Rates increase is not the solution

Posted On Tuesday, 19 March 2002 03:01 Published by
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THE Reserve Bank's decision to hike interest rates in January coincided with the reconstitution of the Bank's monetary policy committee, leading to jokes that Chris Stals was making a comeback.
THE Reserve Bank's decision to hike interest rates in January coincided with the reconstitution of the Bank's monetary policy committee, leading to jokes that Chris Stals was making a comeback.

The changes resulted in a trimmed committee dominated by technocrats most of whom had learnt their economics under Stals and the market was bracing itself for the return of the former governor's decidedly hawkish approach to monetary policy.

Though by no means in the majority on the committee, which includes governor Tito Mboweni and his deputies, at least three of the four technocrats are regarded to be part of the old guard in economics, if not political thinking.

Bar the controversies around the Bankorp baleout and later his expensive and vain attempt to defend the rand during the emerging market crises of 1997 and 1998, Stals is most likely to be remembered for his obsession with price stability.

His most positive legacy will be the fact that he left SA with inflation in single digits.

With his disciples seemingly growing their influence within the Bank, the decision to hike rates in January to the dismay of many economists, leaders in business and labour who thought it should have shown more sensitivity to the continuing economic slowdown hardly came as a shock.

Arguments that inflation was driven by the sharp fall in the value of the rand during December and not rampant domestic demand and that the rate increase would not deliver the stated objective of keeping inflation in check fell on deaf ears.

Economists also warned that international investors were attracted to growth economies, and would therefore be likely to push the rand even weaker. This would lead to even more imported inflation.

But the Bank would hear none of that. The theory about the return of the Stals approach was given some credence when the former governor emerged from retirement to testify to the Myburgh commission probing the currency's free-fall.

Not surprisingly, Stals credited the Bank's widely criticised decision to hike rates in January with being among the major reasons if not the only one behind the stabilisation of the exchange rate at the beginning of the year.

Of course, the currency has deteriorated since then and was trading yesterday at about R12 to the dollar. While most of the weakness has been blamed on Zimbabwe, some economists believe the Bank's decision last week to hike rates again has not made things any easier for the currency.

But does the Bank have any other choice, with inflation seemingly spiralling out of control?

Without doubt, if Mboweni had failed to act, he would have been accused of populism and his independence questioned.

The focus would probably have shifted to his history as the labour minister who pushed in labour reform legislation legislation that is still unpopular among business leaders and some economists.

It would be a sad irony if the conduct of monetary policy was driven by these factors.

It seems that the only logical explanation for the rate increase last week is the Bank's need to be seen to be doing something, as opposed to using Mboweni's own words twiddling its thumbs as inflation spirals out of control.

While the Bank has not been twiddling its thumbs, it has definitely damaged growth internally, and this should have a negative effect on inward investments.

The biggest irony is that the credibility of the inflation target falls outside the influence of the Bank. Only government can move to restore investor confidence and provide some support for the currency, and that is probably the only effective ammunition we can use against inflation.

An early test of this could come today as the world awaits the result of President Thabo Mbeki's meeting with Zimbabwean President Robert Mugabe. A wrong move will probably drive investors away and the rand will come under even more pressure.

Initially the Bank will say it is targeting inflation and not the exchange rate and other observers will rave about the positive effect on exports.

But then the negative consequences of a weaker currency will make their effect felt. Prices of imported goods will go up and so will those of locally produced raw materials and other essential goods, like maize, the prices of which are based on export parity.

This will translate to higher inflation and the Bank is likely to end up being forced to target the exchange rate in order to stop imported inflation getting out of control. It is difficult to imagine that the Bank can control this type of situation via monetary policy alone.

Increasing rates seems to be a pointless exercise, when the issues driving inflation are not interestrate sensitive.

The best thing Mboweni can do under these circumstances is to make sure he gets a word in with Mbeki before the latter jets off to London to discuss Zimbabwe with Commonwealth colleagues today. Maybe he should even join him.

Mnyanda is Business Day's Economics Editor.

Publisher: Business Day
Source: Business Day

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