Gilad Isaacs | When you only have a hammer, everything is a nail and Kganyago is swinging wildly

First published by News24 South Africa , here ,?on 2 June 2023.

The conundrum we face is that we’ve limited monetary policy to fighting inflation and fighting inflation to hiking interest rates. Given the actual causes of inflation, there are far better options available, argues? Gilad Isaacs .

For the tenth time since November 2021, the South African Reserve Bank has raised interest rates. This will make it more difficult for South Africa consumers and businesses to borrow, limit investment and consumer spending, and exacerbate the credit defaults that are already occurring.?

Why is the Reserve Bank raising interest rates??

The Reserve Bank and the National Treasury have interpreted the mandate of the Reserve Bank to narrowly prioritise low and stable inflation, between 3 and 6%. The Reserve Bank has decided that the key instrument for achieving this is manipulating the costs of borrowing in the economy (via the “repo rate”).?

Internationally, at the heart of this approach to monetary policy, is the idea that you tame inflation by restricting economic activity and increasing unemployment, what the IMF euphemistically calls bringing “balance to the labour market”. The?New York Times ?succinctly explains the logic of the US’s Federal Reserve Bank:?

When the Fed raises interest rates, it slows consumer spending on big credit-based purchases like houses and cars and can dissuade businesses from expanding on borrowed money. As demand for products and demand for workers cool, wage growth eases and unemployment may even rise, further slowing consumption and causing a broader moderation in the economy.

In more detail, the South African Reserve Bank describes four “channels” through which raising interest rates is supposed to dampen inflation.

The first two rely on contracting economic activity in the local economy, though making it more expensive to borrow and reducing the value of financial assets.

The third channel is influencing the nominal exchange rate and thus modifying the costs of imports and the balance between the demand for imports and exports. The fourth mechanism is keeping a lid on “inflationary expectations”, hoping that raising rates will lead businesses and workers to expect lower inflation, take this into account and so lower prices set, moderate wage demands, and boost output.

Does this work?

Two problems confront this prevailing approach. First, while raising interest rates may reduce access to credit and influence the nominal exchange rate, they have little impact on the other two channels. Worse still, given the underlying causes of inflation, even if rate hikes further strangle our barely alive economy, they will do little to tame inflation.?

The Reserve Bank’s?recent statement ?correctly notes inflation is “shaped primarily by fuel, electricity and food price inflation”. The price of fuel – an imported commodity with a price set on global markets – and the cost of electricity – impacted by debt, sabotage, and mismanagement at Eskom, is not predominantly shaped by domestic interest rates.

Similarly, the recent round of food price inflation was originally triggered by global factors, such as Russia’s invasion of Ukraine and the cost of inputs like fertilisers. But South African food prices continue to rise despite a 20% year-on-year fall in the United Nations Food and Agriculture Organisation international Food Price Index reported in April 2023.

Local factors such as electricity costs and a depreciating rand likely play a role. But?increasing evidence ?suggests that much inflation, including in food prices – globally and in South Africa – is driven by excessive corporate profit margins. Research by the?ETC Group ?in 2022 shows four to six global companies dominate the agrifood sector. Calling these firms “food barons”, ETC argues their control of the food chain enables them to wield enormous influence over food prices.

Dampening domestic demand through interest rate hikes is therefore unlikely to significantly influence the drivers of inflation. As is obvious, inflation in South Africa is simply not a product of excessive demand or high wage levels which interest rates are supposed to restrain.?

The Reserve Bank, therefore, places some emphasis on “anchoring inflation expectations”. However, in South Africa, as Investec’s Brian Kantor shows, inflation is “backwards looking”. Workers, for example, make wage demands based on what inflation was last year, not what they may “expect” it to be going forward.?

A different motivation for raising interest rates may also be at play – the desire to make it attractive for foreign financiers to bring money into South Africa to earn hefty returns underpinned by high-interest rates. This is partly necessitated by South Africa’s reliance on short-term speculative capital inflows to balance the money leaving South Africa (through trade, profit repatriation, and capital flight). But it’s a strategy that risks boosting asset prices (thereby potentially stoking inflation) and encouraging “carry trade” where speculators borrow in a low-interest jurisdiction like Switzerland and invest short-term in a high-interest jurisdiction like South Africa. It carries significant risks.?

What should we be doing?

The conundrum we face is that we’ve limited monetary policy to fighting inflation and fighting inflation to hiking interest rates. Given the actual causes of inflation, there are far better options available.?

First, it goes without saying that the energy crisis needs resolution, including the provision of significantly more funding to Eskom from the National Treasury – and potentially the Reserve Bank – to pay off debt, undertake maintenance, invest, and severely curtail the planned price hikes.?

Second, the Reserve Bank needs to do more to stabilise the exchange rate at a lower level, thus relieving depreciation-based fuel price increases.?

Third, industrial policy interventions in critical inflationary sectors are needed to help expand output at lower prices. Localising production through deliberately fostering competitive advantages, including in the energy sector, will make us less susceptible to international supply chain turbulence. The Reserve Bank can assist by providing discounted financing to development finance institutions and/or the fiscus.?

Fourth, similar interventions are needed in the sectors providing key services. Investing in rail transport – and resolving the interminable mess that is PRASA – would be far more effective at solving the 15.4% year-on-year public transport inflation than hiking interest rates. While this requires a coordinated strategy across arms of the state, the Reserve Bank could assist through preferentially low-interest financing.

Fifth, short-term price controls are gaining traction internationally in key essential goods sectors, such as essential foodstuffs, in order to ensure access and prevent profiteering.

Sixth, targeted capital controls are required to regulate flows in and out of South Africa in a way that encourages long-term capital investment and doesn’t make South Africa dependent on attracting short-term speculative flows.?

Seventh, this should be complemented by prescribed low-interest lending to the South African government. Together, these measures would reduce the cost of borrowing for the fiscus, with significant ripple effects.?

Eighth, by?lowering?interest rates and making development financing available the Reserve Bank would be able to contribute to stimulating output and growth in the economy.

Poor need shelter from inflation

Ninth, the poor need more shelter from inflation. The inflation rate experienced by the poorest 40% in South Africa was 9.65% in April 2023 year-on-year, compared with only 6.2% experienced by the highest earning 10%. Increasing the level of, and expanding access to, social grants, critically the SRD grant, is one important measure.?

Tenth, all of this is only possible with the departure of the current dogmatic, ideologically-driven leadership at the Reserve Bank.

There are, of course, a host of other critical policy interventions required in South Africa, but these 10 provide an illustration of a different approach to both monetary policy and tackling inflation that could be immediately implemented. In this conception, inflation is an economy-wide issue driven by imports and supply-side bottlenecks, with raising interest rates to strangle domestic demand being a foolish endeavour. Taking this approach allows monetary policy to coherently fit within a broader national development agenda rather than working against it.

By contrast, in the Reserve Bank Governor Lesetja Kganyago’s tunnel vision, inflation is all that matters and interest rate hikes are all that he should consider using. The tragic result is a monetary policy that hammers the economy, with little or no benefit to taming inflation.?

- Dr Gilad Isaacs is the executive director of the Institute for Economic Justice and economist at Wits University.