This paper will investigate inflation targeting policy and its implication on the South African economy. Since the early 1990s, there were more than 30 countries across the globe that adopted inflation targeting as their primary framework for monetary policy (Brimmer, 2002). Inflation target refers to an economic policy in which the central bank evaluates and announces in public a targeted inflation rate, and then attempts to steer the actual inflation towards the targeted range through the use of interest rate changes and other monetary policy instruments (Mishkin, 2000).
Since interest rates tend to be inversely related to inflation, the likely moves of the central banks to increase or decrease interest rates become more transparent under the policy of inflation targeting (Masemola, 2010). According to Svensson (2006), this high level of transparency is abnormal in view of history of central banking, since traditionally, central bank goals, deliberations, and even policy decisions have been subject to considerable secrecy.
The developing countries were lured by relative success of inflation targeting in achieving low levels of inflation in the industrialised world, and also because as, Epstein (2003) correctly puts it, “Even when countries do not put formal inflation targeting, many of them, under pressure from the International Monetary Fund and other orgnisations still orient policy almost exclusively to fighting inflation” (Masemola, 2010).
In South Africa inflation targeting was adopted by the South African Reserve Bank (SARB) in February of 2000, with an objective of maintaining Consumer Price Index (CPIX) inflation between the targeted-band of 3 percent to 6 percent by 2002, using discretionary changes in Repurchase (Repo) rate as its main policy instrument (Uwilingiye, 2010). Before the adoption of the inflation targeting policy, “informal inflation targeting” was already applied by the South African Reserve Bank. Ample emphasis was placed on the attainment of price stability, but the time period over which this would be achieved was not specified.
Later, towards the end of the 1990s, the Reserve Bankmoved to “extensive” or “pragmatic” inflation targeting. In this framework, developments in the monetary aggregates were still regarded as essential components in the inflation process, but the Bank closely monitored developments in other financial and real indicators in reaching a resolution on the appropriate level of short-term interest rates (Van der Merwe, 2004). The purpose of this assignment is to examine inflation targeting policy and its implications on the South African economy. The next section will discuss the debate around inflation targeting.
Section 2 will discuss the rationale for adopting inflation targeting in South Africa. Section 3 will discuss the arguments for and against the use of inflation targeting in South Africa. Debate on Inflation Targeting The debate about the appropriateness of inflation targeting especially within the emerging markets has existed since the inception of this policy framework. Mishkin (2000) argued that although inflation targeting is not a panacea and may not be appropriate for many emerging-market countries it can be highly useful monetary policy framework in a number of them.
However, Roger and Stone (2005) in support of inflation targeting concluded that inflation targeting is associated with an improvement in overall economic performance. Aron and Muellbauer (2007) claimed that the implementation of inflation targeting in South Africa for instance, has helped reduce inflation and promoted healthy macroeconomic performance. The then governor of the SA Reserve Bank, Mr Mboweni in his address at the Biennial Congress of the Economic Society of South Africa, Pretoria (1999) advocated a move away from the “eclectic” or informal inflation targeting monetary policy framework to formal inflation targeting.
His argument was based on the fact that the eclectic framework had created uncertainties about the Reserve Bank’s decisions and actions which were perceived as being in conflict with the stated guidelines for the growth in money supply and bank credit extension. He argued that adopting inflation targeting will minimize the social and economic cost of achieving price stability (Mashele, 2011).
However, Mishkin (2007) stated that the fall in inflation levels and volatility, interest rates, and output volatility is part of a worldwide trend in the 1990s, and inflation targeters have not done better in terms of these variables or in terms of exchange rate pass-through than non-targeting countries such as Germany or the United States. Ball and Sheridan (2005) argued that inflation targeting does not make any difference, since the reflection of apparent success is nothing but simply a reflection of mean reversion; that is, inflation will fall fastest to those countries that start with high inflation rate.
Stiglitz (1999) argued strongly against inflation targeting as monetary policy framework. He stated that the world’s central bankers are a close-knit club, given to fads and fashions. In the early 1980s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. However, after monetarism was discredited (at great cost to those countries that succumbed to it), the quest began for a new mantra; and that answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised (Stiglitz,1999). Rationale for adopting Inflation Targeting
In South Africa, arguments by which inflation targeting was adopted include the following (Van der Merwe, 2004): Firstly, inflation targeting improves co-ordination between monetary policy and othereconomic policies provided that the target is consistent with other objectives. Inflation targeting is a formalized approach defining precisely the coordinatedeffort needed to contain inflation in pursuit of the broader economic objectivesof sustainable high economic growth and employment creation. Secondly. Inflation targeting creates a degree of certainty among the public about the monetary policy stance adopted by the authorities.
Intermediate objectives fall away with inflation targeting and policy becomes more transparent. Thirdly, Inflation targeting serves to increase the Central Bank’s accountability, because the Central Bank has to explain what went wrong when the actual inflation rate deviates from the target. This disciplines the Central Bank and leads to a better understanding on the part of the public why monetary decision are made. Finally, the application of inflation targeting minimizes inflationary expectations, i. e. inflation targeting is perceived to be credible and forms the basis for future price and wage setting.
Arguments for the use of Inflation Targeting in South Africa South African Reserve Bank, as the custodian of the monetary policy, argues that the adoption of the inflation targeting policy framework serves as an institutionalized commitment to price stability as the primary goal of the monetary policy, to which other goals are subordinated (Mboweni, 2000). The bank argues that by setting inflation targeting as the main objective of the monetary policy, it ensures sustainable price stability which will positively spill-off to other variables in the economy, thus maintaining sound economic and monetary outlook.
The argument is that inflation targeting as a monetary policy target, anchors the public’s inflation expectations, thereby improving planning for the economy (Masemola, 2010). According to Gowland (1991-277), the argument for inflation targeting as monetary target is that they are necessary to constrain or discipline governments. The bank attributes that increased monetary policy transparency is ensured through better communication with the public and the markets about the objectives of the monetary policy and the rationale for the decisions taken by the monetary authorities.
It is believed that the policy makes it easier for all players in the economy to make effective future economic decisions, hence their confidence on the financial stability. The defense of this policy is that a low rate of inflation is generally justified as the ultimate goal of the monetary policy (Masemola, 2010). The SARB (2004) argues that the policy makes it easy for investors to know what the central bank considers the target inflation rate and therefore will more easily factor in likely interest rate changes in their investment choices, which is viewed as leading to increased economic stability.
The bank asserts that the inflation targeting policy creates an atmosphere in the economy where financial stability is a certainty as a result of low inflation. Inflation targeting proponents advocate that the stability in prices is the cornerstone to fulfilling many of the country’s socioeconomic ills, among others, the relentless unemployment, poverty, low economic growth, etc.
Arguments against the use of Inflation Targeting in South Africa
The current approach to inflation targeting is indeed not bearing enough fruits for the country’s relatively strong emerging economy. The approach, since when it was officially adopted as the flagship goal of monetary policy, has depressed and in fact undermined many of the country’s macroeconomic policy objectives such as sustainable economic growth, job creation, and because so much is concentrated on price stability, the citizens have been subjected to cumulative increases in interest rates which for most is unfortunate and unbearable.
It has to be noted with absolute shrewdness that inflation is usually measured as the change in prices for consumer goods, called Consumer Price Index. Inflation targeting on the other hand assumes that this figure accurately represents growth of money supply, which is not always the case (Masemola, 2010). The exception occurs when factors external to a national economy are the cause of price increases (Epstein, 2002).
An example in this regard could be the oil price surges and the 2007-2008 world food crises which caused sharp increases in the prices of food and consumer goods, which in turn resulted in a sharp increase in CPI. Under such conditions increases in inflation (CPI) is not necessarily coupled to any factor internal to a country’s economy and adjusting interest rates (which is what SARB did) is ineffectual and will reduce economic growth unnecessarily (Masemola, 2010).
Limiting monetary policy solely to price stabilization cannot guarantee economic growth since low inflation does not necessarily lead to high and sustainable economic growth. For this reason, the United Nations World Summit in 2005 and United Nations Economic and Social Council (ECOSOC) Ministerial Declaration in 2006 stressed the need to place “productive employment and decent work into economic policy making, recognizing that employment can no longer be considered a derivative of economic policy”.
The assertion by monetary authorities that by virtue of pursuing low inflation, there will be positive spill-over economic benefits is very questionable, especially since that will imply high interest rates- which depresses investment capacity, particularly that of private employers as the lending rates become unattainable (Mishkin, 2007).
COSATU (2007) said these deliberate surging of interest rates to curb inflation is frustrating government’s efforts of halving unemployment rate by 2014 as many investors will exercise a conscious approach to investment capacity when interest rates are high, since most of investment is funded through borrowing. The monetary authorities may argue against this assertion but the reality is that under such circumstances, potential new jobs are not realized because firms prefer to borrow when interest rates are lower due to cost-reducing reasons (Masemola, 2010).
Implications of inflation targeting policy on the economy Economic growth remained subdued particularly after the 2008/09 global economic downturn and unemployment levels remains chronically high during the past two decades. South Africa’s youth unemployment rate remains the third largest in the world at present.
This is primarily due to higher sacrifice ratio (positive trade-off between inflation and output, about 1.7 between mid-2000s and early 2010) and structural weaknesses that directly undermine growth and stifle the spillover effects of lowand stable inflation. Moreover, inflation targeting monetary policy does not seem to have succeeded in 29 anchoring inflation expectations around the target range by businesses and trade unions, although it succeeded to anchor expectations of financial analysts (Kumo, 2015). Under inflation targeting, the SARB has missed its official inflation target in 19 of the 37 quarters since the year for which the target was first set.
While this gives the lie to the accusations of COSATU and others that the Reserve Bank focusses too much on meeting its inflation targets, it also raises serious doubts around how successful the regime has been with respect to its primary goal, price stability (Veller & Ellyne, 2011). Recommendations The current moderate policy in the implementation of the inflation targeting should bemaintained, where the primary goal is to achieve price stability but should be cognisantof other crucial elements of the economy that affects society in general, for examplestabilising the business cycle and aspects of financial stability.
Stabilising the businesscycle contribute to stabilising output movements around the potential output. Inpractice and in most situations, this means taking a somewhat more gradual and moremoderate approach to monetary policy, aiming to achieve the inflation target at asomewhat longer horizon than would be technically feasible (perhaps three to fourquarters). It also means accepting that inflation will, in the short term, deviate, sometimes quite a bit, from the inflation target. The SARB should be more flexibletowards the attainment of the inflation target. Conclusion
This paper analysed inflation targeting policy and its implications on the South African economy. The SARB adopted the inflation targeting policy with the objective of maintaining consumer price index inflation between the targeted-band of 3 percent to 6 percent. Many economists around the world on the debate regarding the implementation of inflation targeting policy were in support of the implementation of the policy as it is associated with an improvement in overall economic performance. The inflation target policy has a number of benefits and that on its own has strengthened the SARB’s reason for the adoption of the policy.
Arguments against the policy have mostly come from COSATU as they feel that inflation targeting policy ignores the real side of the economy which is growth and employment. The implications of inflation target policy has been somewhat inconsistent since the inception of the policy, but since the global recession there has been a somewhat inconsistent trend in economic growth which was accompanied by a steady increase in unemployment.
List of sources
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