The global crisis and monetary policy

In South Africa, there has been considerable focus on inflation targeting. The debate has generally revolved around the impact of monetary policy on domestic growth. Globally, there has also been a renewed focus on inflation targeting, but for very different reasons.

The argument put forward by, amongst others, Bill White, formerly of the BIS, argues that inflation targeting contributed to the global crisis precisely because it was too successful. The period of the 2000s was one where global inflation was low and, in terms of the narrow focus on inflation, it meant that central banks could keep interest rates at very low levels.

These low interest rates, the argument goes, led to excessive credit extension and asset bubbles in the housing and equity markets, and to the lending excesses that ultimately caused or exacerbated the crisis. In other words, by focusing too narrowly on inflation, monetary policy ignored the financial stability implications of low interest rates.


This throws the issue of financial stability squarely into the monetary policy arena. What should the appropriate policy have been under these circumstances? Bill White argues that it means that interest rates should have been higher than they were, and this would have prevented the need for such low interest rates later on.

In other words, monetary policy should have a clear financial stability mandate, which is part of the objective function of the Bank.

Others, however, have a different take on this. Firstly it is argued that higher interest rates on their own would not have prevented the credit excesses, and they have been prohibitively high.

The alternative then is to assign different instruments to the financial stability objective while maintaining the interest rate for the broader monetary policy objective. But it is not immediately obvious what these tools are and how effective they will be.

In a recent review of macroeconomic policy issues, Olivier Blanchard and others of the IMF argue that previously discarded tools need to be reactivated and used for focused intervention, even though they may be partially circumvented.

Such tools include reserve requirements, contra-cyclical capital requirements on banks, and loan-to-value ratio restrictions.

A related question is: who should be responsible for financial macro-prudential oversight? Should this be a central bank role, a separate entity or a joint role? If it is a central bank role, does it form part of the mandate of the Monetary Policy Committee (MPC), and how does it relate to the Bank’s supervisory role over the banking system?

These are important questions currently being explored by central banks, and there is no simple or correct answer. Our own view is that the central bank already has an implicit financial stability mandate, and there is widespread expectation that, should a systemic financial or banking crisis occur, the central bank has, and would be expected to have, a key role to play.

Secondly, central banks already compile and analyse much of the macroeconomic data of a country. However, should a financial stability mandate be made explicit, a way needs to be found for co-ordination with government. Our suggestion, at this stage, is that while the compilation of data and analysis would primarily be the responsibility of the central bank, a financial stability committee co-chaired by the Governor and the Minister of Finance could be considered.

These issues have been the focus of much discussion at the bi-monthly BIS meetings. While there is broad agreement that monetary policy should have some focus on macro-prudential issues, there is far less agreement on the application and efficacy of these proposed policy tools. In fact, there is surprisingly little knowledge or agreement.

Much of this is unchartered territory, and we do not really know what instruments to use, how to separate micro- and macro-prudential instruments and banking oversight.

It is also clear that in future the conduct of monetary policy, even within inflation targeting mandates, will need to have a more pro-active financial stability focus.

The idea that central banks cannot recognise or pop asset price bubbles, and that they should only take them into consideration to the extent that these bubbles impact on the inflation outlook, is overly simplistic. Until now the conventional wisdom has been that the best that monetary policy can do is to clean up the mess after the bubble has popped.

The recent cleaning up that central banks and governments have had to undertake in the aftermath of the crisis points to a need for a reconsideration of this issue.

Although there will be more focus on financial stability issues in future, it will not be at the exclusion of other objectives, and we will continue to implement inflation targeting in a flexible manner. This means that while our primary objective remains the containment of inflation, it is not to the exclusion of factors such as growth and employment.

Furthermore, if inflation is expected to remain within the target, monetary policy will have greater flexibility to focus on growth issues, particularly when the growth rate is below potential. This is entirely consistent with a flexible inflation targeting environment.
But we also have to recognise the limits to our impact on growth. Monetary policy can and does affect cyclical growth around long run potential output growth. In other words, we can affect the size of the output gap by impacting on cyclical growth. However, our impact on potential output itself is limited - this is really the job of micro-economic policies.

These include industrial and trade policies, investment in infrastructure and physical capital, technological innovation and productivity, and the quantity and quality of labour.

Low inflation or price stability can contribute to long-term growth by providing greater stability and reducing uncertainty, which will be positive for longer term investment. However we cannot buy more growth with high inflation, and we cannot expect monetary policy to solve what is essentially a structural unemployment problem in the economy.

There is increasing recognition that emerging market economies are, in effect, being forced to adjust to disequilibrium positions in the advanced economies where abnormally low interest rates are still prevalent.
There is also an expectation that these low rates are likely to persist for some time. The resultant search for yield, particularly when risk aversion is low, has seen a wall of money moving into emerging markets, with consequences for their exchange rates.

Year to date has seen non-resident purchases of South African bonds and equities totalling around R35bn, and the consequent impact on the exchange rate. This can be compared with net sales of R76 billion in the second half of 2008 and net purchases of R90bn for 2009.

The fortunes of the rand exchange rate followed these trends.

There is little doubt that the rand exchange rate is one of the most volatile currencies, and is also currently assessed to be overvalued by many market participants and analysts, including the IMF. However, estimates of the degree of overvaluation differ markedly.

The Bank has continued to buy foreign exchange as part of its strategy to increase the level of foreign exchange reserves. Despite significant foreign currency purchases at times, the rand has remained at elevated levels on a trade-weighted basis, but the cost of sterilisation has been significant, given the wide interest rate differential.

One of the consequences of these interventions, and building up the gross foreign exchange reserves of the country to US$42 billion, is that the SARB will report an after-tax loss of around R1billion for the financial year 2009/10.

Past experience has shown that the response of the rand to lowering or raising interest rates is unpredictable, and it has previously responded by both appreciating and depreciating for varying periods of time.
However, the recent rand strength has resulted in an improved inflation outlook, which in turn gave room for a further rate reduction. While we do not target the exchange rate, we would want to see the rand at a stable and competitive level.

Source: The Outlook for Monetary Policy, Gill Marcus,Governor of the South African Reserve Bank
to the Bureau for Economic Research, 22 April 2010