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Inflation targeting: transforming African monetary policy

Date 29/10/2008

Standard CIB Research

Until fairly recently, most African monetary policies focused on targeting monetary aggregates along with holding real effective exchange rates (REER) reasonably constant. As the shortcomings of the system have become more apparent, many of the more reformist African central banks have started a journey towards formal inflation targeting frameworks. The process is proving far from a smooth one, and is likely to take many years. But the fundamental change in the monetary policy approach is becoming structurally entrenched across the continent, and is unlikely to be reversed. This move has significant implications for the behaviour of macro-economic variables. For African currencies it means a greater tolerance for appreciation, at least in the initial phase when inflation expectations are being reduced. It also means that real short-term interest rates will initially remain higher. Moreover, subject to developments in secondary bond market liquidity, it is likely that we will see a flattening of yield curves as confidence in price stability grows, eventually producing lower, more stable overall curves.

Monetary aggregate targeting

Through Africa’s key structural adjustment years in the 80s and 90s, central banks (outside of the CFA zone1) were encouraged to target monetary aggregate growth as the anchor for price stability. The policy tended to be twinned with an objective of keeping the countries’ real effective exchange rates (REER) broadly neutral. Among Africa’s more reformist economies (see Table 1), especially those that adopted more prudent fiscal policy, controlling monetary growth proved reasonably effective in bringing inflation down into single digits.

Figure 1: Disinflation in Africa

Note: Equal weights are assigned to inflation in Botswana, Egypt, Ghana, Kenya, Mauritius, Nigeria, South Africa, Tanzania, Uganda and Zambia.

Source: Standard CIB Research, African Central Banks

Shift to excess FX inflows

In some ways, targeting monetary aggregates worked well because of the paucity of FX inflows. Since early this decade, this situation has changed, and we have seen a marked accumulation of FX reserves by central banks.

The reason for the turnaround in the fortunes of Africa’s currencies are well rehearsed but include:

  • the upswing in commodity prices,
  • increased aid via concessional inflows and/or debt relief,
  • the structural shift towards USD weakness,
  • the growing demand from international investors for higher returns, and, most importantly,
  • the growing investment confidence sponsored by better run economies, which has reversed the outflow of both human and financial capital.

The excess FX inflows have proved problematic to central banks in meeting monetary aggregate targets. In particular, they raised the net foreign asset portion of broad money growth substantially when the central banks took the flows into reserves. In order to sterilise their FX accumulation, the central banks have to undertake mopping up operations, effectively squeezing net domestic asset growth. The result is usually an increase in real interest rates to levels that are often inappropriately high.

More flexible monetary policy

Yet, as many African central banks reached FX reserve levels perceived as prudent (around 4 month cover for the import of goods and services), the relative cost-benefit argument for building FX reserves has waned. Maintaining currency competitiveness is having to be weighed against the net cost to the government of sterilising the accumulation and of course the wider cost of higher real interest rates crowding out private sector lending.

The solution has been twofold. Firstly, the authorities have allowed some moderate currency appreciation. Secondly, they have introduced greater flexibility in their monetary aggregate targets. But with growing flexibility in both monetary targets and the exchange rate, many African governments have been ideally placed to move to an inflation targeting lite monetary policy framework.

Shift to inflation targeting

Indeed, led by the example of South Africa, most of Africa’s non-CFA reformist government’s have announced their intention to move towards inflation targeting in the last year or so. The decision has also been influenced, of course, by the wealth of studies that show that higher sustained economic growth is achieved when longer-term price stability is the pre-eminent objective of monetary policy.

But outside of South Africa, which is itself struggling with its inflation targeting credentials, the shift towards inflation targeting is proving more difficult.

Central bank independence

In order to assist central bank inflation fighting credibility, it must be seen to act independently from the government. Indeed, most established inflation targeting regimes have granted constitutional independence to their central banks. That said, as in the case of South Africa, it is often still the government that sets the inflation target in point or range form, making the central bank responsible for delivering the target. While in reality fiscal policy must be aligned with monetary policy in order to deliver price stability, the idea of monetary policy independence is extremely useful in minimising concerns over inflation, especially around election times. While many African central banks now enjoy some constitutional independence, the degree of actual independence still varies considerably across the continent.

Which inflation rate

A major constraint in the road towards inflation targeting remains identifying which inflation measure to target. There is clearly a tension between using an inflation measure that the majority of the population believe adequately reflects their average consumption basket and an inflation measure that presents underlying inflationary pressures. The latter could exclude volatile subcomponents such as food and energy costs and also interest rates on mortgages whose changes in the short term could in itself be counterproductive to policy aims. In essence, the measure selected for the inflation target should include those items that the central bank has some kind of control over, i.e. items that will respond to changes in central bank policy. Perhaps the key issue in most African countries is whether to include food in the measure. Clearly, central banks have little influence over the weather or for that matter international food prices. Yet to exclude food, which in some countries can be as much as two-thirds of consumption baskets, clearly opens the door for the chosen measure to not adequately capture price pressures.

There are also problems with the credibility of the inflation data and particularly its collection. In addition to concerns about statistical integrity (including sample content and size), most inflation measures are disputed by domestic households. As is the case globally, African households generally believe that inflation is underestimated compared to their perceived average price pressures.

In fact, in contrast to the perception that inflation underestimates true price pressures, a larger problem is administered prices. In particular, there are still a number of subsidies (especially on energy costs) prevailing across the continent. Clearly, changes in these subsidies can cause considerable volatility in the inflation series. Moreover, in countries like Egypt and Nigeria, where subsidies are high, the prospect for the removal of such subsidies pushing inflation sharply higher could delay the introduction of a formal inflation target.

Modelling inflation

In many ways, inflation targeting relates to forecasted (or expected) inflation in so much as policy adjustments are made in order to influence prices ex ante rather than ex post. For this to be successful, the central bank has to have a strong forecasting model based on the drivers of inflation. Such a model would invariably require comprehensive and reliable economic statistics, much of which is still lacking across the continent.

Figure 2: Overall impact of move to Inflation Targeting (IT) Framework

Source: Standard CIB Research

Communicating inflation

With expectations management a key component of inflation targeting, the communication of the central bank on inflation matters becomes increasingly important. Most formal inflation targeting central banks establish a monetary policy committee (MPC) with fixed membership, publicised voting structure and a pre-announced meeting timetable. An efficient communications strategy is developed, whereby the MPC decision is announced at a pre-determined time usually accompanied by a press statement, with meeting minutes often released with an appropriate lag.

The heightened importance of communicating means that central banks now have the additional ability to influence interest rate and currency expectations via verbal intervention. Clearly, as the credibility of the central bank becomes more important, consistency in action and communication becomes increasingly necessary.

While many African central banks now hold MPC meetings (some more frequent than others), the communication of these meetings remains extremely patchy and the consistency of the message somewhat mixed. In particular, because of limited forecasting capacity, comments by central banks tend to be somewhat reflective of past inflation rather than predictive. Going forward, communication around inflation will by necessity become more proactive and less reactive.

Reference rates

Under inflation targeting, a central bank’s key mechanism for communicating its policy bias to the market is via a reference rate. Outside of South Africa, few African countries have managed to provide a transparent and consistent link between the central bank’s reference rate and market rates. This is partly due to underdeveloped financial markets. It is also because most central banks still manage liquidity directly to meet monetary aggregate targets rather than to alter their reference rates to indirectly adjust market liquidity to meet inflation objectives. In most African countries, the 91-day T-bill rate still represents the dominant reference rate, even when central bank’s have official alternatives.

Money market deepening

The difficulty of moving from a liquidity management system to an interest rate expectation framework is particularly held back by the immaturity of the money markets.

Increasing the number of liquidity management instruments available to the central bank is crucial during the transition to inflation targeting. In particular, there is a need to deepen repo/reverse repo transactions to facilitate daily central bank fine-tuning of market liquidity. Such instruments are also key for developing longer-term interest rate derivative instruments, which guide the market in its ability to appropriately price interest rate risk.

Figure 3: Greater exchange rate stability (with strengthening bias) supports inflation fight

Note: Equal weights are assigned to inflation in Botswana, Egypt, Ghana, Kenya, Mauritius, Nigeria, South Africa, Tanzania, Uganda and Zambia.

Source: Standard CIB Research, African Central Banks

Bond market development

Although many African economies have bond yield curves that extend to 10 years or longer, the difficulty of predicting future inflation and thus interest rate expectations means that these curves still tend to trade according to liquidity preferences.

Increased secondary bond market liquidity generally removes the term premium demanded for holding longer-dated instruments. If there is no liquidity premium associated with longer dated bonds, then the choice of where to be positioned along the yield curve becomes an issue of interest rate expectations (or duration risk). The key determinant of interest rate risk is inflation and the central bank’s response to expected inflation outcomes.

Lower rates especially at the long end

By containing inflation expectations against the backdrop of deeper secondary market liquidity, interest rates in general will decline (especially those at the longer end of the yield curve) as perceived inflation risk dissipates. Lower interest rate levels have significant implications for reducing fiscal debt servicing costs. But perhaps more importantly, it reduces the cost of private sector term borrowing while at the same time allowing for the appropriate pricing of funds between savers and borrowers.

Financial intermediation

A major constraint in adopting inflation targeting in many African countries is the low transmission between changes in interest rates and changes in domestic economic activity. The key determinant of this is private sector credit extension.

Many countries have experienced a situation where financial intermediation expands as investor and consumer confidence increases against the backdrop of less public sector crowding out of the private sector. Increased financial intermediation assists the conduct of monetary policy through interest rate changes as it impacts a greater portion of the economy. Indeed, as markets mature, economic agents increasingly pre-empt central bank policy changes, which could reduce actual changes to policy rates required to maintain price stability.

Conclusion

The more reform-focused African monetary authorities are shifting their policy frameworks from targeting monetary aggregates and maintaining stable REER to directly targeting inflation. Most African countries face huge obstacles in establishing effective formal inflation targeting systems. Indeed, it will be several years before even the central bank most advanced down the inflation track will have an effective functioning system in place. Nevertheless, there is little doubt that over the last couple of years most of Africa’s better reforming economies have set off on the path towards inflation-targeting, and this process is unlikely to be reversed.

Trading implications

The experience of countries that have completed a similar monetary policy transformation towards direct inflation targeting suggests some structural trading opportunities.

In particular, during the initial phase of managing down elevated inflation expectations central banks will generally be keen to keep monetary conditions relatively tight. This generally implies moderate appreciation in exchange rates, both nominal (trade-weighted) and REER. It also means that short-term real interest rates will remain higher for longer. The combination of currency appreciation against the backdrop of relatively high real interest rates is ideal for the carry trade.

Equally important is that the process of moving to inflation targeting is generally associated with a deepening in secondary bond market trading. The combination of higher levels of liquidity and moderating inflation expectations almost inevitably results in a sharp flattening of yield curves and often inversions. This presents opportunities for bond market investors, particularly those who have appetite for duration.

Source: Standard CIB Research

 
 


Notes:

1Due to the CFA franc’s peg to the EUR, monetary policy independence is limited and monetary policy in the CFA zone broadly follows that of the EU.