To understand conventional monetary policy dynamics, imagine a central bank as a person vertically balancing a metrestick (inflation) only using the fingertips on one hand as a metaphor for interest rates. As the metrestick leans forward, the central bank must swiftly move its hand in the same direction to push the stick back to equilibrium. The opposite happens when the metrestick tilts backwards.
Acting decisively is crucial, as hesitation could lead to a catastrophic loss of control. Thankfully, the SA Reserve Bank is fully autonomous, providing it with the freedom to execute its balancing act.
Let’s rewind to the 2007-09 global financial crisis, to see a prime example of how the SA Reserve Bank performs this balancing act. As South Africa’s inflation surged from 6.7% in August 2007 to 11.3% in August 2008, the SA Reserve Bank fearlessly raised the interest or repo rate, from 9% to 12.00%, effectively combating the spiralling inflation. When inflation cooled down to 2.9% in September 2010, the SA Reserve Bank gracefully lowered the repo rate from 12% to 5.25%, restoring stability.
Unconventional US policies
However, across the Atlantic, the US was embarking on a journey of unconventional monetary policies in response to the global financial crisis and the looming global recession period. In a desperate attempt to stimulate the economy, the US slashed interest rates from 5.25% to 0.25% between September 2007 and January 2009, and since interest rates cannot go below 0%, the Federal Reserve began to implement what is known as quantitative easing and forward guidance.
According to my example of the balancing act, the act of reducing interest rates when inflation is rising is similar to tilting one’s fingertips backwards when the metrestick is tilting forward. The counterforce should push inflation (or the metrestick) forward. Bafflingly, instead of raising inflation, the Federal Reserve’s actions plunged it close to zero, defying conventional theory.
The recent Covid period only added to the confusion, as the Federal Reserve once again conducted unconventional monetary policy and dropped interest rates to close-to-zero levels to stimulate their economy due to the global shutdown. Despite expectations of increased inflation, rates remained stubbornly low. The traditional monetary policy dynamics seemed lost in the wind, leaving us scratching our heads.
Fast forward to the aftermath of the Ukraine-Russia war, where the oil price shock increased inflation beyond 2%, causing the US to abruptly raise interest rates from 0.25% to a staggering 5.25%. The response was paradoxical as inflation soared to a peak of 9.1%, defying expectations. The US monetary authorities seemed to have lost their compass, misunderstanding the cause-and-effect relationship between interest rates and inflation.
It would appear that the interest rate-inflation dynamics in the US have changed since their implementation of the unconventional monetary policy during the global financial crisis, and this has led to a perplexing situation where inflation appears to respond positively to interest rate movements, contrary to conventional theory. In other words, the causality between them is misconstrued.
To visualise this, picture US monetary policymakers not as a person balancing a metrestick on their fingertips, but rather as holding the metrestick upside-down, like a pendulum. When they swing their hand forward, it propels inflation forward instead of correcting it. Therefore, when inflation increases and interest rates are raised, inflation may temporarily fall but will eventually follow the direction where interest rates are being pushed. The obvious solution would be to cease the arm-swinging, allowing the metrestick to settle at a stable equilibrium. Alas, the US monetary authorities persist in increasing interest rates, ignoring the warning signs.
Grappling with the consequences
But why should South Africa or anyone else care about US monetary policy dynamics? Picture a bamboo raft floating on calm waters carrying several central bankers balancing their own metresticks. The weight of the major central banks, such as the US, UK, and EU, when balancing their own metresticks, causes ripples that destabilise the entire vessel. Other smaller central banks, like South Africa’s, are left grappling with the consequences, making their own balancing acts even more complicated.
The unnecessary interest rate hikes by the US, driven by a flawed understanding of inflation dynamics, force other central banks to follow suit. Ignoring this will only create an interest-rate gap in favour of the US, leading global investors to abruptly remove their capital from developing and emerging economies, thus destabilising financial markets, exacerbating exchange rate pressures and fuelling inflation.
Since the Russia-Ukraine war, the US has hiked interest rates to combat inflation a staggering 10 times. Notably, African countries which have not been able to juggle domestic pressures alongside international monetary adjustments have mutually suffered skyrocketing inflation and plummeting exchange rates.
Consider a relatively strong economy like Ghana, which experienced inflation surging from 13.9% in January 2022 to a jaw-dropping 42.2% in May 2023, and the currency tumbling from ¢6.15/$ to a dismal ¢11.54/$ over the same period. Similarly, Nigeria saw inflation climb from 15.6% to 22.4%, while the exchange rate deteriorated from ₦410/$ to ₦816/$.
Likewise, inflation in Egypt soared from 7.3% in January 2022 to a shocking 32.7% in May 2023, with the Egyptian pound crumbling from E£15.72/$ to a pitiful E£30.91/$. Other African nations like Ethiopia, Malawi, Sierra Leone, Sudan and Zimbabwe (the epitome of catastrophe!), present similarly dire circumstances.
Meanwhile, the SA Reserve Bank has vigilantly tracked US monetary policy, adjusting interest rates 10 times in small increments since 2022 and has managed to contain inflation, which modestly fluctuated from 5.7% in January 2022 to 6.3% in May 2023, while the exchange rate slightly depreciated from R15.31 in January 2023 to R18.45 over the same period. Even amid domestic obstacles such as load shedding and fiscal indiscipline, the SA Reserve Bank’s performance remains commendable, exemplifying the true essence of central bank resilience.
And beyond the borders, South Africa’s neighbours, such as Eswatini, Lesotho and Namibia, which have their interest rates pegged with that of the SA Reserve Bank, have, by default of their currency union, mutually benefited in containing inflation as none of their current inflation exceeds 6.4% in May 2023.
We need to acknowledge the SA Reserve Bank’s herculean task and cease undermining their independence. Its ability to maintain balance amid adversity is unparalleled, warranting nothing less than an A grade for Governor Lesetja Kganyago and his team. As the youth would say, the SA Reserve Bank should be “given its flowers”.
It’s time to give credit where credit is due and show some well-deserved respect for their exceptional achievements. DM