One of the most profound consequences of the global financial crisis has been the complete revision of the intellectual basis of monetary policy and the role of central banks. In a sense it is a repeat of history as monetary theory and policy have tended to develop in fits and starts rather than follow a smooth trajectory, responding to crises as and when they occurred.
No aspect of monetary policy seems to have escaped being disputed.
- The mandate and objectives of monetary policy have been questioned fundamentally, starting with a singular focus on low and stable inflation as applies to, for example, inflation targeting. It has even been suggested that the conduct of monetary policy solely with reference to inflation while ignoring its implications for financial stability contributed to causing the crisis. There is now a strong school of thought that monetary policy needs to take cognisance of multiple objectives and not only inflation. Furthermore, a clear distinction is now being made between micro and macro financial supervision, with central banks being given the responsibility for macro-prudential oversight of the financial system.
- The instruments of monetary policy were expanded with quantitative easing being added to its arsenal of policy interest rates, partly because pursuing multiple objectives requires multiple instruments, but more importantly because of the inability of interest rate policy to effectively deal with a balance sheet recession. Confronting the constraint of the zero lower bound suddenly became a reality rather than an academic matter for many more central banks than just the Bank of Japan, which has had to deal with it for the past 25 years. The question is now being asked whether quantitative easing (or for that matter contraction) should not become a permanent feature of the conduct of monetary policy, to be used not only in crisis conditions but as part of normal policy implementation. However, before this question can be answered the resultant role central banks will then play in credit allocation first needs to be clarified.
- The way central banks communicate, in particular with financial markets, has gained prominence ever since the realisation that managing expectations of future policy decisions was an essential part of the policy transmission mechanism. The financial crisis took this to a new level with forward guidance by policymakers taken to the extreme. On the one hand the European Central Bank has been very successful with its “whatever it takes” rhetoric. On the other hand the US Federal Reserve has caused volatility in financial markets because of its inconsistent messages, the result of taking forward guidance a step too far. Transparency in monetary policy should support and not undermine its credibility.
- The contrast between a recession caused by cyclical monetary tightening in response to escalating inflation risks and a balance sheet recession with its large debt overhang has really hit home in the last five years. The resistance to writing down debt has made it difficult to resolve the debt problem and continues to hamper the recovery. It is valid to ask whether the extremely accommodative monetary policy, in particular historically low interest rates, has not encouraged the postponement of dealing with the debt overhang by making it cheap not only to carry the existing debt but to even add to it.
- The large-scale purchases of government bonds by central banks as part of their quantitative easing activities have brought home the dangers of fiscal dominance. The European Central Bank has come under the most severe criticism for its bond-buying activities, prodding it to adopt the fig leaf of pointing out that it only buys bonds in the secondary market and not primary issues. Apparently it regards it of no consequence that it nevertheless reduces the free flow of bonds through its purchases and that the pricing of primary issues takes its cue from the secondary market where yields are being depressed on purpose! How the unwinding of central bank holdings of their enlarged bond portfolios is to take place without disturbing the balance in markets is still a moot point – holding these bonds till maturity may turn out to be the best option in the end.
- The conduct of central banks in the run-up to the crisis, as well as their subsequent response, has caused their accountability and independence to be questioned anew. Their acceptance of a quasifiscal role in rescuing the financial system from implosion has raised central banks’ profile in the eyes of the public and political representatives, nowhere more than in the US. The matter of goal independence versus instrument independence, with the latter (but not the first) traditionally regarded as the prerogative of central banks, has taken a new twist because of the controversiality of quantitative easing.
The South African Reserve Bank (Sarb) has of course found itself in the middle of these debates because of South Africa’s involvement with inter alia the Bank for International Settlements, the G20, and the Financial Stability Board. Because South Africa was not at the centre of the crisis, many of the issues mentioned above were peripheral to the Sarb’s activity sphere. However, some of the matters raised are very pertinent to the Sarb’s role in a South African context.
Judging by its conduct of monetary policy over the last two years the Sarb on the face of it seems to have been largely unaffected by global developments in central banking in recent years. The exception is at the regulatory level where, in line with current international best practice, it has been given the lead role in macroprudential supervision as part of South Africa’s “twin peaks” approach to financial regulation.
Its raising of the repo rate, now totaling 125 basis points since it started on its tightening cycle 22 months ago, (in the face of a weakening economy) and its own acknowledgment of the absence of any indication of inflationary pressure, arising from excess demand, speak of a determination to uncompromisingly stick to its inflation-targeting mandate. Although the Sarb certainly was true to its self-ascribed role as flexible inflation targeter subsequent to the outbreak of the crisis and the economy falling into recession, it increasingly seems to be taking quite a hard line and fiercely guarding its credibility and independence.
In fact, the Sarb appears to be committed to bringing inflation expectations into line with the mid-point (4.5%) of its targeting range rather than allowing them to settle close to the top-end (5.5-6%).
However, the fundamental issue facing the Sarb in the short term is the preservation of its independence in the face of a political environment that has shown little respect for the integrity and status of important institutions. The mounting challenge of a government debt burden that is continuing to grow on the back of non-growth-enhancing expenditure that will therefore also not grow the tax base from which it is to be financed, makes a hard stand on inflation increasingly unattractive and the monetisation of the government debt likewise more attractive.
With the authority of the National Treasury already being undermined it would be the last straw to push the economy over the precipice if South Africa were ever to go down this route.
Jac Laubscher is the economic advisor for Sanlam.
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