Inflation Targeting Is Not a Suitable Basis for Monetary Policy in South Africa

Cape Times (South Africa), May 6, 2008 | Go to article overview

Inflation Targeting Is Not a Suitable Basis for Monetary Policy in South Africa


BYLINE: Michael Power

The fulcrum of the Reserve Bank's policy has achieved nothing and is not at all suited to a developing economy like ours.

I told you so. Inflation targeting is wrong for South Africa. Why? Because, as a developing country burdened with high unemployment, premature adoption of inflation targeting (IT) has been like putting a cast on a broken leg before realigning the fractured bone and thereby condemning the patient to a permanent limp.

Before IT should be considered, the most important relative price structures in a country - and critically, in the case of South Africa, the US dollar wage of the unemployed semi-skilled labour trapped in our Second Economy, the blight which represents our most "fractured bone" - needs to be more closely aligned to the equivalent clearing price globally.

And this, all too evident here in booming, blooming Beijing from where this commentary is written, is best done via competitive exchange rates, not by targeting inflation rates.

I don't say "I told you so" to gloat but rather to challenge the group-think that has ossified around the conviction that IT is the One True Path for South African monetary policy. It is not. And here is why.

First of all, look at where IT has got us - and here I mean all of us, not just those of us lucky enough to live behind the high and protected walls of South Africa's First Economy. Monetary policy is in a right pickle. The SA Reserve Bank is damned if it raises rates and damned if it doesn't.

Just as inflation is accelerating, growth is stuttering.

Retail sales, car sales and house prices are all down. But doctrinally, the South African Reserve Bank cannot but raise rates even as stagflation threatens. Higher rates will further depress GDP growth and, if that knocks the rand, only make matters worse.

Our Achilles heel - the external deficit, now a yawning 8% of GDP, or R600 million each working day - has heretofore been protected by growth-seeking foreign equity inflows.

Constricting GDP growth risks exposing this weak spot, turning capital inflows into outflows, undermining the rand, increasing import prices and compounding the inflationary problem.

Lower interest rates - unthinkable for an IT regime anyway - would not work either, even if they might support GDP growth.

Given that the pneumonia of double-digit inflation is already raging, lower rates would - via the multiplying mechanism of expectations - intensify into the double pneumonia of even more virulent inflation.

Heads we lose. Tails we lose. How did it - and IT - come down to this?

IT works best for a developed country blessed with near full employment. But given that South Africa is neither developed nor fully employed - our multi-tiered history has left us with a two-tiered economy where one out of four are out of work - we are nowhere near ready for IT.

At a recent academic conference in South Africa, no one questioned IT's suitability as the basis for our monetary policy. One speaker even stated that "the whole world" agreed that IT was the only way to go.

The whole developed world perhaps (though even this would be stretching it), but large parts of the emerging world would beg to differ. …

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