Abstract
This paper examines the impact of exchange rates on the monetary policy conduct of South Africa’s central bank (SARB). We also examine whether the SARB’s responses depend on whether South Africa’s exchange rate is undervalued or not. To investigate these questions, we incorporate a real exchange rate misalignment term into a forward-looking Taylor-type policy rule. We find empirical evidence supporting the hypothesis that the SARB responds asymmetrically to undervalued real exchange rates. Finally, a general result is that the SARB allocates more weight towards expected inflation stabilization, a lower weight towards output gap stabilization and the lowest weight towards the exchange rate.
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Notes
Along these lines, Proaño (2013) shows in a theoretical model of a small open economy characterized by heterogenous, boundedly rational foreign exchange expectations that PPI targeting is superior to CPI targeting when the nominal exchange rate is driven by trend-extrapolating exchange rate forecasting rules.
In de Mello et al. (2013), the transition variable is the expected inflation gap. They also find policy rate responses to exchange rates for Colombia which are positive and statistically significant in the linear part of the model and negative responses in the nonlinear part model.
Clarida (2001) argues that monetary policy with objectives of stabilizing inflation and the output gap may also be consistent with interest rate responses to an exchange rate when it depreciates and/or when an exchange rate is misaligned even if a central bank does not target the exchange rate.
We use CPI because the SARB currently targets consumer price inflation using an inflation target range (band) between 3 and 6% for year-on-year inflation.
The composite coincident business cycle indicator is constructed at the monthly frequency by integrating various individual economic time series into a single indicator time series that reflects the movement of the turning points in the business cycle. The time series included in the business cycle coincident indicator displays various aspects of economic activity. This measure is considered to be the best proxy for output for South Africa at the monthly frequency (Naraidoo and Raputsoane 2015). See also the SARB for details about the composite—coincident, lagging and leading—business cycle indicators.
The commodity price series is discontinued from 2008M01. Thus, from 2008M01 onward, we augment these data with a producer price index that accounts among other things for agricultural products, minerals and coal and petroleum products.
The SARB has had numerous monetary policy frameworks which have included adjusting interest rates to achieve their targets, and the repo rate has been regarded as the main monetary policy instrument since 1998. Further, the repo rate has been the rate adjusted by the SARB when adjusting monetary policy since the adoption of inflation targeting on February 2000. Thus, over our total sample period and subsample period, we only use the repo rate as the monetary policy instrument because it is specific with a particular period and it also allows us to use a consistent data series relating to a policy instrument that covers our sample periods. Refer to Baaziz et al. (2013) for more details about the history of the SARB.
More specifically, using the DF-GLS and Ng–Perron tests with the standard AIC and SIC criterion rejects the null of a unit root in annual inflation. Using a modified AIC and SIC provides less evidence toward failing to reject the null of a unit root. However, along with the Ng–Perron MZt test, the MZa, MSB and MPT lean more toward rejecting the null of a unit root in annual inflation. All unit root tests are reported in “Appendix”. Clarida et al. (1998) outline that in their analysis, their econometric approach depends on the assumption that the short-term interest rate and inflation are I(0). However, they note that for the USA and Japan, there is less evidence supporting that short-term interest rates are I(0). One of the problems that they identify is that the Dickey–Fuller test has low power (especially in the context of short samples) and hence they continue their estimation using US and Japan short-term interest rates. In a related manner, Clarida et al. (2000) note that their empirical analysis is based on the assumption that both inflation and the nominal interest rate are stationary. However, they point out that the persistence of both series generally makes it hard to reject the null of a unit root at conventional significance levels. Another factor noted by Clarida et al. (2000) with respect to the stationarity assumption is that many theoretical models that employ a forward-looking monetary policy reaction function feature inflation and nominal interest rates which are stationary.
For estimation purposes and for all the policy rules, the exchange rate enters with a one period lag to avoid simultaneity problems and also to account for the timing convention associated with the real exchange rate being observable for policy authorities when making interest rate decisions. See also Clarida et al. (1998) and Castro (2011).
The set of instruments for the extended model are the same as the instruments used in the baseline model; however, different lag structures are used for the instruments for different policy rule specifications wherever necessary. For the subsample estimates in Table 2, we include a dummy variable for the period 1998:01–1998:12 because of the Asian financial crisis and the associated effects on the South African economy, especially on the repo rate, annual inflation and the exchange rate. Further, we also include a dummy variable for the period 2003:01–2003:12 which captures a rapid reduction in annual inflation by over 10.5 percentage points over the period and also a substantial 550 basis points reduction in the policy rate over the period 2003:01–2003:12.
Svensson (1997, 2002) notes that inflation targeting is an inflation forecast targeting procedure. Thus, inflation and output forecasts are continuously revised on the basis of past and recently available information. As exchange rate depreciations can lead to inflationary pressures and make a conditional inflation forecast higher than its target, this can result in an upward policy rate adjustment to make an inflation forecast consistent with its target over a particular forecast horizon.
South Africa does not have official data on an industrial production index; however, a total mining (seasonally adjusted) and total manufacturing index (seasonally adjusted) are available from the IMF’s IFS and also from Statistics South Africa. Thus, we construct a proxy for the industrial production index with an equally weighted linear combination of manufacturing production index and mining production index. Using our proxy for an industrial production index, we also find consistent results over the total sample and in most of the specifications over the subsample.
Annual output growth in this data refers to annual growth using a composite coincident business cycle indicator. Similar dynamics are exhibited when examining annual output growth with our constructed industrial production index and also with annual quarterly real GDP growth (seasonally adjusted) over 1984:Q2–1987:Q2.
Similar dynamics are exhibited when examining annual output growth with our constructed industrial production index over May 1995–April 1996 and also with annual quarterly real GDP growth (seasonally adjusted) over 1995:Q1–1996:Q1.
Similar dynamics are exhibited when examining annual output growth with our constructed industrial production index over April 1997–October 1999 and also with annual quarterly real GDP growth (seasonally adjusted) over 1997:Q1–1999:Q1.
Similar dynamics are exhibited when examining annual output growth with our constructed industrial production index and also with annual quarterly real GDP growth (seasonally adjusted) over 2001:Q1–2001:Q4.
Similar dynamics are exhibited when examining annual output growth with our constructed industrial production index and also with annual quarterly real GDP growth (seasonally adjusted) over 2008:Q1–2009:Q3.
Similar dynamics are exhibited when examining annual output growth with our constructed industrial production index over August 2013–January 2015 and also with annual quarterly real GDP growth (seasonally adjusted) over 2013:Q3–2014:Q2.
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Lebogang Mateane and Christian Proaño declare that they have no conflict of interest.
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Appendices
A Multiple periods of adverse macroeconomic dynamics
South Africa has experienced multiple periods of a depreciating currency, rising inflation and low growth. Empirical data sourced from the South African Reserve Bank (SARB) and the IMF’s IFS are exhibited in Figs. 1 and 2 and seem to show that when the SARB is faced with such dilemmas, it has a greater bias toward stabilizing the exchange rate and raising interest rates to stabilize inflation even if it may be at the cost of large output losses. Thus, it seems that the SARB is reluctant to absorb the effects of currency depreciations which can destabilize and increase expected and future inflation and result in credibility loss.
South African macrodata
South African macrodata
Periods prior the implicit and explicit inflation targeting (prior 1994) exhibit that a depreciating real (South African) rand/US dollar is consistent with rising annual inflation and a rising trajectory of the repo rate (even though the repo rate has been regarded as the main monetary policy instrument since 1998). For example, a depreciating real rand/US dollar from October 1983 to October 1984 is consistent with a trajectory of rising annual inflation from February 1984 to January 1986, and this is characterized by a 9.78 percentage point increase in annual inflation. There is an associated rising trajectory of the repo rate from November 1983 to August 1984, and this is characterized by a cumulative 618 basis points change in the repo rate over the period October 1983–August 1984. In the midst of a rising repo rate, annual output growth exhibits a downward trajectory over the period May 1984–August 1987.Footnote 15 Similarly, the real exchange rate depreciates between April 1993 and May 1994, and this is consistent with a rising annual inflation trajectory from April 1994 to April 1995, and annual inflation between April 1994 and April 1995 is 10. 5%. The repo rate increases in a stepwise manner with a 100 basis points upward adjustment at each interval from September 1994 to November 1996, and thus, an associated cumulative 500 basis points change between August 1994 and November 1996. In the midst of a rising repo rate, annual output growth exhibits a downward trajectory over the period March 1995–March 1996.Footnote 16 Over the implicit and explicit inflation targeting period (post 1994), a depreciating real rand/US dollar from December 1997 to July 1998 is consistent with a trajectory of increasing annual inflation from April to November 1998. There is an associated increase in the repo rate from April to September 1998, and it is characterized by a 693 basis points spike in the repo rate over the period. In the midst of an increase in the repo rate, output growth exhibits a downward trajectory over the period April 1997–July 1999.Footnote 17 The exchange rate depreciation and rising interest rates over the period 1997–1998 coincide with the Asian financial crisis and exhibit similar exchange rate, interest rate and inflation dynamics to countries such as South Korea, Thailand and the Philippines. For more details on the triggering mechanisms of the Asian financial crisis and the exchange rate, interest rate and inflation dynamics of South Korea and Philippines over this period refer to Osawa (2006). Over the explicit inflation targeting period (post February 2000), the real rand/US dollar exchange rate depreciates by over 20% in nominal and real terms over the last 3 months of 2001. This is consistent with a trajectory of rising inflation characterized by a 12.23% annual inflation rate between October 2001 and October 2002 and thus breaching the 3–6% inflation target band. The repo rate remains unchanged for the last 4 months of 2001 and only starts to increase between January–September 2002 with an associated cumulative 400 basis point change between December 2001 and September 2002. The cumulative 400 basis points change in the repo rate is stylized by a stepwise increase of 100 basis points at each interval of change. The rising repo rate is in an environment where output growth already exhibits a downward trajectory from April 2001 to February 2002.Footnote 18 The real rand/US dollar exchange rate also depreciates over the period February–July 2006, and this is consistent with a trajectory of rising annual inflation from April 2006 to August 2008 and inflation peaks on August 2008 at about 12% annual inflation. However, this coincides with a rising oil price trajectory from 2006 with oil peaking over the June–July 2008 period. The repo rate starts to increase between June 2006 and June 2008 with an associated cumulative 500 basis points change between May 2006 and June 2008. The cumulative 500 basis points change in the repo rate is stylized by a stepwise increase of 50 basis points at each interval of change. The rising repo rate is in an environment where output growth already exhibits a downward trajectory from April 2008 to August 2009.Footnote 19 The real rand/US Dollar exchange rate depreciates between February–June 2013, and this is consistent with a trajectory of rising annual inflation between June 2013 and August 2014. The rising trajectory of annual inflation breaches the 3–6% upper bound of the inflation target band in consecutive periods, namely July–August 2013 and also over the period May–August 2014. The rising inflation trajectory is consistent with an increase in the repo rate by 50 basis points on January 2014 and a further 25 basis points increase in the repo rate on July 2014 against a background under which the repo rate had remained constant for 18 consecutive months. The rising repo rate is in an environment where output growth already exhibits a downward trajectory from October 2013 to January 2015.Footnote 20 In general, the data exhibit consistent patterns of the dynamics of the real exchange rate, inflation, the repo rate and output growth. It seems that the SARB is reluctant to absorb the effects of currency depreciations which can destabilize and increase expected and future inflation and result in a credibility loss. These patterns are also consistent over periods prior the implicit and explicit inflation targeting periods (prior 1994) and over the implicit and explicit inflation targeting periods (post 1994). Moreover, the interest rate adjustments are in the form of spikes and predominantly in stepwise interest rate increments usually between 50 and 100 basis points. Thus, it seems that the SARB considers the interest rates adjustments to be crucial because as noted by Mohanty and Klau (2004)—using a Greenspan’s baby step approach—a 25 basis points adjustment at each go is considered as advisable but not essential and a 50 basis points adjustment is deemed crucial.
B Unit root tests results
See Table 3.
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Mateane, L., Proaño, C.R. Does monetary policy react asymmetrically to exchange rate misalignments? Evidence for South Africa. Empir Econ 58, 1639–1658 (2020). https://doi.org/10.1007/s00181-018-1595-4
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DOI: https://doi.org/10.1007/s00181-018-1595-4