressures. Frequently, the objectives are in conflict with one another, either in the short-term or long-term, and a government may have to abandon attainment of one in favour of another.

This conflict is seen more dramatically in the conflict between full employment and a stable price level. With a few exceptions, governments that try to secure full employment in the economy tend to find themselves confronted by high rates of inflation, and those which try to control inflation find themselves contending with high unemployment. That is, the two objectives seem to be mutually exclusive. Thus governments, for decidedly political ends, find themselves choosing either full employment or a low inflation rate, and generally leaving the other conflicting objective to find its own level. With the advent of inflation targeting, most governments (through their central banks) have tended to favour low inflation as the overriding objective, while utilising other policy tools to try and mitigate the resulting high unemployment rate.

Because governments in market economies cannot act directly to influence these ultimate macroeconomic objectives, they have instead indirect methods of influence open to them. These indirect methods are embodied in monetary or fiscal policy. Through the use of tools from monetary or fiscal policy (or a policy mix), governments can steer the economy towards the attainment of their macroeconomic objectives. Even though in practice a monetary and fiscal policy mix is virtually inevitable, particular governments typically favour one policy over the other.

2.2 Inflation Targeting and Interest Rates

Inflation targeting regimes typically use a benchmark rate as the instrument to ‘target’ the inflation rate; variously raising the rate in inflationary times or reducing it in deflationary times. In South Africa the target rate is the “Repo Rate” and raising or reducing it is the purview of the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB), the South African central bank. In a theoretical sense, since the inflation rate is a lagging indicator, the Repo rate targets expected inflation, and also serves as a signal on inflationary expectations within society and economic actors.

While the ostensible single target of the SARB is the inflation rate, the consequence of this is that it directly impacts the level of unemployment. So, in reality a choice of an acceptable level of inflation simultaneously implies a choice of an acceptable unemployment level (or, conversely, the level of employment in the economy). This is so because, simply, raising or reducing the Repo rate has an impact on the level of domestic investment activity and consumer demand, which in turn impact economic growth, thereby impacting the economy’s ability to create or not create employment.

Therefore, it may be argued that any inflation targeting regime is implicitly also an employment targeting regime.

2.3 Unemployment and Short-run Inflation

Monetary Policy, conducted through a benchmark rate, is the most potent policy at the disposal of any government and its central bank to affect the level of employment in the economy. The effect of a policy decision on interest rates has a more direct and immediate impact on economic activity, but also acts on the psyche of society and economic actors by signalling a relaxation or tightening of monetary policy.

A relaxation of monetary policy, at least in the short-term, can lead to an increase in employment. How long the ‘short-term’ lasts may be dependent on other factors, for instance structural adjustments and other industrial policies being implemented at the same time (some of which have been advocated in the Minister’s proposals). As has been shown above, this clearly will eventually lead to an increase in inflation. The choice to be made, therefore, depends on which of these twin ‘evils’ is seen as the worst. High unemployment, which leads to societal breakdown and a vicious circle, or some extra inflation.

Such thinking is not unique, nor is it confined to developing economies. Debates around the continued relevance of inflation-targeting on its own without reference to output stabilisation have been ongoing for a while. Indeed, the thinking occupies a whole range, including the possibility of a dual mandate of inflation targeting and output stabilisation. “In this dual mandate framework, central banks’ decisions would be based not only on their views about inflation, but also on direct measures of output and unemployment gaps. Central banks would thus have more discretion to allow inflation fluctuations if addressing them would exacerbate cyclical downturns”. (IMF, April 2013)

The argument that is advanced for not wanting any high inflation rests on a (sometimes fallacious) argument that inflation erodes the buying power of people’s money and therefore leads to economic hardship. That may be true for those that are employed, but ignores the unemployed who suffer even greater hardship, both economic and sociopsychological. It also ignores the more immediate societal and economic harm of unemployment – high crime rates, high levels of government budgetary support (subsidies, etc.), etc.

Any concerns about the impact of such proposals on the independence of a central bank would be unfounded. Central bank independence is about operational independence, not about goal or mandate independence. Clearly, it would not do to change the mandate regularly at a whim but changing it for sound economic reasons and communicating these clearly and unambiguously should be fine.

2.4 Inflation Targeting and Exchange Rates

It is important to indicate that it is a long-settled debate in macroeconomics that you cannot engage in both inflation targeting (using an interest rate instrument) and exchange rate targeting.

In any event, it has been demonstrated many times in the past that an exchange rate target for a small open economy like South Africa is a fool’s errand. Unless you are the United States or the likes of China with their gigantic reserves, any attempt to target the exchange rate would lead to ruin.

3. Monetary Policy Practices from Around the World

3.1 The recent past

During the recent Great Recession and its impact on economies, various developed economies adopted innovative and unconventional monetary policies to limit the damage and to drag their economies back from the brink. 

Central banks ordinarily conduct monetary policy by buying and selling short-term debt securities to target short-term nominal interest rates. These purchases and sales of assets change both short-term interest rates and the monetary base. This conventional monetary policy can potentially stimulate the economy through two types of channels: asset price channels (including interest rates) and credit channels. 

However, when interest rates are at the effective lower bound, increasing the monetary base is not, by itself, considered an effective stimulus. This is what the central banks of the United States, the United Kingdom, the European Union and Japan were faced with when they lowered their rates to zero and negative to alleviate financial distress and stimulate their economies (see figures below.)

Faced with this scenario, the Fed, the Bank of England (BOE), the European Central Bank (ECB) and the Bank of Japan (BOJ) “turned to two unconventional policy tools – quantitative easing programmes and increasingly explicit and forward-leaning guidance for the future path of the federal funds rate – in order to provide additional monetary policy accommodation to help end the recession and strengthen the economic recovery. These unconventional policy actions were intended to put downward pressure on real longer-term interest rates and more generally to improve overall financial conditions, including bolstering prices for corporate equities and residential properties. More favorable financial conditions would, in turn, help boost aggregate demand and check undesirable disinflationary pressures by providing increased support for consumer spending, construction, business investment, and net exports”. (Engen, Eric M., Thomas Laubach, and David Reifschneider (2015)) 

The Fed, BOE, ECB and BOJ steered their respective economies through these difficult times and further showed that their decision-making is empirically based. For example, in recent times whenever there has been an expectation that the Fed will raise interest rates, it has not done so in order to accommodate its other mandate of full employment. (See below)

The People’s Bank of China (PBOC) has shown similar responsiveness to shocks to the Chinese economy, for instance when there was a stock market collapse and the slowing down of the economy.

The purpose here has been to show that other central banks have been prepared to lower interest rates to zero and negative and then to further implement unconventional policies in order to stimulate economic growth and thereby affect unemployment. Indeed, “the [Federal Reserve]’s actions do appear to have appreciably sped up the pace of recovery from 2011 on as the private sector began to learn that monetary policy was going to remain substantially more accommodative than usual over a longer period of time”. (Engen, Eric M., Thomas Laubach, and David Reifchneider (2015))

3.2 The United States – The Federal Reserve

“The one-page well-written [Federal Open Market Committee] (FOMC) “Statement on Longer-Run Goals and Monetary Policy Strategy” (FOMC, 2019, first adopted in January 2012) clarifies the Federal Reserve’s monetary policy goals and strategy. The Federal Reserve’s statutory mandate is to promote maximum employment and price stability…. The FOMC provides further clarification on how it sets monetary policy:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. (FOMC, 2019)

Furthermore, a “balanced approach,” and the statement “we put equal weight on those two things; [the inflation target and the natural unemployment rate] of Bernanke (2015b)” …can be interpreted as an equal weight of stabilization of inflation and stabilization of unemployment. Indeed, Yellen (2012, p. 13) states:

The balanced-approach strategy endorsed by the FOMC is consistent with the view that maximum employment and price stability stand on an equal footing as objectives of monetary policy.

Furthermore, Clarida (2019, p. 5) notes

As a practical matter, our current strategy shares many elements with the policy framework known in the research literature as “flexible inflation targeting.” However, the Fed’s mandate is much more explicit about the role of employment than that of most inflation-targeting central banks, and our statement reflects this by stating that when the two sides of the mandate are in conflict, neither one takes precedent over the other”. (Svensson, Lars E.O., (June 10, 2019)

The Fed has also indicated a strong understanding of where its mandate derives from and the need to re-examine how it applies monetary policy and do so transparently and invite views from outside itself. A recent speech by Jerome H Powell, Chair of the Board of Governors of the Fed, illustrates this point well. Said Powell, “This year’s symposium topic is “Challenges for Monetary Policy,” and for the Federal Reserve those challenges flow from our mandate to foster maximum employment and price stability.… Thus, after a decade of progress toward maximum employment and price stability, the economy is close to both goals. Our challenge now is to do what monetary policy can do to sustain the expansion so that the benefits of the strong jobs market extend to more of those still left behind…” He continues, “Finally, we have a responsibility to explain what we are doing and why we are doing it so the American people and their elected representatives in Congress can provide oversight and hold us accountable…. We are conducting a public review of our monetary policy strategy, tools and communications – the first of its kind for the Federal Reserve. We are evaluating the pros and cons of strategies that aim to reverse past misses of our inflation objective. We are examining the monetary policy tools we have used both in calm times and in crisis, and we are asking whether we should expand our toolkit. In addition, we are looking at how we might improve the communication of our policy framework. Public engagement, unprecedented in scope for the Fed, is at the heart of this effort. Through Fed Listens events live-streamed on the internet, we are hearing a diverse range of perspectives not only from academic experts, but also from representatives of consumer, labor, business, community, and other groups.” (Powell, August 2019)

3.3 The US Fed Response to the Corona virus – 03/03/2020

Yesterday, 03 March 2020, the Fed took the surprise and unusual decision to make an emergency rate cut of  percent in response to the devastation of the coronavirus and its likely impact on economic activity. The Fed did this in line with its mandate of full employment, understanding fully well that a negative impact on economic activity will detract from this goal. Although there are suspicions that the Fed bowed to political pressure from Trump (and the Fed should be immune from such pressures), such timely responsiveness is impressive. 

Indeed, as an aside, even the European Central Bank has indicated that it is willing and prepared to allow some accommodation in its monetary policy stance in response to the possible impact of the coronavirus on European economic activity.

3.4 Japan – The Bank of Japan

Haruhiko Kuroda, the Governor of the Bank of Japan, explained the BOJ’s Monetary Policy this way:

“Now, I would like to explain the Bank’s conduct of monetary policy. The Bank currently adopts the policy framework of “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control.” Under this framework, it sets the short-term policy interest rate at minus 0.1 percent and the target level of 10-year JGB yields at around zero percent…. By conducting this operation, short- and long-term interest rates in financial markets have been stable at low levels and lending rates for firms…have remained at extremely low levels”.

4. What is to be done in South Africa?

4.1 Current Mandate of the SARB

On its website, the SARB states its monetary policy objectives in the following way:

“The Bank has been entrusted with the overarching monetary policy goal of containing inflation. The Bank can use any instruments of monetary policy at its disposal to achieve this monetary policy goal. This implies that the Bank has instrument independence in monetary policy implementation but not goal independence in the selection of a monetary policy goal”. (My emphasis)

4.2 Repurposing the SARB

The proposals make passing remarks in various places to monetary policy, and yet this is the most potent policy instrument available to the government and the South African Reserve Bank (SARB) to influence the growth rate and reduce unemployment. The apparent failure to realise that it is the contractionary policies of the SARB that are negatively impacting growth and employment is puzzling as there’s ample theoretical and empirical evidence to suggest this. As economics is about choice, policy makers make choices that ultimately harm or benefit their economies and citizens.

There’s general consensus that high interest rates lead to lower levels of economic growth and therefore lower levels of employment (or higher unemployment). High interest rates may attract speculative international financial flows, but these are generally fleeting and mostly do not lead to productive investments. On the other hand, they negatively impact demand and domestic investment expenditure. All things being equal, the current inflation target (range), with the resultant relatively high interest environment, is incompatible with the stated growth and employment objectives. In other words, the current monetary policy stance of the SARB harms the country’s growth prospects and is not supportive of the government’s stated growth and employment objectives.

The minister and the SARB should dispassionately and non-ideologically take stock of the situation and accept, as evidence seems to suggest, that the government and the current proposals will not attain the growth and employment targets with the current policy incompatibility. Since the mandate of the SARB comes from government and/or parliament, it is inconsistent to persist with an inflation target range that clearly is at odds with the growth target and the creation of employment. What compounds the situation is the observed, unstated goal of the SARB to target the median of the range. What is the point of the 6% upper limit if the SARB conducts policy in such a way that the rate of inflation is generally restricted from testing this upper limit? The SARB should, therefore, allow inflation to overshoot the target in order to foster employment; alternatively, the SARB’s mandate should be amended to explicitly target unemployment as well or the upper limit of the target range be increased.

The reduction of unemployment, and not a low rate of inflation, should be the key objective of macroeconomic policy in the short to medium-term. This would have a positive impact on the budget deficit through reduced social spending while revenue collections increase. This would allow the government space to increase spending on growth enhancing items like education, crime prevention, etc. creating a ‘virtuous circle.’

Clearly, this monetary policy would have to be complemented by strategies implemented by government and the private sector to ensure that growth is in sectors with the greatest employment creation potential. In other words, avoid the curse of jobless growth. The proposals address this issue.

It is interesting to note that the wage increases typically demanded by unions, particularly public-sector unions, clearly indicate that their inflationary expectations are consistently higher than the actual rate of inflation. This is puzzling as the SARB has maintained consistently low and relatively stable rates for a long time. This, in fact, seems to reflect the strong power that unions have in South Africa. This may reflect general historical union development, but it may also be due to the existence of an alliance between unions and the governing party.

4.3 Monetary Policy and Reduction of Inequality

The oft-cited argument that inflation affects the poor more is fallacious and outright wrong. It can be argued that, while the vast number of unemployed may experience some inflation when they buy some goods, they would rather also benefit from the bump in output and the attendant increase in employment opportunities and wage inflation.

More fundamentally, various quantitative and theoretical research show that in fact, optimal monetary policy can act to reduce inequality. Monetary policy affects consumption risk and inequality through four channels. 

“The first is the income risk channel: when the …income risk faced by households is countercyclical, expansionary monetary policy, by generating a boom in output [and employment], tends to reduce income risk and inequality. More subtly, lower interest rates make it easier for households to self-insure against income shocks, reducing consumption risk for a given level of income risk…. Finally, unexpected cuts in interest rates redistribute consumption…and unexpected inflation redistributes real wealth…. Thus, expansionary monetary policy can reduce consumption inequality through all four channels. 

Given that monetary policy has this power to reduce inequality, how and when should it be used? A utilitarian planner trades off the benefits of lower inequality against the costs of pushing up output and inflation above their efficient levels. In recessions, inequality is already high…so the marginal benefit of reducing inequality is particularly high…. Consequently…the planner prevents output from falling as much as the efficient level of output, even though this entails higher inflation, because curtailing the fall in output also curtails the rise in inequality”. (Acharya, S. et al, 2020 - my emphasis)

4.4 What will the SARB do in response to the Corona virus?

If, as feared, the coronavirus wreaks havoc to the international economic situation, South Africa, by virtue of being plugged into the world economy, will not escape its effects. Even if we don’t get a single case of sickness, we may not be able to escape the economic impact. And that will exacerbate the recessionary environment we have already entered, and the unemployment situation will worsen.

It is quite interesting to wonder, how will the SARB respond? Indeed, how will the SARB respond to the technical recession?

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