FNB: Rex Column: Continuity at the Reserve Bank

Technically, Governor Marcus continued the innovation of her predecessor by relying on a Monetary Policy Committee to regularly meet, discuss and vote on interest rate changes, if any, using a flexible inflation targeting framework as originally agreed with and only recently reconfirmed by National Treasury.

In terms of this policy framework, the SA Reserve Bank tends to practically follow a simple Taylor Rule, aiming to anchor its interest rate setting to an appropriate, stable real interest rate, while simultaneously attempting to address possible output and inflation gaps currently present in the economy within a two year horizon.

Thus the Reserve Bank policymakers continue to take into account the state of the economy and international developments having a bearing on the likely inflation environment over the coming two year horizon.

The Reserve Bank bases its interest rate decision on its inflation forecast and any perceived risks thereto.

The Reserve Bank aims to achieve CPI inflation of 3% to 6% over the two year horizon. To the extent that its inflation forecast projects such an achievement, it accepts its interest rate stance to be correct, with no immediate need to change it.

But besides the actual inflation forecast, as an ultimate check, the Reserve Bank also expresses a sense of how it sees the balance of risks of its forecast actually materializing.

With the forecast projecting inflation inside the target over a two year period and with risks ‘balanced’, no need for a change in interest rate levels is foreseen.

With the forecast projecting inflation inside the target, but with the balance of risks increasingly to the downside, the possibility of policy easing presents itself, always according to the judgment of the Monetary Policy Committee, MPC, as to how such a change in policy stance might change the actual outcome of the inflation forecast and the extent to which this is to be welcomed.

Similarly, with risks increasing to the upside, with the possibility of the actual inflation reality moving outside the target, the MPC may decide to propose a tightening in the policy stance.

Last week continued to offer a rich diet of mixed messages on all these scores, potentially tempting the MPC but it ultimately unanimously voting for no change to the policy stance.

As per the MPC statement released afterwards, the following ingredients were present:

• on current trends the CPI inflation rate is expected to be just within target (between 5.5% and 6%) for most of the next two years, meeting the SARB main objective.
• features were identified as being neutral to the inflation forecast (external mainly, but also fairly benign administered price inflation of 5.5% excluding electricity).
• some features offered downside risk (the firm Rand, easing food inflation, the weak economy with a large output gap and an initially slow recovery expected through 2010).
• as to upside risk, only two were mentioned, namely the uncertainty surrounding high electricity tariff increases these next two years and any second round effects emanating there from, and still worryingly high wage settlements.

The risk posed by the high uncertainty surrounding electricity tariff increases and its effects on the inflation outcome, along with the uncertainty relating to near future wage behaviour, was seen as balancing out the neutral and positive risks to the inflation forecast.

That cast the die in favour of keeping rates unchanged.

Going forward estimation of output and inflation gaps and perceived risks to these forecasts is bound to change at future MPC meetings.

Extracted from the FNB Rex Column, 23 November 2009