The decision by the Reserve Bank’s monetary policy committee to increase interest rates by just 0.25%, rather than the 0.5% increments it has used in the past, highlights the difficulties policy makers face when rising inflation coincides with stagnant economic growth. Such conditions, known as stagflation, suggest conflicting policy responses.
Controlling inflation demands higher interest rates and reduced government budget deficits. Slow economic growth requires the opposite. Achieving an appropriate balance is very difficult.
Until the 1970s, most economists expected inflation would rise mainly during times of rapid economic growth. This belief was given empirical support by the Phillips Curve, which suggested that, historically, reduced unemployment was accompanied by higher inflation.
This was because rapidly growing economies generated new jobs faster than their supply of labour could match. This labour shortage drove wages up, which in turn meant upward pressure on prices. Prices of other inputs also rose as demand outstripped supply.
This historical analysis indicated to policy makers that they had to choose between higher inflation and lower unemployment, or lower inflation and increased unemployment. Unsurprisingly, most governments preferred the politically more popular choice of lower unemployment and higher inflation.
But in the 1960s, this apparent trade-off between inflation and unemployment began to disappear. Inflation rose even in stagnant economies where unemployment was rising. Following the oil price shock of 1973, stagflation became widespread. Today, most economists see the trade-off between inflation and unemployment as temporary. Over time, the Phillips Curve is vertical — there is no benefit to be gained for employment in the long term by allowing inflation to rise.
SA is experiencing stagflation. Inflation has risen above the 6% target set for consumer prices and economic growth has stalled. Economic weakness is being made worse by strike action. But even without strike-related disruptions, SA’s growth would be unlikely to match population growth.
We have no chance of raising economic growth to the required levels of 5%-6% a year to meaningfully reduce unemployment and raise living standards.
Yet raise economic growth we must because global experience shows how difficult managing the economy becomes once stagflation becomes entrenched. The US endured more than a decade of stagflation until then Federal Reserve chairman Paul Volcker took drastic action and sharply raised interest rates in 1979. Inflation fell, but economic growth remained very weak and it was not until 1983 that the US and global economies started to grow more rapidly.
Inflation in the US and most of the world has been subdued ever since. It is sobering to note that inflation in SA is now substantially above the 5.5% the International Monetary Fund (IMF) estimates emerging economies will experience on average this year. Inflation in developed economies will be just 1.5%.
Our growth this year will be only one-third of the 5.4% the IMF expects for sub-Saharan Africa. Such poor performance means our policy options are narrowing. The government is trying to reduce its budget deficit as the interest it must pay on the borrowings incurred to fund past deficits now leaves little scope for other essential spending.
The government is also concerned that increasing debt further will make it harder for it to borrow. This will mean higher interest charges on borrowings, aggravating the pressure on non-interest spending obligations. The only option is to reduce the deficit slowly because the other means for doing this — raising taxes or cutting spending — could precipitate further weakness.
The Reserve Bank has only one instrument to combat rising inflation — interest rates. But it is concerned about the potential damage of a sharp rise in interest rates. This is because households are highly indebted. An increase in rates — especially on mortgage loans — will leave households less to spend on consumption items.
SA is between a rock and a hard place in policy choices, but doing nothing is also risky. If inflation rises further, it will undermine confidence that the authorities have the will to keep it within the agreed limits of 3%-6% over the long term. This could set off rising interest rates in the long term. The Bank’s recent decision represents its best attempt to balance these competing imperatives.
Urgent attention must now be given to reviving economic growth. This requires an end to strikes and increasing our exports. Unless growth recovers soon, SA could find itself structurally trapped between the pincers of slow growth and high inflation. The policies required to escape such a trap will be much more painful than what is needed to address the problems now.
Picture Caption: Reserve Bank governor Gill Marcus announces the monetary policy committee's decision on interest rates in Pretoria on Thursday. Picture by: PUXLEY MAKGATHO
By Gavin Keeton
Keeton is with the economics department at Rhodes University.
Article Source: Business Day