It should be about more than interest rates

Until 2008’s quantitative easing — the creation of additional central bank deposits exchanged for treasury bonds or mortgage-backed securities on an unprecedented scale after the global financial crisis — the cash reserves of private deposit-taking banks in the US would seldom exceed the minimal cash they would be required to hold by regulation.

The banks would often satisfy their cash reserve requirement by borrowing from other banks or, in the last resort, borrowing from the US Federal Reserve. This gave the Fed full control over short-term interest rates, and it would supply or remove cash from the banks by open market operations, to reinforce its interest rate settings. The cash reserves of US private banks now stand at $4.2-trillion. They grew by $2.7-trillion between 2008 and 2014, before declining.

When quantitative easing was resumed as lockdown relief in 2020, the cash reserves of the US banks went up by another $2.7-trillion. Given these huge excess reserves, the Fed could hope to control interest rates only by paying interest on the bank deposits held with it. It has become a very different monetary world.

The SA money base has not changed at all over the 12 months to October 2021, while broader money supply (M3) is up by a mere 3.2% and bank credit to the private sector has increased by a minimal 1.3% in the same 12 months. The Reserve Bank liked to describe its policies as accommodating, because interest rates were allowed to fall below inflation. That the money and credit supplies did not grow indicates that — but it is accommodation to a very weak economy.

There is more to the transmission of monetary policy to the real economy than just interest rates. Wealth effects — including those of more or less money — also matter for spending, as is being proved all over again in the US and SA.

The Reserve Bank has not engaged in quantitative easing despite the lockdowns, and does not intend to do so. However, it is arguing for an alternative framework for managing interest rates. Following developed world examples, it also wants to simply pay interest on the deposits of the banks held by the Bank.

Complicated operations to sterilise changes in foreign exchange holdings or movements in the treasury balance with the Reserve Bank, designed to keep the private banks short of cash and having to continuously borrow from the Bank to maintain their cash reserve requirements, will then no longer be necessary.

Paying interest on what may become permanently excess cash reserves will surely give the Reserve Bank full control over money market rates. But will such an approach “create flexibility for dealing with different stages of the financial cycle”, as it argues in its consultation paper?

The long record of money and credit cycles in SA demonstrates that monetary policy has been consistently procyclical rather than countercyclical. The state of the real economy leads the willingness of SA households and firms to borrow more or less from the banks, and the Reserve Bank automatically accommodates the banks’ demands for more or less cash to do so — at a policydetermined interest rate.

The real spending cycle leads the money cycle, and interest rate settings mostly lag behind, as has been the postlockdown experience. This has meant too much monetary and credit accommodation in the booms, and too little in the recessions.

The Bank should pay much more attention to the money supply, starting with controlling growth in the cash reserves supplied to the banks and its follow-through to the money and credit cycles. Had it paid such attention, the recession would not have been as severe. Had the Fed paid closer attention to the money supply cycle it would not now have to play catch-up with inflation.

Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.