This article was first published by Business Day on 1 September 2024
One thing that all central banks have in common is that none of them knows what interest rates should be. Although the markets watch breathlessly after each monetary policy committee meeting for an announcement on the direction of the targeted interest rate, that is not a sign of central bank omniscience. Rather, it is a tacit admission that interest rates are a market phenomenon, a reflection of the availability of capital relative to demand, and that central banks cannot maintain targeted rates without the resources necessary to interfere in that market.
Although some central banks might have deposit and asset management functions, and regulatory powers, the essential feature that makes them central banks is their monopoly control over supply of the national currency. Pretensions of independence notwithstanding, all central banks are creatures of government. Their superpowers are an extension of government power, and their currency monopolies are rarely, if ever, natural.
Although institutional performances vary around the world, central banks are often the best run government institutions in their countries. But when the best run government institution is the one that gives you 5 percent inflation, you know you have a problem. Compared to other agencies, the Reserve Bank is tied rather closely to the consequences of its actions; it is harder to argue for higher inflation targets than it is to add a few million rand to the national budget and to the debt. Or to add another few million rand of regulatory compliance burdens. Indeed, with the tax and regulatory powers that come with the recent passage of the Climate Change Act, the sky’s the limit.
Just as the cultural context influences the nature of a government and its use of power, a central bank is, by extension, influenced by its current political and economic context. Government statutes that endow departments and agencies with vague mandates delegate bureaucratic powers that are much prized by special interests. When did a 6 percent, or even 3 percent, inflation rate become “price stability” – and who really benefits from this? And do we know the extent of the harm?
When a national government runs budget deficits such that the interest on the national debt is the largest and fastest-growing single item in the budget, there is clear pressure on a central bank to create new money to purchase (monetize) the new debt. The spending and deficits do not cause inflation, but the extra spending can accelerate the manifestation of any inflationary potential in the system. The real source of inflation is the central bank (in South Africa’s case, the Reserve Bank), and their decision to purchase a portion of new government debt is the link that connects government spending to inflation.
The Reserve Bank could target an inflation rate closer to zero and refuse to monetise any amount of debt that is incompatible with that goal – that would require the national government to sell its debt into a smaller market and would cause real interest rates to be temporarily higher than they would have been with monetisation. Higher interest rates would reflect a higher cost of capital and cause financial asset values to be lower than they would have been otherwise.
The Reserve Bank cannot create capital, but through its power of money creation it can redistribute purchasing power and induce the transient illusion that capital is cheaper and more abundant. That illusion can be maintained only with ever-increasing levels of inflation, a path that is unsustainable. To reduce the inflation rate, or even to hold it constant, would bring us closer to market reality, which for many people could be quite different from their current circumstances.
The ultimate cause of inflation is the desire to get something for nothing; that is also what causes governments to grow in size and reach. The levels of government spending and regulatory presence that are needed to protect people and their property, and to facilitate production and trade, are much smaller than what we witness throughout the world. To the extent that governments are used as vehicles for redistribution of income and wealth, government budgets and regulatory burdens expand. And with that expansion comes relatively more to be gained from political activity than from productive activity; some gain, more lose.
The pattern of redistributive trade-offs is always determined through the prevailing system of collective decision-making. The costs and benefits are political in a realm where perceptions are paramount. While one hand of government is seen to distribute social grants of cash, the other hand is on the inflationary throttle reducing the purchasing power of that cash. Inflation has long been known as a stealthy, regressive tax.
When an elevated inflation rate becomes a political liability, central banks like you to know that they are “fighting” inflation. The real solution? Stop causing it. The only fight is over how to manage the withdrawal symptoms as the economy recovers from the tightening.
The South African inflation rate has recently declined to just over 5 percent, and current monetary conditions are non-inflationary. If it is now Reserve Bank policy to bring the inflation rate down to 4.5 percent, it is easily positioned to do even better. By the first quarter of 2025, the narrative should be on whether a 3 percent inflation target is too high.
