So the US Federal Reserve has hiked interest rates by 50 basis points, with more to come as it races to tackle runaway inflation — which it failed to anticipate. Our own central bank is also expected to raise rates again in May as inflation heads higher, even if it has at least done better on the anticipation side and can move more gradually.
The way it works is that when the central bank increases the so-called policy rate — in SA’s case the repurchase or repo rate — the commercial banks then raise the rates at which they lend to households and businesses, which cuts disposable income, curbing demand across the economy and so putting downward pressure on prices, taming inflation.
But how many of us wonder why this works? The SA Reserve Bank’s monetary policy committee (MPC) announces the repo every two months. But why do the banks take any notice, following the Bank’s lead even though they are in theory free to price loans as they wish? Without the ability to implement its interest rate decisions and ensure those repo calls are effectively transmitted to lending rates in the market, a central bank’s monetary policy could in theory be excellent but in practice completely ineffectual. The decisions about interest rates are about economics; implementing them is, as one banker put it, about the plumbing of the monetary system.
The Bank has been seized over the past year or two with plans to upgrade that plumbing, to address some of the changes and challenges the Covid-19 pandemic accelerated as well as to align SA’s approach more closely with global norms. In November it published a consultative document on a new monetary policy implementation framework; at the March MPC meeting deputy governor Fundi Tshazibana said the new framework would be implemented within six months. In essence, it’s a shift from an approach based on a money market deficit to one based on a surplus, similar to what the Fed and other central banks do. The plan is for a three-month transition and the Bank is working closely with bank treasuries on it.
The consultation paper is pretty incomprehensible stuff, but esoteric as monetary policy implementation might be, it’s part of all our lives. It goes to the heart of the payments system that enables the economy to function. And it goes to the core of what central banks do, and their monopoly within that system. When you make a payment from your Standard Bank account, say, to a Capitec account, that has to go through the payments system, SAMOS, which is run by the Bank. That payments system is essentially a closed loop in which the only thing that can go back and forth are bank reserves — or what we could call Reserve Bank money, because only the Bank can issue those reserves.
Banks are required to hold a certain amount of reserves but they gear these up by many multiples to provide credit to the economy. Each day, billions of transactions go back and forth between the banks through the payments system, and the Bank provides liquidity during the day to ensure that. But at the end of the day all the payments have to be squared up and each bank has to be left (on average) with its required reserves. Banks with excess cash can lend to those that are short at the repo. What the Bank does now is engineer a shortage for the market as a whole — which forces banks to borrow from it at the repo rate. That then shapes the short-term rates at which banks borrow and lend to each other and to their customers, so effective rates in the economy end up aligning with the repo.
The deficit approach had become unusual internationally — especially after the global financial crisis, when advanced country markets were awash with liquidity. Even in SA, deficits had become more difficult to engineer. And the Covid-19 pandemic made this far harder, with the average deficit almost halving to about R30bn as liquidity was injected into the market from a variety of sources. The Bank’s bond purchases to stabilise the market early in the Covid-19 crisis meant the Bank was in effect creating more reserves to buy the bonds, injecting cash into the market. The loan guarantee scheme had the same effect, with the Bank providing the liquidity for the banks to provide the cash.
The Treasury itself tapped into some of the sterilisation reserves it was holding at the Bank. Then there was about $5bn of loans from international financial institutions that the Treasury needed converted into rand at the time, so the Bank swapped the dollars into rand — adding rand into the market (a move that also created some unfortunate distortions in the foreign exchange market, which may have deterred foreign investors in SA bonds).
With the new approach, the Bank will give up on engineering deficits and will instead pay banks interest on their excess cash, at the repo rate. That essentially provides a floor for the price of money, because banks won’t lend at less than they can earn by simply keeping their cash in reserves. But SA will also limit how much banks can do this, capping the amount they can keep in reserve at the full repo rate to ensure they don’t hoard too much cash and that the interbank lending system continues to work smoothly.
It will be an interesting time for central bankers and bank treasurers — and as with all plumbing, as long as it works, most of us will never notice it. Beyond the plumbing, there is the matter of monetary policy itself — and how far it still has to go. Some economists would argue the real, inflation adjusted rate is the one to watch in terms of economic impact, and on that score SA’s 4.25% repo still counts as a negative real rate compared to inflation of 5.9% — so is still stimulatory for the economy.
But that’s mild compared to the US, where the Fed has raised its policy rate to 0.75%-1% — with inflation at 8.5%. Even if US inflation heads back down towards 5%, real interest rates would still be hugely negative and there’s still a long way to go to the “neutral”, non-stimulatory rate needed to tame inflation. The world and SA are right to worry about the fallout.
• Joffe is editor at large.
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