FUNDS ON FRIDAY. The fiscal benefits of a lower inflation target Written by: Carmen Nel, Macro strategist at Matrix Fund Managers

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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 1 3 S e p t e m b e r V o l u m e The fiscal benefits of a lower inflation target Written by: Carmen Nel, Macro strategist at Matrix Fund Managers Inflation targeting (IT) as a monetary policy framework has grown in popularity since it was first adopted by the Reserve Bank of New Zealand in 1989, followed closely by the Bank of Canada in Since then the IT following has grown to now include over 50 countries that have some form of inflation target as part of their monetary policy objectives. Even the US Federal Reserve in 2012 (a relative late-comer) adopted an explicit inflation target of 2.0% as part of its dual mandate. South Africa was a relatively early adopter from an emerging market perspective, with then Governor Mboweni and the National Treasury announcing in 1999 that the SARB would operate under an inflation targeting regime from February The initial target range was set at 3% -6% for calendar average inflation, with an intended adjustment to 3% - 5% from 2004 onwards. The currency crisis of 2001 posed a notable challenge to lowering the inflation target range and it was decided to maintain it at 3% - 6%. However, in late 2003 the policy makers switched from a calendar average target to a continuous basis in a bid to lower inflation and interest rate volatility. The SARB has been reasonably successful in delivering on its mandate. Not only has the level of inflation fallen from the 10% average in the 1990s to 6.1% average in the 2000s and 5.3% in the 2010s, but the proportion of time that inflation has been within the target range has also steadily increased (Figure 1). In addition, inflation expectations have become notably less volatile and have become anchored, albeit only slightly below the 6% upper end (Figure 2). Page 1

2 Figure 1: Inflation inside the target more often The shaded area shows a 1 if the inflation reading in a given month was inside the target range and 0 when it was outside the target range. Source: Stats SA, iress, Matrix Fund Managers Figure 2: Inflation expectations anchored, albeit close to 6% Inflation expectations (%) 12 Target range Current year One year ahead Two years ahead Q00 4Q01 1Q03 2Q04 3Q05 4Q06 1Q08 2Q09 3Q10 4Q11 1Q13 2Q14 3Q15 4Q16 1Q18 Source: BER, Matrix Fund Managers Yet the SARB has begun to voice its concern that expectations remain too high and that if these were anchored closer to the mid-point of the target range, then it would give the Bank more flexibility to deal with price shocks. In this regard, the SARB has begun to communicate the 4.5% mid-point supported by its relatively new model (the Quarterly Projection Model QPM). Another consideration is that while South Africa s effective inflation target and inflation outcomes have averaged between 5% -6%, inflation in South Africa s trading partners has on balance declined over the past 20 years. The question is whether there is a real benefit to effectively implement a lower point target of 4.5% (with a range around it) rather than the existing 3% - 6% range? Page 2

3 The trade-offs of a lower target The literature is awash with the benefits of inflation targeting and the attendant central bank transparency that the framework entails. By and large the consequences of credible inflation targeting include lower inflation, lower inflation volatility, and less variability in GDP growth. Granted, the decline in SA s macro volatility is probably not solely due to the adoption of inflation targeting and the SARB s actions, as the framework coincided with the tail-end of the great moderation in the global economy. Nevertheless, there have been incremental benefits to macro outcomes to running credible monetary policy. Views among experts and policymakers on the benefits of further lowering the inflation target remain mixed. The main concern is that a lowering in inflation outcomes would require tighter monetary policy. Even if the lower realised inflation will feed through to adaptive expectations, central banks believe there is a trade-off between inflation and growth, at least in the short term. This is the sacrifice ratio in central banking lexicon effectively it is the amount of growth policymakers will have to sacrifice to achieve a lower level of inflation. Yet this debate misses a key channel through which a lower inflation target would benefit the economy in the long run: government borrowing costs. Inflation, FX and the fiscal factor The first benefit of a lower inflation target would be via the exchange rate. Inflation differentials feature as a key determinant of the longer-term trend in bilateral and multilateral exchange rates (Figure 3). All else assumed equal, if South Africa s inflation differential with the rest of the world declined, then the pace of nominal exchange rate depreciation in the longer term will also be slower. A slower pace of depreciation will partly result in lower inflation, presenting a potential virtuous cycle. Page 3

4 Figure 3: Inflation differentials a key long-term driver of exchange rates USD/ZAR (quarter average, LHS) SA/US CPI (quarter average, RHS) The SA/US CPI is the consumer price index (CPI) relative. When converted into a rate of change it would yield the inflation differential. Source: iress, Bloomberg, Matrix Fund Managers In South Africa, inflation accounts for a meaningful share of short-term and long-term interest rates (Figure 4). On this basis, the second benefit from a lower inflation target would be lower nominal interest rates. Figure 4: Inflation makes up more than half of SA s nominal interest rate Inflation share of interest rate (5-year rolling average, %) 110 SARB policy rate 10-y yield A nominal interest rate is composed of a real component and inflation component. The chart shows the share of the inflation component of the nominal interest rate, smoothed over time. Over the last five years, the inflation component accounted for c.90% of the nominal policy rate, while it accounted for c.65% of the 10-year yield. This means that more than half of the nominal interest rate is driven by inflation, which presents an opportunity for lower interest rates via lower inflation. Source: Stats SA, iress, Matrix Fund Managers On balance, countries with high inflation targets have higher FX i premiums embedded in their local currency bond yields (Figure 5). A lower inflation target, if credibly achieved, should lower inflation expectations and so too the FX premium and inflation component in the long-term yield. Figure 5: Lower inflation target associated with lower FX premium Page 4

5 Turkey 800 FX premium (bp) Peru Mexico Colombia Indonesia Philippines Chile Russia Brazil South Africa South Korea Inflation target mid-point (%) Source: Bloomberg, Matrix Fund Managers The fiscus would benefit not only from lower local currency borrowing costs, but also via its inflationlinked bonds and its external debt. The inflation revaluation is a meaningful component of redemption costs on inflation-linked bonds, as such, lower inflation over time would mean a lower redemption profile (Figure 6). This would be a net saving to the Treasury. Similarly, exchange rate depreciation would lead to a revaluation on the government s external debt. A slower pace of depreciation would mean a lower revaluation. Figure 6: Impact of 6% trend inflation versus 4.5% trend inflation on government debt Rbn 750 ILB debt stock assuming 6% annual inflation rate ILB debt stock assuming 4.5% annual inflation rate FY18 FY19 FY20 FY21 FY22 FY23 FY24 FY25 FY26 FY27 FY28 ILB: Inflation-linked bond The profile assumes no new issuance of ILBs and shows only the inflation impact on the debt stock. Source: National Treasury, Matrix Fund Managers If low and stable inflation leads to macro stability and lower funding costs for the government, then a lower inflation target could contribute to a relative improvement in the country s sovereign credit rating. A better credit rating would be accompanied by a lower credit premium, which would also contribute to lower funding costs. While the first round effects of a lower inflation target would be evident in financial markets, the second round impact will be via the fiscal position s impact on the real economy. Due to the primary deficit ii, the government is borrowing to pay interest on its debt, making the fiscal position unsustainable. The Page 5

6 interest bill is crowding out other government spending. This is in sharp contrast to the 2000s when the falling interest bill enabled the roll-out of government grants (Figure 7). Hence, the cost saving from lower inflation could help to reverse the crowding out and so enhance government s financial capacity for service delivery, which is the ultimate goal. Figure 7: Debt service crowding out social services Government spending (% y/y) Social security and welfare Debt service savings reticulated into welfare spend Debt service costs Debt service costs growing faster than wellfare spending FY01 FY02FY03FY04 FY05FY06FY07 FY08FY09FY10 FY11FY12FY13 FY14FY15 FY16 FY17FY18 Source: National Treasury, Matrix Fund Manager Conclusion Is it plausible that the National Treasury and the SARB will lower the inflation target any time soon? Probably not. The economy is near stagnation, and with the national election around the corner there will be little appetite for further constraints on the consumer. Yet, as with all reforms, a lower inflation target will be a case of short-term pain for long-term gain. The current backdrop of an unresponsive economy, lower exchange rate pass-through, and structurally tight credit conditions could be just the environment to start the move lower. However, the success of such a change would be limited by the lack of broader macro and market reforms to lower the cost structure of the economy. These are not within the remit of the SARB s Monetary Policy Committee. Even so, we should not underestimate the long-term opportunity for South Africa s fixed income markets from a combination of a lower inflation target and fiscal stabilisation. Many investors were probably dismissive of South Africa s ability to implement inflation targeting and fiscal consolidation, missing out on a c.500bp rally as the 10-year yield hit single-digit territory in the early-2000s (Figure 8). As the saying goes, history does not repeat, but it rhymes. This could be a nascent opportunity on a multi-year horizon. Figure 8: The benefit to yields from lower inflation and fiscal consolidation Page 6

7 18 Inflation (%, LHS) 10-y yield (%, LHS) Government debt/gdp (%, RHS) Inflation targeting announced Inflation targeting implemented Source: iress, Matrix Fund Managers 1 IMF, various central bank websites 1 For more detail on the adoption of inflation targeting in South Africa and the target variable please see Van Der Merwe, E J, Inflation targeting in South Africa, SARB Occasional Paper No 19, July Cabral, R et al, Inflation targeting and exchange rate volatility in emerging markets, World Bank, Policy Research Paper 7712, June 2016 Brito, S et al, Disagreement about Future Inflation: Understanding the Benefits of Inflation Targeting and Transparency, IMF Working Paper, WP/18/24, January 2 1 More recent research suggests a general bias in the findings of previous research into inflation targeting, but nevertheless concludes that the framework is beneficial, albeit impacted by idiosyncratic factors: See Balima, H W et al, Settling the inflation targeting debate: Lights from a meta-regression analysis, IMF Working Paper WP/17/13, September The FX premium is defined as the local currency bond yield less the dollar-denominated bond yield of a given sovereig 1 Government revenue less non-interest government expenditure Page 7

8 Glacier Research would like to thank Carmen Nel for her contribution to this week s Funds on Friday. Carmen Nel BSc Actuarial Sciences BSc (Hons) in Mathematical Statistics BSc (Hons) in Advanced Mathematics of Finance CFA, FRM Carmen is an Economist and Fixed Income Strategist with 16 years experience covering South African economics and financial markets. She joined Matrix in July She has worked for leading global and local investment banks and has won numerous industry awards for fixed income research over the years. Page 8