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Economic Commentary: SA facing high inflation, low growth dilemma

Updated: Nov 25, 2018

Name :Mia Janse van Rensburg

Title of article:SA facing high inflation , low growth dilemma

Source:News24.com


SA facing high inflation, low growth dilemma

Oct 18 2015 10:56

Rene Vollgraaff

Johannesburg - The South African Reserve Bank’s interest rate tightening cycle doesn’t mean borrowing costs will be increased at every meeting of the Monetary Policy Committee, Sarb governor Lesetja Kganyago said.


“We accept that we are on a tightening cycle, but that does not mean that every meeting you will decide that you are hiking,” Kganyago told reporters late on Friday in Pretoria. “You have to watch the data all the time.”


The MPC kept the benchmark interest rate unchanged in September after raising by a full percentage point to 6% in three steps since January last year. While inflation of 4.6% in August was within the bank’s 3% to 6% target range, it’s forecast to exceed that goal in the first and fourth quarters of next year. The economy will probably expand by 1.6% compared with an estimated 1.5% this year, according to central bank forecasts.

“The data tells us we are facing a policy dilemma of rising inflation and low growth,” Kganyago said. “That makes the balancing act of the Monetary Policy Committee tricky.”

While the central bank has said the rand is the biggest risk to the inflation outlook, the pass-through of the weaker currency to price growth has been less than anticipated, according to Brian Kahn, a MPC member and adviser to Kganyago.


The rand reached a record low of R14.1599/$ on September 29. It closed 0.3% weaker at R13.0851 on Friday, paring its decline for the year to 12%.


The Reserve Bank won’t intervene in the foreign-exchange market to determine the value of the rand, Kganyago said. The currency’s decline has served as a “shock absorber” for the economy, he said.


The US Federal Reserve’s decision to delay its monetary policy tightening until possibly next year has helped to underpin the rand. The Fed’s recent communication about policy has been clear and consistent after it gave mixed signals about rate normalisation in 2013, Kganyago said.

SA facing high inflation, low growth dilemma. (Stagflation)

This article is about the about the South African Monetary policy committee facing a particular policy dilemma of rising inflation and low growth/high unemployment. The deputy governor of the central bank describes this as a tricky balancing act and he indicated that they are in a tightening interest rate cycle. The focus of the central bank’s monetary policy is inflation targeting in a narrow band of 3-6%.


Monetary policy refers to actions of a central bank determining the size and rate of growth of money supply which in turn affects interest rates. The objectives are normally to promote stable prices (low inflation) and increase Gross Domestic Product (GDP) and employment. Inflation is an increase in price level of a country’s goods and services over time. This can be a result of strong growth in demand (demand-pull) or cost-push inflation.


The central bank can have a Contractionary or Expansionary monetary policy, depending on the objective at the time. The South African government clearly indicated that they are following a Contractionary policy, aiming to reduce the money supply and increase interest rates in order to keep the inflation rate in the targeted band. Fig 1 shows how limiting the money supply will increase interest rates and decrease AD to AD1.











Evaluation -

The key question is whether monetary policy on its own can be effective in dealing with the stated dilemma. South Africa is facing a slowdown in GDP growth indicating that high inflation is not caused by demand pull inflation but rather by cost push factors such as an increase in labor costs and raw materials. These factors will increase the cost of production and shift the nation’s SRAS to the left (SRAS2) shown in figure 2.














A further complication of cost push inflation is that it increases unemployment and reduces output from YFEto Y1.


The effect of monetary policy for nations experiencing cost push inflation is shown in Fig 3 below.















The SRAS curve shifts to the left from SRAS1to SRAS2with the effect of prices moving up from PEto P1and output dropping from YFEto Y1. The monetary policy intervention through higher interest rates then moves the AD curve from AD1 to AD2, decreasing prices from P1to P2but with a further output drop from Y1to Y2. The net effect is that prices move up from PEto P2 with output reducing from YFEto Y2.


Advantages of using monetary policy under these circumstances include a reduction in inflation by dampening demand. Price stability also provides the platform for growth in the longer term. Finally, inflation targeting through interest rates is flexible, quick to implement and easily reversible.


Disadvantages include the fact that demand side policies are not that effective for cost push inflation as output is reduced even further from Y1 to Y2. An increase in interest rates will result in firms having more difficulty to establish a line of credit at a higher cost of borrowing. Firms will find it more difficult to expand. The effect of interest rates on inflation also takes some time to occur and is not immediate.


Conclusions

Monetary policy on its own is not enough to address a low growth and high inflation scenario. Inflation targeting will result in a drop in output and the demand side policies need to be supplemented by supply side policies to increase the productive capacity of the country and increase the aggregate supply from SRAS2to SRAS1to return to full employment (YEto YFE). This is indicated in Fig 4 below.














In circumstances where the equilibrium price levels (PLE) are high and increasing with output below full employment (YE), monetary policy on its own could drive the country into recession. Supply side policies which push SRAS2to the right to SRAS1are required resulting in pricing easing to PL1and the economy going to full output at YFE. Supply side policies could include policies to encourage competition, like deregulation, privatization and trade liberalization. The notion is that more competition encourages better productivity and lower prices. Other supply side policies could include labor market reforms to make the market more responsive to supply and demand, or incentive related policies where a reduction in tax could encourage higher productivity and the expansion of the business.


Bibliography:

http://www.fin24.com/Economy/SA-facing-high-inflation-low-growth-dilemma-20151018

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