Inflation Targeting: hearings

Meeting report

FINANCE PORTFOLIO COMMITTEE
1 March 2000
INFLATION TARGETING: HEARINGS

Documents handed out :
Submission by Nick Barnardt of Africa Merchant Bank
Submission by Iraj Abedian of Standard Bank
Submission by Michael Power of UCT
Submission by Neva Makgetla of Cosatu
Actuarial Society Of South Africa Memorandum on Budget

SUMMARY
There were mixed reactions to the envisaged process of inflation targeting in order to bring inflation down to between 6 and 3%. Assurances that this process would be nurtured in terms of political accountability and better management, were met by both scepticism and optimism.

Some felt that the possible negative impact of inflation targeting was being exaggerated by critics since it was only one of many processes aimed at improving the economy and creating stability in order to stimulate growth. On the other hand it was argued that growth had to come before stability, especially in relation to the high cost of capital in corporate South Africa. Thus whilst inflation targeting would reduce instability and volatility in the market, stability without growth would result in economic death. One view was that the gains associated with achieving the target of 3-6%, could not be justified by the pains such an exercise could involve especially if inflation rose above the current rate of 7.7%. Others criticised the adoption of inflation targetting as a fad. Some analysts felt that inflation targeting was being adopted without proper research and consultation. In countering this, the Department pointed out that the commitment to inflation targeting was not a new concept and had already been put before Parliament in 1999.

MINUTES
Assessments on inflation targetting were provided by: Nick Barnardt, Chief Economist of Merchant Bank; Iraj Abedian, Group Economist, Economics Division of Standard Bank; Michael Power, PHD candidate at the University of Cape Town and Neva Makgetla of COSATU (see their presentations).

Debate on Inflation Targeting
It was decided not to follow the normal question and answer procedure, but instead to have a debate, essentially amongst the panellists, the Director General, Ms Ramos and her deputy in the Finance Department.

Dr Nick Barnardt stated the need for accountability by the Reserve Bank if inflation targeting is to be followed through effectively. He criticised the manner in which the subject was brought to the committee as top down, rushed and undemocratic.

He generally agreed with the concept of Inflation Targeting but expressed concern at the way in which the target had been set. SACOB had put forward a figure of 5.5-6.5% and COSATU a figure of 6-8% which are in a very close range. These closely-ranged figures were an indication of the generally accepted level for inflation targeting. Thus the government's set figure of 3-6% indicated that government had not entered into much discussion about the topic with the result being an undemocratic decision.

Mr Barnardt broadly agreed with the concept but felt that it was imperative to block any decisions about the timing and details (such as the range) as no credible research documents looking at the costs, benefits and risks had been produced by the Department. He felt that South Africa, in making this decision, had compared itself to other countries using inflation targeting such as Poland, Australia and Canada, forgetting that South Africa had not reached the level of development of these countries.

He felt that not enough 'what if' scenarios had been looked into - such an inflation rise and a currency depreciation if there was a global economic upswing or imports rose and an economic upswing in South Africa occurred. He wanted to know to what extent the government was willing to go to meet these targets. Were they willing to smash growth and labour to reach these targets?

He expressed concern at the suspicion that government is trying out inflation targeting because it is what is being done by other Central Banks. He called on the government to remember that South Africa cannot compare itself to other countries such as the United States of America, which has a good basis of high employment and high growth to implement such policies.

Dr Iraj Abedian said that inflation targeting would be successful only under certain conditions. He felt that many Eastern European countries and Third World Countries have tried inflation targeting because it is the flavour of the day yet the notion of financial markets does not even exist in these nations. He believed that the question that needed to be asked was whether South Africa has the checks and balances in the financial regulation system to monitor and keep control. He felt that South Africa is globally credible in this regard. South Africa does have financial and fiscal architecture which allows for the more sophisticated monetary management which inflation targeting would require.

Dr Abedian stated that he was pro-inflation targeting but only in the light of certain conditions :
- He believed that the Reserve Bank and the Department of Finance would be forced to beef up their financial management and strengthen their capacity for fiscal management. In order for the inflation targeting system to be properly controlled though, the Department of Finance and the Reserve Bank would have to make independent assessments of the economy and would therefore be performing necessary checks on each other.
- Decisions should not be made by individuals, as they would be subject to certain whims and paradigms. (For instance Chris Stals' opinion that you cannot be half pregnant would mean that he would sanction very high inflation or no inflation at all). Inflation targeting should be institutionalised and there must be balances and checks to keep the process democratic when choosing a particular framework.

It should be remembered that South Africa is a small open economy not to be compared with the United States which is a large economy and therefore a different "beast to manage" and the policies should be set in line with this.

Mr Mapathla felt that Mr Barnardt comment about inflation targeting being given an undemocratic " rubber stamp" was unfortunate as it had been put before Parliament in 1999 for discussion. He felt that the Department was being unduly criticised when the decisions they had made in the past have resulted in lower inflation and interest rates.

He stated that the purpose of inflation targeting was to ensure that the economy would not be consumed by inflation and to protect poorer income from being depreciated.

Ms Ramos detailed the effects of inflation targeting which were amongst others to encourage growth by reducing the current account and budget deficits, both of which would result in sustainable levels of growth.

She disagreed with the statement that inflation targeting was being followed because it is the "flavour of the day" amongst policy makers but emphasised the fact that it was a change from the old way of "money supply" policy which no one understood anyway. She agreed with the need for the Reserve Bank to be accountable and saw the implementation of inflation targeting as one such means to achieve that accountability.

Mr Michael Power stated that from his experience in London, investors ranked countries according to:
Growth
Valuation
Liquidity (buying power)
Currency risk
Management( both macro and micro )

In light of this ranking procedure he portrayed himself as a "nasty capitalist" whose investment decision is primarily determined by the growth he expects to receive on his investment.

He said that while the argument that inflation targeting would reduce "mirror shake" (market instability and volatility) was important, the question of growth would also have to be resolved in order for the resulting stability to make any sense at all. Growth is the essence of the economy and stability without growth is the same as economic death.

He agreed that inflation targeting is good in that the "nasty capitalist" knows exactly what returns he will get on his investment but it only works when a structure is imposed which results in the correct prices being reflected in the market.

Dr Neva Makgetla was concerned at how targets were arrived and whether enough research and consultation conducted. She pointed out that it would be very difficult to assess whether the targets were set at the correct rate if information on how the targets were arrived at was not readily available. She asked the question "what happens if the current conditions change?" and whether enough research had been done to determine the effects such changes would have on employment and growth. She felt it was necessary for everyone involved to be aware of the assumptions made about growth and exogenous factors such as floods and petrol price increases.

Closing Arguments
Dr Abedian argued that South Africa cannot expect to have growth without stability, stability is a precursor to growth. Inflation targeting can crunch the economy if the Reserve Bank unwisely follows its past procedures of keeping a forward book and protects the currency from market determined devaluation. If however the Reserve Bank learns from its past mistakes, then inflation targeting can work.

Mr Barnardt stated that he agreed with the concept of Inflation Targeting but only if it was done in a democratically correct way. He emphasised again that the principle of inflation targeting should be approved but the implementation of the detail should be postponed until there was more discussion on it and a general not one-sided consensus was reached.

On the stability-versus-growth argument he felt that it was necessary to stabilise growth at 5% at least and grow the labour market before inflation targeting is meaningful.

He also felt that regular assessments on growth and labour had to be done to see if inflation targeting was having positive effects on the economy.

Ms Ramos agreed that growth was of primary concern but also pointed out that inflation targeting was merely one of the instruments of economic policy management - not the be-all of it.

She stated that the effects of exogenous shocks had been built into the set targets. She was satisfied that South Africa had the financial and economic architecture in place to introduce inflation targeting successfully. She felt that it was very unfair that people had the attitude that Australia and Canada could do it but "you down there in South Africa cannot!"

Mr Power emphasised that inflation targeting should not be used to reduce "camera shake" at the expense of other important objectives such as growing the economy. Inflation targeting is one of the important questions but it is not the big question, the big question is not what is the appropriate cost of capital? There is plenty of literature to show that reducing inflation from 20% to 10% is beneficial but a reduction below 10% will only be beneficial if other things, one of them being growth, are achieved.

Mr Mapathla pointed out that there had been interaction and consultation between the Finance Department and the Reserve Bank. The Reserve Bank preferred three years for the implementation of the system, while the Department of Finance envisaged two years.

He said it should be remembered that the Department was aiming at creating an environment of low inflation and interest rates and that their work was economic management (which touched all aspects of the economy including labour and debt) rather than portfolio management.

Dr Maketla closed by saying that she did not agree with the mindset of setting targets and then having faith or assuming that the institutions will change. She felt this was the wrong way to approach this as the institutions must first change and then targets can be set once the institutions can handle them.