Essays on the impact of inflation targeting in South Africa
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Date
2012
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Abstract
Through the literature review this study points out the debate as to whether inflation targeting
(IT) has been effective in anchoring expectations, stabilizing output, reducing the inflation
rate, and the volatility and persistence of inflation, is still an open question. Further, this
study asserts that perhaps the perceived success of IT is nothing more than just ‘conservative
window dressing’ (ie., raising interest rate to maintain low inflation at the expense of output
losses).
In the form of three separate essays this study attempts to contribute to the above debate
about the effectiveness of IT and the conservative monetary policy assertion. The first essay
undertakes a detailed econometric investigation into whether the inflation expectations of the
various market players (viz., financial analysts, business executives and trade unionists) are
anchored to an inflation target, and if so then it would imply that they find the central bank’s
IT framework to be credible (termed the credibility proposition). However, if expectations
are not anchored to the target then it implies that agents do not find the central bank’s IT
policy to be credible. When the inflation and expectations data are stationary then the
credibility proposition can be tested using the Cruijsen and Demertzis, (2010) vector
autoregression framework, but when the mentioned data are nonstationary, as is the case of
South Africa, then the Johansen (1991) cointegration and vector error correction modelling
techniques must be used. The study found that only financial analysts tend to find the South
African Reserve Bank’s IT framework to be credible while business executives and trade
unionists do not find this policy framework to be credible.
The second essay attempts to investigate whether inflation volatility and inflation persistence
have declined since the adoption of IT, since IT purports to anchor expectations around a
target or target band, thereby reducing inflation volatility and inflation persistence. This study
contributes to the debate by examining South Africa’s IT performance in respect of inflation
volatility and inflation persistence using the generalized autoregressive conditional
heteroscedasticity (GARCH), GARCHM (-in mean) and AR (2) (second order autoregressive
model) methodologies. In order to avoid erroneous conclusions the study accommodates for
structural breaks in the data using the Bai and Perron, (2003), the Lee and Strazicich (2003), the
Andrews and Ploberger (1994) and the Lumsdaine and Papell (1997) unit root tests. The study found
no significant changes in inflation volatility and persistence over the pre and post IT periods. The third essay estimates forward-looking hybrid Taylor-type reaction functions using the
general method of moments (GMM) technique. as was estimated by Clarida, Gertler and Gali
(1998), Gerdesmeier and Roffia (2003), Hayo and Hofmann (2005). The results showed that
over the IT period, South Africa followed a conservative (high weighting on inflation
reduction and low weightings on output deviation in setting the repo rate) predictable
monetary policy.
The study also presented case studies of the IT experiences of Chile, Brazil, Turkey and
compared them to South Africa. The findings suggest that in all the countries, IT is effective
in reducing inflation and achieving sustainable economic growth. However, whether IT is
effective in reducing inflation expectations, volatility and persistence and stabilizing output
close to its normal levels, from a statistical perspective is still an open question.
A synthesis of the three essays suggest that the authorities have not succeeded in convincing
price and wage setters that IT can credibily maintain inflation within the target band, hence
inflation and inflation volatility persists. Moreover the success of inflation targeting is hinged
on raising the repo rate to prevent the second round effects of supply shocks (eg., oil price
hikes, exchange depreciations) from manifesting itself, however the effect of this policy
stance is at the expense of output stabilization, which poses challenges for the transformation
of monetary policy in the future.
Description
Submitted to the Faculty of Commerce, Administration and Law in fulfillment of the requirements for the D Com (Economics) Degree University of Zululand, South Africa, 2012.
Keywords
Inflation targeting -- South Africa, Inflation -- South Africa