Gordhan to Marcus: I got your back

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Unequivocal support for inflation targeting.

PHILADELPHIA - In an unusual move, the Reserve Bank last week published a copy of a letter from Finance Minister Pravin Gordhan to Reserve Bank governor Gill Marcus, in which the minister underscored the centrality of the Bank's inflation targeting mandate, with a small pinch of salt.

The letter (which, amusingly, looks like a form letter into which someone inserted the name "Gill") was sent the day before the Budget was presented (Click here for the full Budget 2010 coverage), and drives home the message that the minister also communicated in his Budget Speech: inflation targeting ain't going nowhere.

Where it gets interesting is that Gordhan did say in his letter to Marcus that the Reserve Bank's monetary policy should be flexible and that when external shocks (like global oil price jumps or economic crises) bump up inflation, the Bank should try to return it to the target range while avoiding "unnecessary instability in output and interest rates."

Wrote Gordhan, "While it would be important [in the face of externally driven inflation increases] to bring inflation back to within the target range, the time frame for the adjustment should attempt to avoid unnecessary instability in output and interest rates.

"The policy response should have due regard to the factors that might impact on the attainment of balanced and sustainable growth. These factors include the source of the inflation shock; the size of the gap between actual and potential economic growth; credit extension and asset bubbles; employment and other labour market developments; and the stability and competitiveness of the exchange rate."

This is interesting, it suggests that Gordhan and Marcus, whose institution published the letter, are proposing a flexible, rather than a rigid inflation targeting regime, one that is sensitive to a range of economic concerns.

It's also interesting that the minister and governor felt the need to present such a united front on the issue, and to communicate it so clearly. It suggests that there is a lot of political pressure from various quarters on the Reserve Bank to change its policy stance and to lower interest rates in order to boost growth and perhaps dent unemployment. There are those, many of them in organised labour and other left-wing groupings, who want to see the Bank given a more explicit mandate to target employment or growth, rather than, or in addition to, inflation.

As we've discussed here before, there is an appeal to this call. Many countries around the world have monetary regimes that target a combination of growth, employment and/or inflation, including the United States of America, and most are none the worse for it. If you recall, monetary policy has to do with how the government manages the supply and availability of money and the interest rates; this is in contrast to the other main arm of government financial management, fiscal policy, which is about how government collects and spends revenue or taxes.

Together, these two types of policy are the main way that government directs a country's economic course. In the last twenty years or so, thinking about these two types of policy has been dominated by the ideas of balanced budgets for fiscal policy and inflation targeting for monetary policy.

Balanced budgeting is pretty obvious, it's the idea that governments should spend roughly the same amount that they take in; you may recognise this concept from your own financial management! Inflation targeting is a little more complicated. Basically, the idea is that government should balance the money supply and interest rates to ensure that the prices of consumer goods, and by extension, the value of consumers' money, don't rise too fast.

The rationale behind inflation targeting, in a nutshell, is that it gives predictability and stability to monetary policy, helps citizens to plan and encourages them to save and invest, and prevents governments from using monetary policy to paper over economic weaknesses and problems. In the past, some governments, often those in emerging markets, would simply print money to plug budget gaps or to boost economic growth figures. Inevitably, of course, poor monetary management led to more problems than it solved, but the technique kept many inept or corrupt governments in power long past their sell-by dates.

Inflation targeting emerged, in part, as a response to this. The idea is that if governments have a clear mandate, the success of which can be easily measured, policy is more likely to be appropriate and transparent. In addition, good monetary policy should encourage sound fiscal management, because governments can't use the mint's printing presses to fix the budget. There are a host of more technical rationales, but the basic idea is that by targeting inflation, monetary policy will have a sound and stable anchor, and so will people's financial plans and expectations.

Inflation targeting is not, however, universally adored. Some argue that it can be overly restrictive, and that it can be especially problematic when inflation rises in a country due to external shocks, like sudden global increases in oil or food prices. When this happens, inflation-targeting-based monetary policy can hurt the economy, because it leads to interest rate increases that may not really be appropriate.

Nevertheless, inflation targeting remains a popular and widely used device, and both the Treasury and the Reserve Bank have underlined its central role in South African policymaking, albeit with some additional flexibility.

This is a sensible move. South Africa faces some serious economic challenges, including our old friend unemployment, sluggish economic growth, high consumer debt levels, rising energy prices, and a still-listless housing market.

Could South Africa's new dynamic financial policy duo be trying to hint to the market that some interest rate cuts could be on the horizon as monetary policy responds flexibly to the unusual economic conditions we're facing? We'll find out soon enough, but it seems clear from the Budget Speech and letter that we're going to keep our inflation targeting regime, and that's good news for all savers and investors.

Write to Felicity Duncan: felicity@moneyweb.co.za or follow her on Twitter at http://twitter.com/FelicityDuncan

*This article first appeared in Discovery Invest