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					Managing Alphen Money Asset Sensibly Management

The Alphen Angle is an electronic publication of Alphen Asset Management

16 May 2008

Inflation baskets – which items should be in and out?
In South Africa at present we are witnessing yet again a heated debate about the merits of inflation targeting. Many inflation observers are complaining that the SARB is implementing a flawed inflation targeting program in that they are raising interest rates to quell inflation that is actually not consumer or demand driven. Adrian Clayton This is a common argument raised by various market commentators, believing that much of South Africa’s current inflation spike is driven by fuel and food costs, a global problem where interest rates are a blunt tool in combating it. It is, however, not only a South African problem and in various parts of the world economists are arguing that monetary policy at present is dislocated from the realities of the real price pressures being experienced by consumers on a day to day basis. There is also a large degree of inconsistency in the factors that are included within the inflation indices of central bankers around the world and used to formulate monetary policy – in SA the SARB includes fuel and food but in the US, these are excluded – this raises the question as to who is right? In America where the Fed targets core inflation, a measure of inflation that excludes the rate of increase of various volatile components such as food and energy, one can easily argue that this understates real consumer inflation pressures. The fact that less affluent American households spend a major portion of their budgets on food and energy accentuates this argument. But why would an institution as sophisticated as the Fed target an inflation number that seems to have little bearing on a real consumer? Governor Frederic S. Mishkin, a member of the Board of Governors of the Federal Reserve System, gave an insightful speech on exactly this topic in October 2007 in Montreal, Canada. I have taken the liberty to summarize what I view as his most enlightening points: Although monetary policy is capable of controlling overall inflation in the long run, it does not have the ability to control relative price movements such as those for food and energy. Temporary supply shocks raise the prices of products in the short-term and can have substantial effects on inflation in the short term, but these changes are inherently noisy and do not reflect the long-term underlying rate of inflation. However, when shocks to non-core items are of such a nature that they look like they may permanently affect the rate of change in prices of core products on a sustainable basis, then central banks should take these prices more seriously. Headline inflation (which does include food and energy prices) in the US over the past 25 years has tended to revert to core inflation (which does not include food and energy prices) rather than the other way round. We have added a graph to this article comparing US core and headline inflation. Our analysis reveals some interesting points, firstly, that the difference between the two measures over time is almost zero, secondly, that headline inflation is much more volatile than core inflation and lastly, that currently the difference between the two is as large as it was in the 1970’s and mid 1980’s, two seriously inflationary periods. Core inflation is a much better approximation for permanent changes to inflation than headline inflation. Headline inflation measures tend to be volatile and transitory. If monetary policy makers respond to this, they tend to respond to temporary fluctuations in inflation with serious implications for economic growth. There is always a lag between monetary policy and inflation changes and targeting an incorrect and volatile measure that is unaffected by monetary policy could have the affect that interest rates go much higher or lower than is necessary to deal with true underlying price changes.






Managing Money Sensibly

16 May 2008

16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Jan-61 Jan-64 Jan-73 Jan-76 Jan-85 Jan-88 Jan-00 Jan-03 Jan-06 Jan-58 Jan-67 Jan-70 Jan-79 Jan-82 Jan-94 Jan-97 Jan-91

US Core Inflation (excluding energy and food) Source: Federal Reserve Bank

US Headline Inflation

In my opinion, Mishkin initiated his speech with an essential point that monetary policy is not all about controlling inflation; it should also be equally concerned about maximizing sustainable employment. With this in mind and taking account of all the points raised above, I will conclude this Angle with the following questions. Firstly, whilst being aware that in developing economies food and energy makes up a much larger component of the average consumer’s discretionary spend than in developed economies and consequently many emerging central banks do target an inflation measure inclusive of these components. The question remains, why is the South African Central Bank targeting an inflation measure that is disregarded by the most sophisticated central bank in the world? Secondly, is inflation targeting in a small open and developing economy appropriate when the exchange rate remains a key driver of the inflation rate? Finally, assuming that the SARB is unlikely to deviate from inflation targeting, is it not time for the local central bank to take a serious breather with respect to interest rate hikes considering the lagged affects of monetary policy on inflation together with the point that current inflation is being driven by exogenous factors which are unaffected by monetary policy?

Enjoy your weekend.

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If you have any queries regarding the above commentary please contact Mark Cliff on 021 799 8069 or 083 700 3600 or

PLEASE NOTE: While every effort has been made to ensure that the information contained herein is correct, Alphen Asset Management cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of Alphen Asset Management. Views and opinions expressed herein may change with market conditions and should not be used in isolation.

Alphen Asset Management is a subsidiary of PSG Fund Management Holdings (Pty) Limited

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