Constitution of South Africa includes mandate for its central bank..

Mr Lesetja Kganyago, Governor of the South African Reserve Bank was recently reappointed as Governor of South Africa Reserve Bank. The central bank has been under pressure as it is one of the few banks which is held privately.

In a recent speech, Kganyago talks about the mandate of the central bank. It is interesting to note that it is mentioned in South Africa’s constitution (Like Swiss):

Today, I would like to talk about the South African Reserve Bank’s (SARB) mandate: what it is, how we interpret it, and where we are in our national
conversation about the SARB.

The Constitution, in section 224, instructs the SARB to protect the value of the currency in the interest of balanced and sustainable growth. This
mandate reflects an understanding that protecting the value of the currency is a critical foundation for achieving lasting growth.

Clearly, the mothers and fathers of our Constitution did not want us to let inflation run. We might have got more growth but it would have been
unsustainable. As many countries have discovered, after a temporary boom, we would end up in stagflation, with weak growth and high inflation.
The framers of our Constitution also cared about macroeconomic imbalances, which might, for example, result from a debt boom, or if we
spend well in excess of what we produce, with imports running too far ahead of exports.

The Constitution tells us what to do, but it is not explicit about how we do it. We had to figure out a monetary policy framework for ourselves. In fact,
it took us a few years to arrive at the approach we use now: the Constitution was passed in 1996, but we only started inflation targeting in
2000 – after a false start using the so-called ‘eclectic approach’ that included a failed attempt to control the exchange rate.

To be more specific, SA’s constitution devotes three sections to the Central Bank and monetary policy:

Central Bank

223. Establishment

The South African Reserve Bank is the central bank of the Republic and is regulated in terms of an Act of Parliament.

224. Primary object

1. The primary object of the South African Reserve Bank is to protect the value of the currency in the interest of balanced and sustainable economic growth in the Republic.

2. The South African Reserve Bank, in pursuit of its primary object, must perform its functions independently and without fear, favour or prejudice, but there must be regular consultation between the Bank and the Cabinet member responsible for national financial matters.

225. Powers and functions

The powers and functions of the South African Reserve Bank are those customarily exercised and performed by central banks, which powers and functions must be determined by an Act of Parliament and must be exercised or performed subject to the conditions prescribed in terms of that Act.

Hmm..

Further, he talks about how the inflation target has evolved:

The inflation target, agreed between the SARB and National Treasury, was initially set at 3-6% before being shifted to 3-5%. The emerging market crisis of 2001 led to the reinstatement of the 3–6% target, and it has remained since then. More importantly, the target created a clearer framework for decision making and enhanced public understanding of the SARB’s monetary policy objectives.

But this choice of target also left important questions open. In particular, because the 3-6% we ended up using is a wide range, it created uncertainty about the SARB’s true objective. I recall that a consultant helped us with some educational materials, including for our website, who wrote that with a 3-6% target the SARB would cut rates when inflation was under 3% and hike rates when it was over 6%.

That was a logical interpretation, but it was completely wrong. The fact is that during the inflation-targeting era, the SARB has not seen targeted inflation below 3%.  We have nonetheless cut rates on many occasions. In fact, these rate cuts have typically happened with inflation over 5%, already in the top end of the target range. Various analysts and academics have spent a lot of time trying to estimate the SARB’s de facto target, and they have tended to
conclude it has been close to 6%.

They did a review and figured people expected inflation to be 6%, top of the range. This meant expected inflation was much higher.

This left us in a trap: nominal interest rates had to be high because inflation expectations were anchored at around 6% but high interest rates
meant there was always pressure to cut. Meanwhile, the indexation bias meant that inflation never fell much, and so in turn interest rates stayed
structurally high. 

The paradox is that we have often been accused of being hawkish and keeping interest rates too high, when in reality we have often tolerated as
much inflation as we can, ignoring the bottom half of our target range. This is the main reason why our interest rates haven’t fallen further. We tend
to spend a lot of time comparing ourselves to low inflation and low interest rate economies, when we really are not in that particular picture frame.4
Given this analysis, we decided to make some changes. We could better achieve permanently lower interest rates if we were clearer about where
exactly we want inflation to be, within our range.

This led them to a preference for the mid-point of 4.5%:

The simplest and most honest option would be to emphasise the middle of our target range, 4.5%, as our goal. By analogy, we began to think of
the 3-6% target range as the lines on a road. When you’re driving down the road, you try to steer between the lines. You don’t drive along the
yellow line or the centre line, unless you’re a bad driver. Of course, you can’t keep the car dead-centre in the middle of the road all the time, but
every time you start to drift towards the lines, you correct, aiming back for the middle of the lane. For monetary policy, the 4.5% midpoint is the
middle of the lane in this metaphorical road, and 3-6% are the lines.

When we decided on this adjustment, we were aware that using interest rates to move inflation expectations from the top of the target to 4.5%
could be costly. For this reason, we started with some communication, expressing our preference for inflation expectations moving towards 4.5%
over time. We also began more detailed work on ‘sacrifice ratios’, which is the term economists use for how much growth it costs to lower inflation.
These exercises generated a range of estimates, but, broadly speaking, they suggested we would have to do a series of rate increases, lifting the
repo rate to 8% or higher, to get inflation to 4.5% – assuming everything else in the economy was normal. The estimated output sacrifice ratio was
in the range of 1-1.5% of GDP.

Superb stuff…

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