Can a central bank simply announce an inflation target and get
everyone to believe it? Our Global Economist Arunima Sinha looks
at the cases of South Africa and Brazil to explain why it’s a
subject of decades-long debate.
Read more insights from Morgan Stanley.
----- Transcript -----
Arunima Sinha: Welcome to Thoughts on the
Market. I'm Arunima Sinha, Global Economist at Morgan
Stanley.
Today I'm going to talk about how inflation targets of central
banks matter for market participants and economic activity.
It's Tuesday, August 12th at 10am in New York.
Tariff driven inflation is at the center of financial market
debates right now. The received wisdom is that a central bank
should look through one-off increases in prices if – and it is an
important if – inflation expectations are anchored low enough.
Inflation targets, inflation expectations, and central bank
credibility have been debated for decades.
The Fed's much criticized view that COVID inflation would
be transitory was based on the assumption that anchored
inflation expectations would pull inflation down. The Fed is more
cautious now after four years of above target inflation. Can a
central bank simply announce an inflation target and get everyone
to believe it?
Far away from the U.S., the South Africa Reserve Bank, SARB, is
providing a real time experiment. The SARB’s inflation target was
originally a range of 3 to 6 per cent, with an intention to shift
to 2 to 4 percent over time. At its last meeting, the SARB
announced that it was going to target the bottom end of the
range, de facto shifting to a 3 percent target. A decision by the
Ministry of Finance in the coming months is likely necessary to
formalise the outcome, but the SARB has succeeded in pulling
inflation down. It has established credibility, but we suspect
that more work is needed to anchor inflation expectations firmly
at 3 percent.
Key to the SARS challenge, as the Fed’s – the central bank cannot
control all the drivers of inflation in the short run. For South
Africa, fiscal targets and exchange rate movements are prime
examples. The experience in Brazil offers insight for South
Africa. The BCB adopted an inflation target in 1999 following the
end of the currency peg that helps the transition away from
hyperinflation. The target was initially set at 8 percent,
lowered to 4.5 percent in 2005, and then lowered again to 3
percent in 2024.Fiscal outcomes, market expectations, and
currency volatility have been hard to contain. The lessons apply
to South Africa and also the Fed. Successful inflation targeting
relies on a clear framework, but also on institutional strength
and political consensus.
For South Africa, as inflation falls ex-ante real interest rates
will rise. That outcome will be necessary to restrain the economy
enough to make sure that the path to 3 percent is achieved. For
an open EM economy, there likely needs to be consistency by both
monetary and fiscal authorities with regard to short-term
pressures, both internal and external.
While we ultimately expect the SARB to be able to anchor
inflation expectations, the journey may not be a quick one; and
that journey will likely depend on keeping real interest rates on
the higher side to ensure the convergence.
We take the experiences of South Africa and Brazil to be
informative globally. Simply announcing an inflation target
likely does not solve the problem. The Fed, for example, spent
much of the 2010s hoping to get inflation up to target – while
now ironically, inflation in the US has run above target for
almost half a decade.
Whether the lingering effects of the COVID inflation has affected
the price setting mechanism is unclear, as is whether tariff
driven inflation will exacerbate the situation. Our read of the
evidence is that inflation expectations and central bank
credibility come from hitting the target, not from announcing
it.
Thanks for listening. If you enjoy the show, please leave us a
review wherever you listen and share thoughts on the market with
a friend or colleague today.
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