Chasing low inflation may dent growth

Posted On Wednesday, 15 October 2003 02:00 Published by
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Band of 5% to 7% ideal, says economist

Economy and Finance Reporter

THE upper end of the inflation target range should not be lowered for 2006 or the South African economy's growth prospects could be severely damaged, Iraj Abedian, Standard Bank's group economist, said yesterday.

Economists expect the upper limit of the inflation target to be reduced to 5% for 2006 by Finance Minister Trevor Manuel in his medium-term expenditure framework to be presented to Parliament in Cape Town next month.

Abedian said the target ceiling should be increased to 7% or at the least remain at 6% for 2006, based on technical issues relating to the inflationary bias of price indices.

Research conducted by Standard Bank's economic division also cited the cost of inflation and deflation; the relationship between inflation and growth, and the operational management of the central bank under inflation targeting as contributing factors to the recommendation of a 3% to 6% range for 2006.

Abedian said price indices suffered from measurement error which caused them to overestimate the rate of inflation.

Although there is no estimate of the magnitude of the bias of SA's inflation statistics, in developed countries inflation has been overestimated by up to 1,5% and probably even more in developing countries, said Abedian.

He said keeping in mind that the ultimate objective of policy was not low inflation, but rather to create a macroeconomic environment in which price stability was conducive to higher growth, a band should be chosen where the midpoint did not harm growth.

Econometric research has concluded that inflation only hurts the South African economy when it is outside the 2% to 5,5% band, therefore the target band should ideally be 5% to 7%, so that it gravitates towards 5,5%.

Abedian said it was a mistake to try and steer local inflation towards the same low rates as SA's trading partners while the country's microfactors were not as comparatively efficient as Japan's, the European Union's and the US's.

He said South African companies did not know how to do business in a low inflationary environment because the experience of the past 40 years was of higher inflation than at present.

Abedian said the biggest issue was that managers and shareholders had not adjusted their expectations and still wanted to see 20% to 30% nominal returns in an environment where returns of that size were no longer possible.

He said the same arguments, such as differentials in growth, inflation and political risk from other economies, used to advocate high interest rates in the past could now be used to advocate lower interest rates because the South African economy was now in line with other economies in all areas.

Measurement bias that contribute to an overestimate include commodity substitution bias where people switch expenditure to cheaper products, quality bias where increased quality is not taken into account, new goods bias where new goods entering the market are not measured and outlet substitution where consumers switch to cheaper outlets.

Oct 15 2003 07:37:31:000AM Rochelle McCauley Business Day 1st Edition

Publisher: Business Day
Source: Business Day
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