By Cees Bruggemans, Chief Economist of FNB.
Central banks claim, with some justification, they can do only so much. But what they do hardly ever remains without effect.
The main modern objective of monetary policy is to keep inflation low and contained, and employment full and growing at potential (or something sounding like it).
An ultra-modern addendum would be to prevent asset markets from acquiring bubble conditions (unless it is seen as part of macro-prudential policy, another leg).
Under non-crisis conditions, central banks primarily rely on interest rates as the main policy instrument, assisted by ‘communication’ (market signaling).
In crisis conditions exceptional measures can be attempted, including bond buying.
That’s about it where the weaponry is concerned. The rest is mainly analysis, shrewd judgement and implementation (making signaling noises, announcing rate decisions, lying low as it rains tomatoes, rotten eggs and abuse from vested interests and others on the sidelines where, it is generally well known, the best captains reside).
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All very nice, but how does a modern central bank go from a condition of high structural inflation to low inflation, and vice versa? How does it handle cyclical inflation? Most of all, how does it handle the future?
The magic mainly involves opportunism.
There are two types of opportunism involved, at least to the long observer of the passing scene.
One cannot know the future. Fundamentally, therefore, there’s nothing more wasteful than to muse about what ‘could’ happen, as the future’s armoury includes trillions of possibilities, anyone of which can be activated, depending on the exact circumstances, total precise information about which is always lacking, leaving hazy approximations of unfolding reality).
But this doesn’t mean there aren’t trends, favourable or otherwise, which spell risk. It allows a forward-looking central bank to paint pictures as to what is likely to evolve, given certain assumptions based on experience.
But when it comes to action, one likes firm ground under one’s feet, for which reason recent data, especially with a good record of being leading indicators, are most important to shape final decisions.
For changing interest rates is a massive weapon in a modern market economy, changing incentive structures and influencing behaviour. It nearly never remains without major effect, the full impact taking as much as two years to show.
Even when strong views are being aired as to where recent trends are likely to lead on a one year or more time horizon, however, one does not want to overreact. For over-steerage tends to inject unwanted volatility into the economy and financial markets, the correction of which tends to be costly.
That’s one reason why central banks don’t change their intervention rate daily, even if capital markets do precisely that every second of the day globally.
The human interventionist wants to take distance, allowing a few weeks if not months to go by before officially contemplating the adequacy of ruling rates, letting much of the daily noise cancel out to the extent this is possible, for the true underlying tendencies to show more clearly, and then pounce if a clear deviation from intention manifests itself.
But even that is an exercise in opportunism, like a heron on one leg standing at a waters’ edge the whole day, totally immobile, with cold snake eyes watching the passing scene below where ever so peacefully everyone is going his way.
Until it is time for a snack and a thinning of the fish, frog or insect population, whoever comes near enough when the moment is ripe for qualifying as the sacrificial lamb, thereby centrally contributing to keeping the pond’s population stable and sustainable.
For that split decision at that moment in time one mostly needs immediate information, the most exactness on offer (and then still often only mainly involving estimates, approximations or reflecting pure price discovery).
Reality only presents itself with total hindsight, long after the effect of the policy action has been felt and become embedded. Thus the science may be important but the art of the moment is all important in this particular business.
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If the day to day central bank decisions involve some measure of opportunism, there is yet another form, this time on a much longer timeframe.
If one inherits an economy with a high structural inflation rate, and the objective is to get it down to low single digits (the universal long-term ideal to foster optimal economic growth conditions), how does one go about this?
As SARB Governor Chris Stals, with a wry smile, used to say in the late 1980s when deeply entrenched inflation expectations were still in 12%-15% territory, he could get it down to 3% in no time, but nobody would like the experience!
A Democracy is capable of enduring only so much pain. The dislocation of forcefully eradicating inflation rapidly would come at politically unacceptable cost to labour and holders of capital.
But if the political will has finally been marshaled to eradicate an ensconced high inflation, reducing it to within optimal parameters, how does one do that? It turns out mostly in stages, opportunistically.
This can be described in two ways.
Over time one can maintain a relative high real interest rate for a number of years, gradually working in on credit, speculative, investment, saving and consumption behaviour, and not forgetting the support it provides to the exchange rate. Thus the inflationary expectation may be slowly grinded lower, if at the opportunity cost of higher activity and employment forgone for the duration under the influence of the high interest rates.
This may have been primarily a South African approach, also bearing in mind that external financial crises tended to demand a fairly defensive interest rate stance, higher than what a more self-contained, less threatened economy could have afforded.
At about the same time, in the 1980s and 1990s, mainly under Greenspan, the US Fed followed a more opportunistic policy stance over the full business cycle to gradually squeeze out too high inflation over a number of business cycles in a still politically acceptable kind of way (not quite unnoticeable, but not quite unbearable either).
Fed chairman Paul Volcker had taken draconian action in 1982 to break the upward momentum in US inflation, getting it back into single-digits. But the cost of this action was high.
Thereafter, the Fed was inclined to make greater use of stealth (or opportunism). It could not sell higher-than-warranted interest rates during an economic upswing. And it could not Bundesbank-like simply enforce its objective, for America remains one large town hall where the people tend to know what they want.
But with the onset of recession, nothing could prevent the Fed from keeping its interest rates unchanged into the downswing a little longer than strictly necessary, before finally relenting and easing policy.
Over two decades this approach assisted in step-like and gradually lowering inflation towards its ultimate ideal near 2%.
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What does all this suggest about what might still come next, as much in the US as in South Africa, and affecting both our Rand and interest rates?
In the US they have today the opposite problem of what they used to have. For the first time in fifty years (since 1960), the Fed has recently stated US inflation is now too low (core below 1% and falling).
High unemployment following three years of crises is steadily grinding inflation lower, with the danger of turning into deflation if nothing is done to counter it.
For this reason, the Fed has mobilized all its weaponry to maximum extent (interest rates, communication and bond buying) to prevent such an outcome.
But there is still one arrow, the stealth strategy, that is yet to be fully played but which has already been alluded to yet perhaps not fully understood.
That is to keep rates ‘low’ even as recovery begins, as resource utilization is so low and unemployment and under-employment so high, that it may take a long time overcoming such disinflationary forces and the expectations these shape.
When, therefore, US growth starts to accelerate again, don’t immediately expect the Fed to start signaling the imminence of policy normalization and higher interest rates.
The Fed is now also increasingly focused on getting the US economy back to more normal resource utilization (‘potential’). Opportunistically, it may decide to keep US rates unchangingly low for a long time, wanting also inflation to return to nearer a more normal (2%) level before it feels it cannot any longer keep up the exceptional support without doing longer term damage.
Expect lots of criticism of this approach, and inner Fed disagreements as well, but do build in a healthy timeframe for the Fed remaining low for long.
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Implications for South Africa are many.
Longer period of Dollar weakness, Rand strength (even exceptional), grinding down our inflation, forcing our industry to become more efficient, while allowing the SARB to follow through with its interest rate policy, also low for longer than many may imagine, though not necessarily on the Fed scale.
Our output gap will give way much earlier, and we will prove to be more a middle-ranker between outperformers such as Singapore, Aussie, Israel and Brazil on the one extreme (very early risers in terms of interest rate normalisation) and the US and UK at the other end (very late risers).
That said, bear in mind our SARB never took exceptionally strong support actions (so far) and will probably not need to ‘normalise’ as much as other countries had (or still have) to do.
Still, while the SARB will undoubtedly remain forward-looking its focus will remain focused on actual data flow and trends in the here and now. Risks will be noted but not always carry the same weight, with policy action notably anchored in the present, both as regards inflation and output gap performance.
In South Africa’s case it is unlikely that inflation will fall too low for too long as in the US, though the output gap may remain unacceptable large for too long.
Some of the remedy may be supply-side linked and therefore requiring structural policy reforms, which the SARB can’t do anything about.
Any unforeseen new shock events also impacting the Rand negatively, as in 2008, could turn the SARB cautious about what to do next.
But aside of new surprise shock events, the Fed is likely to set our scene for the next few years, in which we can expect global conditions to favour Rand strength, low inflation and low interest rates, probably for longer (into 2012) than currently foreseen.
Also in our case it suggests an eventual reduction of the output gap and resumption of employment growth, certainly on a three year view.
Source: Cees Bruggemans, First National Bank, October 25, 2010.
