Public Lecture: The Governor, South African Reserve Bank

comes and changed as the new normal for central banks facing a price shock. The key is to manage the second round events. If a central bank has strong credibility, if everyone trusts inflation will revert to target soon, it can be possible to look through a shock without raising interest rates. But the look through strategy has pitfalls. Why is that? Shocks have a bad habit of traveling in groups. If you commit to looking through shocks and then two or three arrive one after another, trust is low, inflation starts to...

Last year you also had a food price shock and on top of that the exchange rate weakens. You do not get higher inflation. You have to wait for high inflation with no end in sight. In this context, it is probable that price and wage setters will start to make decisions as if they live in an economy with consistently higher inflation, and this is a self-fulfilling prophecy. Another pitfall is that committing to a look through strategy ties your hands. The future is full of surprises. If you keep your options open, you can easily change course when supply rises happen. If you give away optionality by insisting that you will ignore shocks coming from the supply side, the pivot becomes more embarrassing. You can end up sticking with the wrong strategy for too long. The last thing you want to do is insist that only demand side inflation matters for monetary policy and never supply side inflation. Supply side shocks can move expectations and countries can develop inflation problems without ever facing clear demand side pressures. For this reason, central banks have done better by taking responsibility for inflation in general rather than trying to ignore shocks. The famous example is the German Bundesbank which did better than other major central banks like the US Federal Reserve and the Bank of England at managing the inflation pressures of the 1970s and 1980s. Indeed, the superior performance of the Bundesbank was important for the development of inflation targeting. A third problem is assessing the starting point correctly. If you say you are going to look through shocks, that is usually understood as not raising rates. But as economists, we know that real interest rates matter. It is not just the nominal interest rate, but the rate adjusted for inflation. If your starting point is a loose stance and the real rate then falls further as inflation rises, that is a very different policy setting to a starting point with a tight stance. Do nothing can be better advice for one starting point and bad for another. These pitfalls were on display during the post-COVID global inflation surge. It was not just one shock. It was fuel and food and supply chains and exchange rates all together. Policymakers and commentators got into a big debate between team transitory and team persistent. Sometimes people were so identified with their positions in that dispute, it was hard to acknowledge new data. And the starting point was very loose monetary policy to deal with the COVID-19 crisis. In South Africa, we had the lowest policy rate on record. For all these reasons, it made sense to raise rates. And countries that delayed tightening regretted it.

After that inflation crisis, emerging markets were widely recognized for understanding the shock better and responding more proactively than their peers in the developed world. This reflected long experience dealing with supply shocks and the knowledge that second round effects are better dealt with preemptively. If you delay, by the time the second round effect is manifest, you are behind the curve and you need to move more aggressively to try and catch up, which creates extra pain. This experience underscored the point that good policies in the face of supply shocks cannot be reduced to look through the shock. A more sophisticated reaction would have the following characteristics. First, policymakers should look through first round effects but not second round effects. Second, policymakers should respond continuously. This requires a judgment call about whether second round effects are likely, which is the difficult part. But there are clues. Second round effects are more likely when there are large and overlapping shocks. Second round effects are also more likely when inflation expectations are not well anchored at the target. Third, policymakers should assess the current stance of policy and decide what that starting point means in the context of a shock. Applying these guidelines, what can we say about South African monetary policy at this juncture? It is natural to begin of course with the starting point. As I said, this crisis is finding us with policy moderately restrictive and with inflation at target. Real rates may be falling as inflation rises, but we also have tighter financial positions. Markets were pricing in rate cuts this year but have now dropped those expectations. For example, the one year treasury bill rate was 6.95% at the end of February and 7.76% at the end of April. This is some implicit tightening even without the SARB raising rates. At the same time, inflation expectations are not firmly anchored at 3%. The new target is less than a year old. We have made good progress in that time building credibility at 3% but we have not completed the journey. Overall, it is not the ideal starting point, but it could be worse. Higher real rates, tighter financial conditions, and the enhanced monetary policy credibility created by the new target probably balance the fact that expectations are not anchored at 3%. It is a broadly neutral set of initial conditions. Moving on to the question of large and overlapping shocks, we are experiencing the biggest jump in fuel price inflation in the history of inflation targeting. Fuel is going from deflation to double-digit inflation. There is no doubt this is a large shock. Whether we will see multiple shocks is less certain. The rand exchange rate has been surprisingly resilient so far. It depreciated in March but then recovered to roughly pre-crisis levels. Many of our peers have had similar experiences. The broad resilience of emerging market currencies may well be due to weakening global trust in the US dollar and the need of investors to diversify portfolios. It is not that they are abandoning the dollar but nowadays no one wants to be all in on the dollar either. Exchange rate dynamics therefore look somewhat reassuring but it will matter what the other central banks do. It is hard to sit out a global tightening cycle. A bigger problem is food prices. The Middle East conflict has large implications for fertilizers and diesel, both critical components of the food supply chain. We are also looking at a possible El Niño pattern next year which means drier growing conditions in southern Africa. Consistently higher food inflation on top of the fuel shock could pose serious risk to inflation expectations. In these conditions, we will be studying the data very carefully both to assess how these variables are playing out and to see if there is any evidence of underlying inflation starting to move. We can look for this evidence in measures like surveys of inflation expectations, wage indicators and core inflation data. Complicating the task is the problem that global conditions are highly uncertain. The shock is only about two months old and at any moment there could be some news flash or social media post that causes a big move. Negotiations could be off or they could be on. The Strait of Hormuz could be open or closed again. The next move could be devastating attacks on civilian infrastructure or it could be a ceasefire. Given the risks to inflation and the uncertainty, it makes sense for us to keep our options open. In our next few meetings of the monetary policy committee, we will have to make tough decisions about whether second round effects are coming or whether we have enough space to look through. As ever, we are not going to precommit to a path and give up optionality. We cannot offer certainty about our next steps. Instead, we want to maximize certainty about where inflation is going, specifically that it is going back to target. To support this, like many other central banks, we are finding scenarios helpful. For these exercises, we lay out different possible futures and then show how policy is likely to respond. The idea is to clarify the reaction function so our stakeholders can then watch how events unfold and understand how we are likely to respond. Our most recent projections from our March meeting included a benign baseline where rates were unchanged, an intermediate scenario where they rose a little and an adverse scenario where they rose more. All those scenarios had inflation coming back to target over time. That is really our most important message. Although we cannot do much about higher inflation right now, we are very committed to getting inflation back to 3%, just where we had it before the shock hit us.

Ladies and gentlemen, to conclude, there is nothing South Africa did to create this problem. At the same time, it is our problem today. As a small open economy and as an oil importer, we are going to get hurt. Our job as policymakers is to minimize the pain, keeping focus on our long run objectives. It is unfortunate that this shock is hitting during the transition to the new lower inflation target. Until now, that transition was going about as smoothly as we could have hoped. It seemed we were going to complete the disinflation soon, perhaps this year. Now this process will take longer. At the same time, it is a big plus to go into this shock with record low inflation expectations and monetary credibility as strong as it has ever been. If we do have to raise rates, it will be to sustain low and stable inflation and all the benefits that it brings. The lower target helped give us lower borrowing costs and a stronger rand. Some of those gains were reversed with the shock but not fully and not for long. These gains are valuable and we do not intend to lose them. Thank you.

Thank you very much for those. The young lady didn't say your name but it doesn't matter. You were asking about the focus on... you said we focus on first effects. No, it's the other way around. Focus on the second effect. There's nothing we can do with the first because the first they hit you now, the oil price has gone up now, there is nothing the central bank can do with the oil price that has gone up now. So what you then focus on is does the rise in the oil price lead to other prices in the economy going up. So the oil price goes up, fuel prices go up, the cost of transport goes up. And if the cost of transport goes up and the distribution costs go up and then the other goods go up, then that is what you have to worry about. That is what we call the second round. Unfortunately, if you wait until all of that process completes itself, you are late. You are late. And that is going to lead to you as the policymaker having to act more aggressively. So you needed a dosage of one tablet and you might have to take three to deal with another because you had... my accountant... open market operations are used differently. But when open market operation is when the central bank buys or sells financial instruments to affect liquidity in the financial system so that interest rates converge to where the central bank would like to have. But you have raised a very important point about maintaining of strategic oil reserves and having domestic refining capacity. We still do have strategic oil reserves. The question is how long would they last us? But understand when the strategic oil reserves are released into the market, they are not released at the old oil price. They are released at today's oil price. So the fact that you have the strategic oil reserves only assures you of supplies. It doesn't assure you that the price would be low. Similarly for refining capacity. Refining capacity only shields you against shortages when you import the refined product. But if you have a refining capacity and you can refine your own, that refinery will still have to process crude oil at a higher price. So having that capacity just assures you of supply. It does not shield you from the price. Which countries would we be compared with? I am always very careful about that because you see when you compare South Africa with other countries, you have got a choice. You can say that well we are doing very well but if you look at this country we are doing so much better than them, or you can take a view that says that you know what these countries are doing very well. We actually would like to be as close to that head as possible. But the nature of the economics profession is such that you are going to have to look at everyone and say compared to the total group how do I look like the whole world and then we go as we do here say compared to the developed world how do we look like, compared to the other emerging market countries how do we look like, and then of course we would then go and say regionally how do we look like and regionally it becomes a big thing for us because for all intents and purposes we are sort of like an anchor economy and so when we set, we are seen as the ones who set the pace. So last year when we were having debates in South Africa about inflation target, my colleagues in the region were calling me saying can you guys make a decision because we want to know where you are going so that we can also calculate our policy in that manner and now it looks like there is a wave in the region of countries lowering their targets towards the 3%. So that is how we would... Mr. Palana, we released a report as part of the court papers. Our report was challenged in the courts and when we released all the information to the court, the party that took us to court withdrew their case literally this year and said that they no longer want to pursue the case. That was the robustness of our report. It could stand the scrutiny of the courts. So when we say what does it take to contravene the exchange control regulations, don't try it. Don't try it because if you contravene the exchange control regulations, the punishments vary from criminal to administrative. So we issue these things in the Gazette and we would say these amounts have been forfeited because people have been in breach of exchange control regulations. That report that you referred to reached a conclusion that said that there was no confirmation and it stands there. What the Constitutional Court decides is not deciding on whether that report was... it was dealing with parliament and not with us. Yes, thank you very much.