Beware of half-baked ideas on interest rates

The tools of monetary policy are, by design, limited, says the writer

The Reserve Bank's Monetary Policy Committee (MPC) decision to hike policy rates by 50 basis points to 8.25% last month received several criticisms. 

Analyst Duma Gqubule asserts that the Bank's decision was irrational and was political suicide that could trigger a recession before the 2024 elections. Instead, the Turkish economy and President Recep Tayyip Erdoğan are revered by the author as role models to follow.

There are several flaws to this thinking and the conclusions drawn. Those persuaded by these views must be careful not to treat the economic cancer that reduces job creation with morphine — populist short-term relief that proposes cutting interest rates and instituting a permanent basic income grant that does not solve the underlying cause of the cancer.

Eventually, when the morphine ends, the economy will collapse with dire consequences for recipients of grants and those with jobs. Worse still, those still looking for jobs will have their chances reduced to zero.

Let’s walk through the Reserve Bank's so-called irrationality.

Inflation shot up above the 3%-6% target. Yes, initially supply constraints were the reason for the spike in goods inflation. This eventually translated into services inflation when the pandemic stimulus packages and reopening of economies spurred demand.

Thus, in the end, headline inflation ended up having both supply and demand drivers which were not transitory. In any case, whether inflation is demand or supply side is neither here nor there as far as its impact is concerned. Its effects are the same: it erodes the value of the currency and of social grants that are already inadequate.

The tools of monetary policy are, by design, limited. The main monetary policy tool at the Bank's disposal is the repo rate, which has been proven theoretically and in practice across different countries to be effective in controlling inflation. Advocating an untested solution to bring inflation down is akin to asking a brain surgeon to use a spade to remove a brain tumour. There is a high probability that would kill the patient.

Was the Bank's decision irrational? No.

The truth is that the rand weakened to a record high due to the uncertainty around allegations that South Africa sold arms to Russia. That is a recent development. The more structural domestic driver has been load-shedding, which has a high correlation with the weakness of the currency.

In simple terms, if the central bank hikes rates and stabilises the rand, the cost of imports also stabilises. As a result, the current account deficit would not be as wide as it would be with a much weaker currency, which implies that there are fewer funding requirements that would weaken the currency.

Is the Bank at fault for the weak economy or the lackadaisical job market? No.

The Bank is not responsible for energy, logistics, health, education or safety and security. Yet, these are some of the biggest constraints on economic growth, in a long list.

The tired view that the Bank must go out of its mandate to try to engineer economic growth with methods that have been proven many times to be flawed reflects the dangers of little knowledge, a paraphrased saying attributed to Alexander Pope in An Essay on Criticism.

Suppose this thinking is allowed to live in our discourse. In that case, we might as well ask the Reserve Bank to deploy its staff to arrest people for corruption, teach language in classes and fix our rail lines — functions they would surely fail at spectacularly because they are not trained for them.

To be clear, I am not saying there must not be a debate on the Reserve Bank, its mandate, and the effectiveness of its instruments. The debate must happen.

However, as we have seen, tweet-size text cannot be the basis of structural reforms; there is just not enough space to discuss even the assumptions. Arguments must be presented, the evidence put forward, and the underlying data and modelling framework must be explained and available for replication.

The arguments presented so far in criticism of the Bank's response to the inflation surge barely require a response. But for the unsuspecting and those policymakers who are less accustomed to monetary policy, it is necessary to warn them of the dangers of half-baked panacea solutions to our most pressing issues.