transmission mechanism in South Africa(1)
“Monetary policy works largely through indirect channels – in particular, by influencing private-sector expectations and thus long-term interest rates.” Bernanke (2004).
Central banks often have to respond to actual, perceived or anticipated events. ,In their efforts to achieve domestic price and financial market stability in the ever-changing internationalised economy, South African monetary authorities have increasingly become exposed to numerous challenges.
When a central bank decides on a route or action to be taken, it sets in motion a series of economic events. The sequence of events starts with the initial influence on financial markets, which, in turn, slowly works its way through to changes in current expenditure levels (especially private consumption and investment). Changes in domestic demand influence current production levels, wages and employment, and in the process lead to a change in domestic prices, i.e. the rate of inflation. Economists refer to this chain of developments as the “transmission mechanism of monetary policy”.
The monetary transmission mechanism is one of the most important mechanisms in the economy as it explains the process through which monetary policy decisions are transmitted to real gross domestic product (GDP) growth and inflation. Changes in monetary policy are linked to changes in output, inflation, employment and a variety of economic variables. It is widely accepted that the main goal of central banks should be the pursuit of low and non-volatile inflation. Many economists agree that in the short run, monetary policy actions can affect real output and other economic variables. However, in the long run, money is generally considered to be neutral (i.e. it does not affect real economic variables such as production). Nevertheless, there is broad agreement about the important contribution that monetary policy (which is oriented towards maintaining price stability) can make to improve economic prospects and raise living standards. However,, there is far less agreement on how precisely monetary policy exerts its influence on the economy i.e. consensus on the transmission mechanism does not always exist.
Since there are long lags in the transmission mechanism (i.e. between monetary policy initiatives and the rate of inflation), the chain of events emanating from a change in the South African Reserve Bank’s (Bank) repurchase rate(2) (repo rate) needs to be studied and analysed conclusively. The study of these intricate links between the key economic variables will ensure that correct policy measures are implemented to effect a specific outcome in future. Therefore, to be successful in conducting monetary policy, monetary authorities must have an accurate assessment of the timing and effect of their policies on the economy, thus requiring an understanding of the mechanism through which monetary policy affects the economy.
The main links in the transmission mechanism of monetary policy can be depicted in Figure.1. The repo rate has direct effects on other variables in the economy, such as other interest rates, the exchange rate, money and credit, other asset prices and decisions on spending and investment. Eventually, changes in the repo rate affect the demand for and ultimately the supply of goods and services.
Channels in monetary policy transmission (3)
Through economic research, various models were developed to explore and better understand the channels through which monetary policy affects aggregate demand and ultimately inflation. This section briefly describes the interest rate channel or transmission mechanism that is important in an inflation targeting regime.
Official interest rate decisions affect market interest rates to varying degrees. At the same time, policy actions and announcements affect expectations about the future course of the economy and the confidence with which these expectations are held as well as prices and the exchange rates. The size of the change in any central bank’s interest rate is not a good indication of the likely impact of monetary policy on that economy. If market interest rates, the exchange rate of the rand, credit or other asset prices do not respond meaningfully to changes in the official interest rate, monetary policy will have little effect on the economy, i.e. the channels are blocked or not fully functional. The key links in the mechanism are illustrated in Figure 1.
Figure 1 The transmission mechanism
The interest rate channel can be presented as follows:
The first stage of the mechanism involves the impact of this change in the repo rate on other interest rates and asset prices. A change in the repo rate (e.g. an increase) is immediately transmitted to other short-term money-market rates, both to money-market instruments of different maturity and interbank deposits. But these rates may not always move by the exact amount of the official rate (repo) change. Soon after the repo rate changes (typically the same day), banks adjust their standard lending rates (prime rates), usually by the exact amount of the policy change. This quickly affects the interest rates that banks charge their customers. Rates offered to savers also change to preserve the margin between deposit and loan rates. This margin may vary over time. The repo rate influences market rates in two ways: Firstly, it directly influences banks' marginal cost of funding and secondly, it reflects the bank's stance on monetary policy. Therefore, even the interest rates of banks which do not participate in the repo auctions are adjusted when the repo rate is increased or decreased. Thus the cost of capital is affected, causing a decline in investment spending (I) and consumer spending I, leading to a decline in aggregate demand and real output (y). It is precisely through these channels that demand pressures feed through changes in the output gap to inflation.
The role played by the expectations of economic agents in determining the impact of monetary policy changes is difficult to restrict to a particular channel in Figure 1. Repo rate changes can influence expectations about the future course of real activity in the economy, and the confidence with which those expectations are held. Such changes in perceptions will affect participants in financial markets, and they may also affect other sectors in the economy, for example changes in expected future labour income, unemployment, sales and profit. The direction in which such effects work is not clear and can vary from time to time. An increase in the repo rate could, for example, be interpreted as indicating that the Monetary Policy Committee (MPC) believes that the economy may be growing faster than previously thought, giving a boost to expectations of future growth and confidence in general. However, it is also possible that a rate increase would be interpreted as signalling that the MPC perceives the need to slow growth in the economy to reach the inflation target, and this could lower expectations of future growth and confidence. The possibility of such effects contributes to the uncertainty of the impact of a policy change and increases the importance of having a credible and transparent monetary policy regime.
The final stage concentrates on the impact of the various channels on inflation(4) . All else being equal, the contraction in total demand will reduce output relative to its potential level, and this will, in turn, slow the rate of increase in the price level relative to its trend. It will also reduce the rate of wage increases in the labour market. These effects are supplemented by a direct effect for price and wage expectations (second-round effects) to influence the inflation process, and also a direct channel for the appreciation-induced reduction in traded goods prices to pass through to lower domestic inflation. Together, these channels transmit the effect of an increase in the repo rate to ultimately lower output and inflation.
(1) The views expressed in this article are that of the author and do not necessarily reflect the view of the South African Reserve Bank.
(2) Through its refinancing system, the Bank provides liquidity to banks, enabling them to meet their liquidity requirements, charging the repurchase rate (repo rate – a fixed interest rate determined by the Monetary Policy Committee (MPC).\
(3) Other channels of monetary policy transmission include asset price channels, credit channels, bank lending channels and balance sheet channels.
(4) Unfortunately all the channels cannot be described in detail due to lack of space.