Dawie Roodt | Kganyago is absolutely right about inflation targets
Various views
Economist Dawie Roodt defends the South African Reserve Bank's inflating targeting stance
A widely held view is that inflation is mostly "caused" by administrative prices and that by increasing interest rates, the SA Reserve Bank (SARB) punishes the wrong people.
As Garth Theunissen set out in a column this week, the argument is that a lower inflation target will be too costly to the economy because interest rates will have to be higher for longer. Those pesky administrative prices are immune to interest rates, which means that we will have inflation and higher interest rates will not help.
This is dead wrong.
Before I unpack my arguments, it is important to understand why inflation is bad. We all know that inflation hurts those on a fixed salary, that it leads to higher prices, that money loses its value, it’s bad for savings, and so on. But the single most important reason why inflation is bad is often not mentioned.
Inflation distorts the allocation process of scarce resources in the economy, and high inflation will always result in low economic growth. Prices that change are crucially important for an economy to function properly. Changing prices are like signals, telling us what, when and how much to produce and consume. But when all prices go up (inflation) we can’t "see" the signals, resulting in a suboptimal allocation of resources and weak economic growth.
Interestingly, in the old Soviet Union all prices were fixed, and the allocation of resources was done by committees of economists who naturally got the allocation process mostly wrong. The result was the eventual collapse of the Soviet Union!
One definition of inflation is: "Inflation is the continuous increase in the prices of most goods and services".
But a definition I prefer is: "Inflation is the continuous fall in the value of money".
Although these two definitions sound similar, there are important differences.
With the first definition, the emphasis is on prices that go up, which then results in inflation.
This definition is popular because it pinpoints a "reason" for inflation, and means that administrative prices can be blamed for inflation.
What is wrong about this argument is that the increase (or a few) in prices is not inflation. When one price (or set of prices) increases and other prices decrease with the same magnitude, then the impact will be zero on inflation. Remember, inflation is the increase of "most" prices. That is why the increase in, say, the petrol price is not inflation. It only becomes inflation if this increase becomes a process. And it is this process that the SARB tries to slow down by increasing interest rates.
By increasing interest rates, the SARB forces the rest of the economy to take the inevitable pain (of an increase in the petrol price, for instance), whether it is the consumer's fault or not. It is irrelevant if we don’t have "excessive" demand in the economy.
That is why I prefer the "money loses value" definition of inflation, because the emphasis is exactly where it is supposed to be, namely on the value of our currency, and it is the SARB's responsibility to protect the value of the rand.
The SARB does extensive research on which prices change in the economy. And there is value in knowing whether inflation is supply- or demand-driven, for example. This allows the SARB to improve on their timing and magnitude in changes in monetary policy. But "where" inflation comes from is not really that important; inflation is inflation and it is always bad.
And that is why I absolutely agree with the governor of the SARB, Lesetja Kganyago, that the inflation targets should be reduced. And yes, it will result in interest rates staying a bit higher for longer. But eventually, the SARB will force inflation and inflation expectations lower, improving the growth potential of the economy.
I also prefer a point target because the upper end of the band usually becomes the target. That is why the SARB targets the mid-point of the band, namely 4.5%. I would also like to see the inflation target reduced to an initial 4% and then gradually and eventually lower to 2%.
But Theunissen is right in pointing the finger to administrative prices. Admin prices often add to the process of inflation and are a major reason why the SA macroeconomic environment is highly unproductive. Admin prices are things like Eskom price increases, petrol price increases and various tax increases by, for example, local authorities.
These entities can increase prices basically unhindered because they are not, like most of us, forced by market forces to be disciplined. These prices are typically determined by some silly committee or a bunch of ineptocrats and politicians that simply increase prices because they can.
By increasing interest rates, when necessary, the SARB also identifies those bad actors in the economy that really cause the pain. We must understand that an inefficient, incompetent and often corrupt administration is a major contributor to inflation and high interest rates, and that we consumers will always pay the price for their mismanagement.
All this would have been much worse if we had much higher inflation on top of all our other problems.
*Dawie Roodt is the chief economist of the Efficient Group.**
As Garth Theunissen set out in a column this week, the argument is that a lower inflation target will be too costly to the economy because interest rates will have to be higher for longer. Those pesky administrative prices are immune to interest rates, which means that we will have inflation and higher interest rates will not help.
This is dead wrong.
Before I unpack my arguments, it is important to understand why inflation is bad. We all know that inflation hurts those on a fixed salary, that it leads to higher prices, that money loses its value, it’s bad for savings, and so on. But the single most important reason why inflation is bad is often not mentioned.
Inflation distorts the allocation process of scarce resources in the economy, and high inflation will always result in low economic growth. Prices that change are crucially important for an economy to function properly. Changing prices are like signals, telling us what, when and how much to produce and consume. But when all prices go up (inflation) we can’t "see" the signals, resulting in a suboptimal allocation of resources and weak economic growth.
Interestingly, in the old Soviet Union all prices were fixed, and the allocation of resources was done by committees of economists who naturally got the allocation process mostly wrong. The result was the eventual collapse of the Soviet Union!
One definition of inflation is: "Inflation is the continuous increase in the prices of most goods and services".
But a definition I prefer is: "Inflation is the continuous fall in the value of money".
Although these two definitions sound similar, there are important differences.
With the first definition, the emphasis is on prices that go up, which then results in inflation.
This definition is popular because it pinpoints a "reason" for inflation, and means that administrative prices can be blamed for inflation.
What is wrong about this argument is that the increase (or a few) in prices is not inflation. When one price (or set of prices) increases and other prices decrease with the same magnitude, then the impact will be zero on inflation. Remember, inflation is the increase of "most" prices. That is why the increase in, say, the petrol price is not inflation. It only becomes inflation if this increase becomes a process. And it is this process that the SARB tries to slow down by increasing interest rates.
By increasing interest rates, the SARB forces the rest of the economy to take the inevitable pain (of an increase in the petrol price, for instance), whether it is the consumer's fault or not. It is irrelevant if we don’t have "excessive" demand in the economy.
That is why I prefer the "money loses value" definition of inflation, because the emphasis is exactly where it is supposed to be, namely on the value of our currency, and it is the SARB's responsibility to protect the value of the rand.
The SARB does extensive research on which prices change in the economy. And there is value in knowing whether inflation is supply- or demand-driven, for example. This allows the SARB to improve on their timing and magnitude in changes in monetary policy. But "where" inflation comes from is not really that important; inflation is inflation and it is always bad.
And that is why I absolutely agree with the governor of the SARB, Lesetja Kganyago, that the inflation targets should be reduced. And yes, it will result in interest rates staying a bit higher for longer. But eventually, the SARB will force inflation and inflation expectations lower, improving the growth potential of the economy.
I also prefer a point target because the upper end of the band usually becomes the target. That is why the SARB targets the mid-point of the band, namely 4.5%. I would also like to see the inflation target reduced to an initial 4% and then gradually and eventually lower to 2%.
But Theunissen is right in pointing the finger to administrative prices. Admin prices often add to the process of inflation and are a major reason why the SA macroeconomic environment is highly unproductive. Admin prices are things like Eskom price increases, petrol price increases and various tax increases by, for example, local authorities.
These entities can increase prices basically unhindered because they are not, like most of us, forced by market forces to be disciplined. These prices are typically determined by some silly committee or a bunch of ineptocrats and politicians that simply increase prices because they can.
By increasing interest rates, when necessary, the SARB also identifies those bad actors in the economy that really cause the pain. We must understand that an inefficient, incompetent and often corrupt administration is a major contributor to inflation and high interest rates, and that we consumers will always pay the price for their mismanagement.
All this would have been much worse if we had much higher inflation on top of all our other problems.
*Dawie Roodt is the chief economist of the Efficient Group.**
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