Pete’s blog

So just to recap last week’s email quickly. Increasing interest rates decreases money supply and decreases inflation. Also increasing interest rates decreases economic growth as people borrow less and spend less. Conversely decreasing interest rates increases money supply and increases inflation. Decreasing interest rates fuel economic growth as people can borrow more and spend more.

Unfortunately Tito did exactly what was expected last week and has given me more to talk about. So starting with the South African situation. As I explained last week, central bankers decided that the way to make their jobs easier was to use interest rates to control inflation. Inflation is therefore bad and must be restrained by increasing interest rates. This is exactly what Tito Mboweni did. His mandate is to keep inflation within a target range and inflation is currently way outside of this range, therefore interest rates need to be increased. Simple, easy, misses the problem entirely. Inflation is not a simple beast and comes in many different forms. So to break the types of inflation down (using my names for the inflation, I don’t know what the text book names are):

1. Money supply inflation. If you increase money supply faster than your economy grows, you will have too much money chasing too few goods. The price of goods with therefore increase. This is a no brainer – if your money supply is too much, reduce money supply. In South Africa’s case, this means increasing interest rates.
2. Inefficiency/overheating inflation. If your economy is growing too rapidly, people start just spending money without thinking about it. Business becomes less competitive and less efficient. Growth in demand outstrips supply. Since the economy is growing, people are willing to pay higher prices for goods without haggling – why worry about 5c now on something that is going to help you make 50c tomorrow. This is another no brainer – if your economy is growing too fast, slow it down. Once again this would mean increasing interest rates.
3. Bubble inflation. This is a more specific kind of inflation that generally affects only one kind of asset. The one most spoken about lately is of course the housing price bubble. Overheating inflation is actually exactly the same, except that it affects most sectors of the economy, whilst bubble inflation affects only a part of the economy. This is caused by people becoming too excited about some type of investment and driving prices above the actual underlying value of the asset. Although it is only a particular asset that is the bubble, it can affect the rest of the economy. High house prices mean people start demanding greater wage increases which then pushes up overall inflation. You can wait for the bubble to burst, which will result in pain and suffering and overcorrection, or otherwise you can try and slow and reverse the bubble’s growth. Depending on your bubble, you will need a customised response to be most effective at controlling it. However a basic blunt instrument would be to increase interest rates. Especially for housing bubbles, since this would make borrowing money to buy property more expensive and therefore reign in over-demand for property. Note that raising interest rates will however affect all sectors of the economy, not just your bubble.
4. Supply inflation. Overheating and bubble inflation are generally driven by demand – as demand outstrips supply, prices increase. However the last type of inflation is driven by supply. Things that reduce supply lead to price increases. A drought for example would result in food prices increasing, driving inflation. Increasing costs of raw materials/input goods force producers to increase their prices. Therefore either factors that reduce supply of goods or increase the cost of supplying those goods drive this type of inflation. Currently for South Africa (and many other countries), we have two major causes of supply inflation – oil and food. High demand worldwide for oil and food, combined with restricted supply has pushed prices to record levels. Since South Africa does not produce much oil and is a net importer of grain, these price increases are causing supply inflation. If we were an oil producer or a grain exporter, then we would have to be weary of overheating or bubble inflation. The response to supply inflation should not be to increase interest rates. Why? First supply inflation is generally caused by factors beyond your control – drought, overseas markets, etc. And second, because the problem is with supply, it means your economy is probably already contracting. Raising interest rates will only cause your economy to contract further – not a desirable outcome.

So what’s the situation in South Africa and what should Tito be doing? Well, because nothing is simple, South Africa has been experiencing some of all four types of inflation – money supply, overheating, bubble and supply. Our economy has been experiencing one of the longest continuous growth periods in our history, with rising employment and wages. Although our growth has been restrained and hasn’t quite overheated, it has been driving inflation. House prices have been increasing rapidly – some people argue that it is a bubble, others that property prices are only now approaching their true value. But money supply inflation has been one of the major drivers in the past. With low interest rates, job security and increasing property prices, people have been able to borrow more money. And banks have perhaps been a little too eager to lend it to them. All this extra debt has effectively increased money supply. And now of course we have rising global food prices and record oil prices – supply inflation. Inflation, inflation, inflation… So to disentangle all the problems. First Tito was correct to increase interest rates for the beginning of last year – people were borrowing too much and this did need to be restrained. But that inflationary pressure showed signs of decreasing about August last year, he could have stopped increasing interest rates then. Then oil and food started taking over the inflationary pressures. People started borrowing more – not to buy more goods, but to be able to maintain the ones they already owned and to be able to afford petrol and food. People have the same budget, but now can afford to buy much less since food and petrol is so much more and their interest payments have increased. Increasing interest rates just increases this distress. In fact, since the South African economy has a large growth potential, the businesses and consumers could absorb the additional costs of petrol, food and electricity (the next problem) if they were able to grow and increase their incomes. Increasing interest rates and reigning in economic growth is only going to prevent them from adapting. What I am saying is that although inflation is going to be sky-high, serious consideration should be given to reducing interest rates slightly. A little bit of breathing room could go a long way.

Next week (or maybe sooner), I will have a look at the American situation – which is very different and the Fed Reserve’s response was also very different (but also arguably very wrong). But one last optimistic thought. As painful as Tito’s interest rate hikes are, South Africa is sitting very pretty in a global context. Interest rate increases cause businesses and consumers to re-evaluate their spending, to become more efficient and streamlined. Everything becomes leaner and meaner. There is going to be a global economic downturn and some tough times ahead, but what matters is who will be able to take advantage of the upturn as soon as it happens. In South Africa, as soon as the upturn happens we can start lowering interest rates. The lean and mean businesses will now have access to money that they know they can afford and use it to buy up cheap assets or invest it in growth. In places like America with low/decreasing interest rates, they will not be able to lower their interest rates any further, businesses will already have as much debt as they can afford and they will not be able to respond to the upturn as rapidly. Pain and suffering for us now, happiness later… if only they would make the pain and suffering a little less…