SOUTH AFRICA’S OPTIMAL MONETARY POLICY

AND THE EXCHANGE RATE

Word count: 3 510

INTRODUCTION

In his 2010 budget speech, Mr Pravin asserted the South African government’s commitment to a low

rate of inflation and a competitive exchange rate, while “providing a buffer against global volatility”.

These remain highly desirable goals but in a world where a regulator cannot control all facets of the

economy at once, certain trade-offs must inevitably be negotiated in order to meet the ultimate aim

of sustainable economic growth.

According to the Mundell-Fleming model, a country allowing free capital mobility cannot

simultaneously control its exchange rate and its monetary policy – a trilemma known as the

“impossible trinity”. This has become a source of tension between priorities of many emerging

economies, not least South Africa, who are especially concerned about exchange rate fluctuations.

While it may be tempting for South Africa to tighten its control of the exchange rate, this would

necessitate a loss of central bank monetary autonomy. Inflation targeting by definition requires the

ability to affect monetary variables and thus allowing the exchange rate to float.

This paper explores whether some form of exchange rate regime would be more effective than

inflation targeting for controlling inflation and maintaining economic stability in South Africa, while

bearing in mind each policy’s trade-offs, in the context of South Africa’s international trade

competitiveness and vulnerability to global and domestic shocks. While there is no perfect solution,

given the ramifications that flow from the inability to affect monetary policy, inflation targeting

appears to be the most appropriate choice for South Africa.

WHY TARGET INFLATION?

Low inflation is commonly regarded as being essential for sustainable economic growth. Freedman

and Laxton (2009:3-8) provide a comprehensive list of the costs of inflation:

(i) High inflation is associated with high inflation volatility.

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(ii) High inflation yields a greater likelihood of asset-price bubbles as investors confuse the

nominal asset-price increases for rises in real value when in fact they are merely a result

of persistant inflation.

(iii) High inflation is associated with lower levels of potential output and output growth. This

could be because inflationary distortians negatively effect incestment decisions, which

leads to a smaller and/or less productive capital stock. Inflation infects investment

decisions by promoting uncertainty and therefore higher risk premiums in bond

markets.

(iv) Social costs result from the distortions causes by high inflation. Firms find difficulty in

synchronising price increases and relative prices thus tend to misrepresent the real costs

of production. This leads to sub-optimal decisions by economic entities.

(v) There are distortionary tax implications. “It is likely that some firms will be overtaxed

and others undertaxed...and consequently that there will be distortions in investments

as firms seek to maximise their after-tax profits” (Freedman & Laxton, 2009:5).

(vi) Inflation erodes savings, which is especially detrimental to pensioners and low-income

individuals who will likely find it more difficult than higher income individuals to protect

themselves from the affects of inflation.

(vii) The uncertainty surrounding future prices associated with high inflation makes wage

setting and negotiation a difficult and precarious task, which might lead to a higher

number of days lost to strikes.

There is also some evidence to suggest that high inflation is positively correlated with business cycle

volatility. Freedman and Laxton (2009:7) offer Canada and the United Kingdom as examples of

countries that experienced sharp cyclical movements in unemployment during times of high inflation

which became less erratic after the countries entered periods of lower inflation. Further evidence

comes from Kumhof and Laxton (2007) who have shown that 50% of the improvement in the

performance of macro variability in the US can be attributed to better macro policies. This is relevant

because US monetary policy is preoccupied with maintaining a low rate of inflation (Freedman and

Laxton, 2009:8). Time and again, high inflation appears to be detrimental to a healthy economic

environment. This underscores the importance of controlling it. There is some debate, however, of

how best to accomplish this.

THE CASE FOR CONTROLLING THE EXCHANGE RATE

While maintaining low inflation is imperative to ensure a stable economy, there is a large body of

evidence that shows that real exchange rate misalignments are also detrimental to economic

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performance and growth. This finding has been confirmed by, among many others, Ghura and

Grennes (1992), who focused exclusively on Sub Saharan Africa.

Emerging market economies are particularly vulnerable to exchange rate fluctuations. Mishkin

(1996) notes that such countries tend to rely more heavily than developed countries on foreign debt

and depreciation in the value of the home currency multiplies this burden. This is true for both

public and private debt. This is relevant in South Africa’s case as it had an estimated public debt

standing at 35.7% of GDP as of 2009, according to the CIA World Factbook (2010). A further

consideration is the exchange rate’s effects on global competitiveness and the balance of payments.

This is especially relevant given the rand’s recent strength. A strong rand causes South African

exports to be relatively more expensive to the rest of the world, which, ceteris paribus, depresses

international demand for domestic goods and leads to a decrease in GDP, according to the Marshal

Lerner condition. At the same time, foreign imports become more attractive to South Africans as

they become relatively cheaper. This causes deterioration in the current account balance.

Another important impact of exchange rate volatility, which is linked to inflation, is what is known as

pass-through. Pass-through occurs when import prices increase due to currency depreciations and

lead to lasting higher inflation expectations (Mishkin, 2004), thereby countering the effect of

monetary policy designed to rein in inflation. This is a problem for developing countries with a

patchy track record and low monetary policy credibility as the public is more likely to be sceptical of

the government’s ability to control the second-round effects of inflation, leading to a self-fulfilling

spiral of increasing prices. South Africa’s imports amounted to an estimated 25% of GDP in 2009 (CIA

World Factbook, 2010).

Frankel (1999) recognises that a major advantage of fixed exchange rates is the reduction of

exchange rate risk and transaction costs. While hedging can mitigate such risks, they remain a great

concern. However, currency crises have emanated from countries with fixed exchange rates, such as

Mexico in 1994 and in the 1997 Asian currency crisis. Therefore, while fixed rates might placate

investors in times of government confidence, they do not necessarily have the same effect during

tumultuous economic periods.

A CRITICAL ANALYSIS OF INFLATION TARGETING

Inflation targeting (IT) firmly sets the inflation rate as the official nominal anchor. The nominal

anchor provides a focal point to which expectations of the public and policy objectives of the

government and central bank converge. This provides clarity and focus to all economic actors of the

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objectives of the central bank. It encourages transparency and an open line of communication as

policy makers commit to meeting targets based on the anchor (Freedman and Laxton, 2009).

According to Bernanke et al (1999), full-fledged IT (FFIT) is characterised by (i) public announcements

of target inflation rates or ranges over a specific period of time, (ii) common knowledge that low

inflation is the priority of monetary policy, (iii) strong communication of the central bank’s objectives

and plans with the public, and often (iv) processes that solidify central bank accountability for these

objectives. Mishkin (2007) adds that it entails more than merely publicly announcing a target for

inflation. He also contends that it should be a holistic policy, which includes considerations of the

exchange rate and monetary aggregates in rolling out its policies.

Besides for being a convenient method for keeping inflation low, Freedman and Laxton (2009)

identify two “intellectual roots” for its adoption:

(i) The absence of an exploitable long-run trade-off between inflation and output

There is a well-documented short-run relationship between inflation and output, which

is captured in the short-run Phillips Curve (SRPC) – an increase in output beyond its

natural level is associated with an increase in inflation. However, Friedman (1968) and

Phelps (1968) observed that the SRPC would shift up over time as people expected

higher future inflation. This would eventually cause output to shift to its original level

but at a higher inflation level. Therefore, merely stimulating production beyond its

natural level is harmful in the long-run. By focusing the authority’s attention on inflation,

it would prevent such myopic policy implementations.

(ii) The time-inconsistency problem

While policy makers might be aware of the follies of increasing output beyond its natural

level in the long run, they might none-the-less be tempted to do so for short-run gains.

That IT demands a commitment to keeping inflation at or within a specific qualitative

level acts to sterilise such temptations.

Mishkin and Schmidt-Hebbel (2005) have found that inflation targeters have experienced significant

improvements compared to their own historic economic performance and fare better than most

non-inflation targeters. This confirms empirical findings of such researchers as Ball and Sheridan

(2003) Hyvonen (2004). According to the IMF (2006), “[non-industrial] countries that adopted

inflation targets have, on average, outperformed countries with other frameworks.” However, we

cannot infer a causal relationship between IT and superior performance and the results are based on

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relatively short time periods. However, the results do add to the body of circumstantial evidence

that points to the success of IT.

The IMF (2006) conducted a statistical analysis comparing performance improvements of emerging

market economies that adopted inflation targeting to those that adhered to alternative monetary

policies. 13 inflation targeters and 29 comparable emerging market economies were included in the

study over the period 1984 to 2004. The results are displayed in Table 2. The table supports the

IMF’s (2006) findings that “improvements in key measures of macroeconomic performance in

emerging market economies under inflation targeting have been greater than under other monetary

regimes.” The IMF concedes, however, that this was a relatively benign economic period and

therefore the experience under a more volatile period might prove to be different. Interestingly,

however, the results suggest that inflation targeters did not have to sacrifice output stability, in fact

experiencing slightly lower output volatility over the period.

In the same report, the IMF (2006) cites examples of countries that fared well during crises under an

inflation targeting policy, noting the experiences of Brazil, Hungry and South Africa in 2002, and

going on to say that “Shocks of similar magnitude have destabilized these countries in the past,

suggesting at least that the framework has contributed to the economy’s resilience to shocks.” In

addition, there appears to be a significant negative correlation between inflation targeting and

financial market volatility. These positive results are mirrored by the findings of Schmidt-Hebbel et al

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(2002), who examine the experiences of Chile, Mexico and Brazil since their adoption of IT. They

found that these countries performed better than their historical levels would predict.

There are, however, some disadvantages to inflation targeting (apart from an inability to set the

exchange rate). Monetary policy has uncertain effects on inflation (Mishkin and Posen, 1997), which

makes it more difficult for authorities to precisely make an inflation target than one based on a more

graspable figure, such as the exchange rate or aggregate money supply. This is exacerbated by

monetary instruments’ lagged effects on inflation. Policies effecting the exchange rate and money

supply do not experience such lags, making such policies easier to assess.

A policy that rigidly targets inflation, with no consideration for the causes and likely second-round

effects of shocks to the economy, is likely to cause other problems. For example, automatically

increasing the interest rate in the face of a temporary inflationary supply shock has become

recognised as a faux pas. While this is more likely to bring inflation under control than a less

stringent policy, it will also increase output volatility and deepen economic turmoil. For this reason,

Mishkin (2004) asserts that countries should be flexible in their approach of IT. For instance, a “dirty

float” is often advantageous to smooth exchange rate fluctuations. The lesson here is that countries

should not use a strict, set rule for when to lower or raise interest rates based on headline inflation

but should also consider the effects that interest rate changes will have on output volatility and

whether price shocks are likely to affect future inflation expectations. In addition, Freedman and

Laxton (2009) find that even “in the face of supply shocks, medium-term expectations remained

anchored...there was less or no need to raise interest rates in the face of a temporary supply shock.”

INFLATION TARGETING IN SOUTH AFRICA

Mishkin (2004) points out that emerging market countries differ in their ability to implement IT in

that they have ”weak fiscal institutions; weak financial institutions including government prudential

regulation and supervision; low credibility of monetary institutions; currency substitution and

liability dollarization; vulnerability to sudden stops (of capital inflows).” Inflation targeting is

commonly considered to require strong central bank credibility to affect expectations and a stable

financial system to be able to accurately target interest rates and the money supply. The absence of

such criteria in emerging market countries raises questions as to the viability of an IT policy. SARB

has managed to achieve “transparency, accountability, credibility” (Reid and du Plessis, 2009), which

is supported by findings of Aron and Muellbauer (2008). Furthermore, South Africa has robust

financial and fiscal institutions. As already mentioned, other developing countries, such as Chile and

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Brazil, have had successes with inflation targeting (Mishkin, 2002) despite questionable institutional

integrity and central bank credibility.

Figure 1 is reproduced from a paper by Heintz and Ndikumana (2010), showing CPIX inflation since

the adoption of inflation targeting in 2000 to the first quarter of 2009. It shows that SARB has had

some success in bringing inflation within the targeted band of 3-6% between the fourth quarter of

2003 and the first quarter of 2007. The target was met roughly half of the time. The first spike in

inflation is due to rapid currency depreciation while the second is attributed to high food and energy

costs. In both cases, inflation has been reigned in, without spiralling out of control. This lends

credibility to South Africa’s ability to sustain a successful inflation targeting policy. Heintz and

Ndikumana (2010) also note that GDP growth and economic performance were strong compared to

the years before IT was adopted. Interestingly, this has been accompanied by a declining real

exchange rate, as figure 1 illustrates. One must be careful not to draw a causal relationship.

However, it is suggestive of the potential of IT in South Africa.

THE EXCHANGE RATE REGIME AS AN ALTERNATIVE TO INFLATION TARGETING

The full spectrum of conceivable monetary policies is broad. However this paper explores the most

popular and frequently proposed alternative: an exchange rate target – prioritising the level of the

exchange rate over domestic variable targets, such as the monetary aggregate or inflation rate. This

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involves fixing the exchange rate to some degree but between the extremes of floating and hard

pegged exchange rates, there lies intermediate policies. These include adjustable pegs, crawling

pegs and target bands. In addition, targets can be based on a single currency or a basket of

currencies. Other extremes are currency boards or monetary unions such as the arrangement in the

EU. However, the “common currency” in these cases must still be governed by some sort of

monetary policy. For example, the euro is still allowed to float relative to other currencies. This

paper does not examine the effectiveness of each specific regime but rather looks at the concept of

controlling the exchange rate to keep inflation low.

A fixed exchange rate allows a country to “import inflation” from the country or basket of countries

to which the domestic currency is pegged (Thakur & Greene). For this reason, it has been proposed

that a fixed exchange rate can lead to less inflation volatility at a given level of output. The

mechanism by which inflation is imported from overseas is derived from the lack of domestic central

bank monetary autonomy (Frankel, 1999). Recall that the impossible trinity states that capital

mobility and a fixed exchange rate makes controlling monetary policy impossible – because any

change in the interest rate would also affect the exchange rate. Therefore, the authority’s hands are

effectively tied in decisions relating to money supply and the interest rate – it is committed to

following the domestic monetary policy of the targeted country (Hoggarth, 1996). If there is

credibility that the government will abide by its exchange rate target then expectations of future

inflation will converge to those of the foreign country to whom the exchange rate of the domestic

currency is pegged. This results from the credibility of the fixed exchange rate as a nominal anchor

and its high visibility.

The advantages to a fixed exchange rate have already been discussed. However, while being able to

fix the exchange rate might allow South Africa to correct for any real exchange rate misalignments, it

does not guarantee that fixed rates will do any better to align the real exchange rate with its

equilibrium level (Edwards, 1989). Mishkin (2004) notes independently, as well as in a paper with

Posen (1997) that IT can lower the incidence of pass-through by helping to focus inflation

expectations and therefore decrease the likelihood that price shocks will lead to inflationary second-

round effects. While fixing the exchange rate might mitigate pass-through by preventing

depreciations, its advantages are overrated compared to a flexible exchange rate under a credible IT

regime that can fix inflationary expectations.

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As noted by Thakur and Greene, fixed exchange rates have indeed succeeded in some cases in

lowering inflation, citing Argentina, Chile and Uruguay in the late 1970s as examples. They also note

several pitfalls of such a policy:

(i) Convergence to the inflation rate of the targeted country is typically slow, because of

the slow rate of adjustments in the labour and goods markets and wage price stickiness.

(ii) The slow rate of inflation means that the level of inflation in the home country is higher

than that of the country being targeted, yielding a higher real exchange rate, which

might harm demands for exports and contribute to deterioration in the current account

balance. If this becomes unsustainable, a forced devaluation is inevitable.

(iii) The improved economic activity following the adoption of a fixed exchange rate is

typically followed by a sharp downturn in output and employment.

Many countries have abandoned fixed exchange rates due to the inability of central banks in such

countries to affect monetary policy or because of currency crises resulting from unsustainable

current account imbalances (Freedman & Laxton, 2009). Examples include industrialised countries

(for example, the UK, Sweden and Finland) and emerging market economies, such as Brazil and

Chile.

ASSET-PRICE BUBBLES, INFLATION TARGETING AND EXCHANGE RATE TARGETING

An asset-price bubble appears when an asset becomes overvalued and “irrational exuberance” and

credit market imperfections interact to create a self-fulfilling upward spiral in the nominal price of

that asset (Bernanke et al, 2000). A bubble can be “popped” in theory by tightening monetary policy

(Kent & Lowe, 1997). However, when a bubble is not associated with high average inflation, IT can

be somewhat ineffectual at controlling bubbles.

However, Kent and Lowe (1997), Gruen et al (2003) and Bean (2003) maintain that IT can, and at

times should, be used to pop asset-price bubbles before they become too large. “Other things equal,

the case for ‘leaning against’ a bubble with monetary policy is stronger the lower the probability of

the bubble bursting of its own accord, the larger the efficiency losses associated with big bubbles”

(Gruen et al, 2003).

There is no evidence that a fixed exchange rate would be any more effective at pricking asset-price

bubbles. In fact, it might serve to indirectly promote bubbles through the subsequent inability of the

central bank to deal with a bubble using monetary policy. In any case, it is often difficult to identify

bubbles from rational price increases based on underlying fundamentals (Bean, 2003). While more

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sophisticated methods for detecting bubbles would allow authorities to better deal with them, there

is no reason to believe that other monetary policy frameworks would fare better in this regard.

CONCLUSION

As with most complex problems, there is no one perfect solution. South Africa has a credible central

bank and a robust financial system. This bodes well for an IT policy. South Africa’s relative economic

stability and successes in the face of economic shocks, since the adoption of inflation targeting,

suggest little reason to abandon it. The advantages associated with a fixed exchange rate are

outweighed by the negative consequences of a loss of central bank monetary autonomy. Inflation

targeting does not preclude using monetary policy to control the exchange rate to some extent and

many economists support doing so. The argument supporting the adoption of a fixed exchange rate

in emerging market countries – that it is the only means of providing a credible nominal anchor –

does not apply to South Africa because of its strong financial system and credibility. Inflation

targeting thus remains the appropriate monetary policy for South Africa to achieve low inflation and

stable economic growth.

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