Fiscal and monetary policy go hand in hand

Last week the SA Reserve Bank issued a rather predictable statement confirming that the monetary policy committee had resolved to once again increase the baseline interest rate, by 50 basis points.

The predictable nature of the statement was premised on the fact that the Bank applies a set of linear parameters in its implementation of its monetary policy mandate. Whenever the inflation rate breaches the 3%-6% range, it adjusts rates upwards to mitigate the negative effect of inflation on the rand exchange rate.

Over the past year, as the inflation spike that escalated in the aftermath of the Russian invasion of Ukraine persisted, the Bank increased rates in response not only to the upward inflationary pressures precipitated by that crisis but also to implement a correction to the long-term curve, which had been obscured by the Covid-19 crisis.

A usually predictable reaction to an interest rate hike is the appreciation of the rand, premised on the idea that higher interest rates attract greater interest in the local currency and may lead to positive investment inflows. The problem with last week’s statement is the currency went in the opposite direction, and continued its slide to new lows.

The backlash against the Bank’s decision naturally escalated as its actions worsened the income squeeze and did nothing to arrest the currency decline. Part of the problem is that what the Bank seeks to address — runaway inflation — is actually being driven by external factors rather than local demand.

This means the traditional transmission mechanism — where higher interest rates translate to lower demand — is not actually playing out in this case. As the Bank highlighted, the elevated levels of food and transport inflation are large contributors to the current inflation spike.

The problem with just these two examples is that citizens aren’t really in a position to stop eating or going to work, to “cool down” these elements. Given the external factors driving food and transport inflation it is increasingly obvious that standalone monetary policy responses aren’t going to address this problem.

The complementary fiscal policy measures that should be working alongside the increasingly moot monetary policy response are missing in the deliberations. In the governor’s address, the effect of administered prices of water, electricity and municipal rates looms large as a key driver of domestic inflation.

The increases in such administered prices, which for the period 2010-2020 were recorded at 213% for water, 177% for electricity and 118% for municipal rates, have driven up inflation. Unfortunately, these are the lifeblood of government finances at municipal level. In the absence of alternative revenue streams the temptation to squeeze the maximum out of the existing options is obvious for all affected structures of the government.

During 2022 the government implemented a moratorium on the increase in the fuel levy. While this idea was noble, it came at a cost to the fiscus and was — best intentions notwithstanding — aimed at the one element whose very design is premised exclusively on external factors. In other words, even if the moratorium had been extended, the volatility in global oil prices would leave many citizens wondering if the moratorium had any effect at all.

The upside of that action is it indicated the state is capable of identifying crisis-appropriate fiscal policy measures to help citizens navigate a crisis. As illustrated in the Covid-19 pandemic, fiscal policy responses have a more direct effect than the more elusive transmission mechanisms of monetary policy.

The inability to engage in difficult conversations about which instruments to deploy at times like this represents a collective failure to navigate the economic headwinds. As a result, the absence of fiscal policy gurus means those who are brave enough to make the difficult calls — even when the effectiveness is moot — become the primary reference point for our collective disillusionment.