High Inflation, Same Solution

Published on 9th June 2008

Ultimately, all monetary policy must concern itself with the rate of domestic price inflation. This is true even when a central bank does not have a formal policy called “inflation targeting.” The South African Reserve Bank does have such a policy framework, which explicitly calls for the CPIX price index to increase yearly by three to six percent. The target itself is high, but reasonable and easy to achieve. Reserve Bank governor, Tito Mboweni, is quite correct to defend the policy against those who would dilute or confuse the targeting.

It is both a strength and weakness of explicit inflation targeting that there is not a specification of how (by what methods) the target is to be achieved and maintained. This flexibility allows the Bank to make periodic deviations from prudent practice in order to assuage the immediate concerns of some or other political interest group that might otherwise threaten to disrupt the future policy process. As long as CPIX growth remains near the lower end of the target range, there is room to play that game. But with price inflation now back in double digits – with CPIX growth of 10.4 percent to April – the game is being rather badly lost.

Those who believe that high inflation rates promote economic growth are fooling themselves. Some special interests can benefit, but over time, the whole country is harmed. If anyone should be called an “inflation nutter,” it is those who promote higher inflation, those who seek to shrink the value of their countrymen’s currency. Calling such people “nutters” is actually rather tame.

We know why the inflation rate is so high. The Reserve Bank is causing the amount of base money, M0, to increase too quickly. Whenever it does that, it can expect to fail to achieve its targets. Any talk of setting interest rates is just a guideline for how much money the Bank will create. The actual setting of interest rates is neither necessary nor desirable: the Bank has no way of knowing what interest rates “should” be. But that is how they operate. In order to hold interest rates higher in the short term, the Bank will reduce the rate of increase in the quantity of money. Reducing the rate of money growth is the essential element here. This will, in turn, reduce price inflation and interest rates.

Are there any excuses?

It is not the job of the Reserve Bank to manage the demand for goods and services. People are quite capable of deciding for themselves what and how much to buy. The Bank could make the job easier for everyone by maintaining the value of the currency, that is, by keeping the inflation rate low. Consumers don’t cause inflation; they just use whatever amount of currency is given to them.

Similarly, it is not the job of the Reserve Bank to manage the supply of goods, or to respond to changes in relative prices. When the price of oil rises relative to the prices of other goods, people will adjust their expenditures accordingly. The change might be a surprise, and the adjustments might be unpleasant, but this is not an excuse for increasing the quantity of money. Calling such an event a “shock” does not make it a special case. Although the adjustment process might bring a period of reduced economic growth, it is hard to find any such “supply shock” in modern history that might explain double-digit price inflation. What usually happens is that, fearing recession, the central bank panics and inflates the money supply. Then, when prices start shooting up, the Bank blames the “shock” rather than its own reaction to the shock. In other words, the rising price of oil does not cause inflation. Consumers can’t buy more of everything: if they pay more for one thing, they must pay less for something else.

What to do?

With real GDP growing at just over two percent, and the quantity of money produced by the Reserve Bank, M0, now growing at over 15 percent, we should not be surprised by double-digit price inflation. Even if GDP were growing five, or even seven percent per year, we should expect high price inflation. Money growth is the big factor.

High inflation is an impediment to economic and social progress. The Bank will have to slow the monetary growth rate. Whatever its short-term fears, the longer it waits to start the process, the worse will be the adjustment.

Suggestion to the Reserve Bank: bring M0 growth down to no more than 10 percent and leave interest rates to the market. That is the way to stay on target.

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