Treasurers’ Conference – What’s on the MPC’s mind?

Dr Rashaad Cassim, Deputy Governor of the SARB, elaborates on the key issues that enabled the SARB to respond to the Covid pandemic.

He explains how South Africa was able to use the lowering of interest rates to stimulate the economy due to the fact that we were not in the zero-to-low interest rate environment that many other developed markets found themselves in. He also describes the various factors that the MPC is focussing on at present, such as the recovery in the housing market and the Fed’s reactions to inflation concerns, and how these might affect their decision-making given the current climate.

How the SARB navigated the Covid pandemic
Covid was the first time where the bank had to not only think about monetary policy, but also financial regulation and financial stability. When they significantly decreased interest rates at the beginning of the crisis, it was almost trivial to the markets, which were more concerned about liquidity. They had to intervene to ensure market functioning and provide capital relief in the banking sector. When many central banks in advanced countries began to deploy their balance sheets on steroids, we had something that advanced countries did not, which was that we were not at zero lower bound. Using your balance sheet to stimulate the economy is not as effective as using interest rates.  If your interest rates are at the zero lower bound, you have to use your balance sheet, but this comes with risk.  Because South Africa does not have a deflation problem, we could use our interest rate policy to begin stimulating the economy in a way that many advanced countries could not do. We started off at 625bps and have now come to 350 bps. Another element of our response to the crisis was to ensure that the financial system was functioning efficiently by intervening through liquidity programmes, buying bonds if necessary, etc. The third part of our strategy was to relax some of our capital and liquidity tools without encouraging banks to act recklessly. At 350bps, our economy is still far from its potential, but there is some upside risk to inflation to worry about.

Financial stability report
Monetary policy is supposed to stimulate aggregate demand. We felt that in the initial Covid period, the reduction in rates gave people cash relief and did not stimulate aggregate demand. We are now all worried about whether Covid will lead to some fundamental restructuring of the economy. While technology is thriving, we know that there will be permanent income loss in other parts of the economy, such as tourism and social contact industries. The real challenge for us is to what extent we are seeing a reallocation away from some of the social contact industries given that the virus is persisting for longer than was anticipated. One of our roles is to flag risks in the financial system. We went into Covid on the back of a technical recession and were in a weak position already. What worries us is the extent to which Covid exacerbates many of the metrics we were already worried about, such as public debt and volatility in our financial markets.
 
How will we manage a 3rd or 4th wave?
Our projections for 2021 is that our economy will recover about 4%, which is not yet at pre-Covid levels. We only expect that to happen in 2022. Normalisation is contingent on the pace at which we think the economy will recover. We have slowed down our participation in the bond market. Unlike many advanced countries, we don’t use the bond market as a form of stimulus, but to ensure normality in the bond markets. We are a market maker of last resort. If there is more market disfunctioning and instability, we will play that role.

How have households fared vs corporates?
We’ve been monitoring the housing market and construction sector with some interest. We’ve been trying to establish what impact moving the Repo rate down from 625bps to 350bps has had on the housing market. Mortgage extensions form the banks took a massive dive in March 2020, but we’ve seen a fairly good recovery in the housing market and low interest rates must play a critical role. Low interest rates have to be juxtaposed with the loss of income due to retrenchments, etc. We may reach a point where, despite low interest rates, income losses have been so significant that interest rates have played some role in reviving the housing market, although it may not be sustainable. We know the housing market is not out of the woods, but we see some recovery although not on the corporate side. We’ve been surprized at the recovery in some of the consumer durables because people are allocating their discretionary spending away from other parts of the economy. If you look at the total compensation in the economy from 2019 to 2020, in nominal terms there was a slight decline, which is very unusual. There is evidence that compensation is rebounding to 2019 numbers. Commodity prices have picked up, which is what we need to help boost the economy.

EM and tightening of financial conditions
Some countries started loosening their financial conditions too soon and are now having to tighten them. Many countries are bridging their inflation targets. We are at the mid-point of our inflation target, so our decision to go the route of some of the other emerging markets will depend on whether we think we are persistently going above the mid-point of the target. We will have to look at inflation expectations, second round effects from electricity, oil and food, etc. There a lot of elements to the loosening or tightening of financial conditions. This includes the cost of borrowing for a household whose loan is pegged to the short-term interest rate. Another aspect of financial conditions is what happens to a range of interest rates in the economy, such as the long-term 10-year yield. One area that many emerging markets are concerned about is the extent to which you are going to see the yield curves go up, making it more expensive to borrow. We are monitoring this very closely to assess the risk to us if there are capital outflows and we see financial conditions tightening.

Is the Federal Reserve being complacent and should we be concerned?
The Fed has a new monetary policy framework. An important part of this is that it bridges its implicit inflation target of 2%, but at the end of the day it’s the average that matters. The real issue is whether the last two inflation numbers are going to be persistent or not. When you think of inflation risks in the Fed, is it that inflation will go above 3% for a long time or that it will remain in the 2%-3% range while the economy overheats, but will then go back to 2%? It’s the latter that is the Fed’s view. For our purposes, we must separate the inflation differentials between us and the US with the interest rate reaction to the inflation prospects. If US inflation goes up relative to South African inflation, it’s a good story that the inflation differential is narrowing as it bodes well for our competitiveness. If inflation is impacting on imports from the US, then we have to look at our import price index to see if inflationary pressures are coming from the US into our inflation basket. The more aggressive the Fed becomes in responding to the potential threat of inflation we are likely to see more volatility. This may have implications for the way we think about whether a more aggressive interest rate will have an impact on our financial market and whether we think there will be some exchange rate risks and subsequent inflation risks for us.

How will outflows affect SA given our recent history of muted inflows?
SA is still seen as a reasonable investment for several reasons, including bank resilience, a deep financial sector, well-functioning institutions, etc, which translates into easy financial conditions for us. The negative aspect is that the more dependent you are on non-resident flows, the more vulnerable you become when there is a crisis. If some of our ownership of bonds was taken over by local pension funds, insurers and banks, it makes you less vulnerable to an outflow of non-resident investments in the country. When non-resident investments flow out of the country, many South African residents who have investments abroad also bring their money back.

High & rising government debt
One of the links between monetary policy and the fiscus is that if investors become less confident in your ability to take on fiscal issues, you often see this expressed in a more volatile exchange rate. For us a more volatile exchange rate means more volatile inflation. In terms of financial stability, with the government issuing paper and the financial sector buying more sovereign bonds, we’ve flagged the extent to where we reach a threshold where it becomes unhealthy for the financial system to own sovereign bonds to the extent that there is pricing and interest rate risk for the banks who buy these bonds. If you have a loop between more ownership of sovereign bonds  and you’re worried about interest rate risk with sovereign bonds, there is a potential financial stability risk. Banks need to be more aware of what they own in their portfolios and what implications this may have.

Will decentralised financing change the way monetary policy is implemented and have a knock-on effect on the financial services industry?
When we look at the role of the central bank, we have a financial and a price stability role. We also have an oversight role as a bank regulator. It also has oversight and involvement in our payment system. Our payments platform is a very important platform whereby the infrastructure of the financial system operates. We have launched a project on digital currency and experiments on fintech firms and the type of legislation that’s necessary for fintech. We’re asking if we should we move to a digital currency? If consumers had a choice between cash and digital, what would they choose? Are people who live far from cities better off doing their banking on a very cheap mobile phone? We have to embrace technology and ask whether it will make the financial system more efficient, provide cheaper access to money and promote financial inclusion. We are busy exploring this through various projects.

Is the SARB looking at financial institutions and their role in terms of climate risk?
The SARB is part of various international networks on climate change. Financial stability is very important in certain contexts, such as the insurance industry as we see more financial upheaval. What if droughts become more frequent, etc? Central banks are becoming asset biased themselves because they manage reserves themselves. What does green finance mean and what are the kinds of initiatives we should be taking about? In the financial stability space, we do stress tests. Many central banks are looking at climate stress tests. It’s early days and we need to understand it better, but it’s an important area.

What keeps you up at night?
The main challenge we’ve been experiencing is that the potential of this economy has declined over the last few years, and we have to take that as our starting point. There’s a limit to what central banks can do to ignite growth in the economy and once you embark on any reforms, the central bank can complement that by getting growth moving. Central bank policies run out of steam if other parts of the economy are not functioning well. I hope that in the future we can apply monetary policy in the context of an upward growth potential rather than a downward movement in our potential growth.