INFLATION TARGETTING IN SOUTH AFRICA: A VAR

ANALYSIS
G Woglom
*
Abstract
he first part of the paper analyses CPI inflation targeting in an open
economy context. Inflation targeting makes the exchange rate less
flexible in response to foreign shocks and thus lessens the automatic
stabilisation provided by flexible exchange rates. The second part uses
VAR techniues to study the relative freuencies of different kinds of
shocks impinging on the !outh African" #e$ %ealand and Canadian
economies. The results suggest that !outh Africa is not a good candidate
for an inflation target relative to the other t$o countries because of the
relative importance of foreign shocks and of the $eak linkage bet$een
monetary policy and inflation.
T
1. Introdut!on
A number of industrial countries have recently adopted inflation targets with an apparent
degree of success (see Bernanke and Mishkin (1997)) !his apparent success has led
some to speculate that inflation targets might also be desirable for countries at somewhat
lower stages of economic development (see Masson et al (1997))" including #outh
Africa !he idea of an inflation target for #outh Africa has" in fact" drawn growing
support as a practical response to the increasing difficulty of monetary targeting with a
liberalised capital account (see $astelei%n (1999)" #tals (1999) and Mboweni(1999))
!his paper looks at the historical evidence to %udge whether #outh Africa is a good
candidate for an inflation target &n particular" the #outh African evidence is compared
to the evidence from $anada and 'ew (ealand" two countries that have adopted inflation
targets in 1991 and 199)" respectively !he main conclusion of the paper is negative
primarily for two reasons* 1) !he e+change rate is highly volatile in #outh Africa" and
some of this volatility appears to be stabilising the effects of e+ternal shocks ,nder
inflation targeting" monetary policy would have to dampen these e+change rate
movements which are affecting the consumer price inde+ ($-&). /) !he linkage between
monetary policy instruments and future inflation rates in #outh Africa is weak As a
&
0isiting 1ulbright #cholar (,niversity of the 2estern $ape)" 3epartment of 4conomics" Amherst $ollege"
Amherst" MA )1))/" ,nited #tates of America 4mail* grwoglom5amherstedu
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) 1
conse:uence wide swings in policy instruments would be needed to fulfill an inflation
target
!he rest of the paper comprises the ne+t three sections &n the first of these sections the
complications of inflation targeting in an open economy are analysed &t is shown that
inflation targeting has the disadvantage of making the e+change rate less fle+ible in
response to shocks to the goods market !he subse:uent section uses vector
autoregression techni:ues to provide a description of the dynamic behavior of the #outh
African economy and the $anadian and 'ew (ealand economies for the period before
their adoption of an inflation target !he performance of the #outh African economy is
then compared to the pretarget performance of the other two economies with regard to
the importance of the e+change rate and to the strength and predictability of the linkage
between policy instruments and subse:uent rates of inflation !he paper;s ma%or
conclusions are summarised in the last section
". T#$ t#$or$t!%l %n%l&'!' mon$t%r& (ol!& (ro$dur$'
".1 T#$ tr%d!t!on%l l!t$r%tur$ on !n)l%t!on *!%' %nd nom!n%l %n#or'
4ver since <ydland and -rescott (1977) introduced the time inconsistency problem into
macroeconomics" the analysis of monetary policy regimes has focused on two aspects of
any rule or procedure (eg" 8ogoff (19=>))* 1) !he inflationary bias inherent in the rule
or procedure and /) the stabilisation properties of the rule or procedure !hus
discretionary monetary policy with the dual ob%ectives of inflation and real output
stabilisation is viewed as having the advantage of the greatest potential for stabilising all
types of shocks" but the disadvantage of an inherent inflationary bias !he stabilisation
advantage of totally discretionary policy" however" only e+ists to the e+tent that the
central bank can use its discretion effectively to offset the effects of shocks
!he disadvantage of the inflationary bias can be lessened by adopting a monetary policy
rule aimed at a single nominal ob%ective" eg" the money stock" the inflation rate" or
nominal ?3- (although not the nominal interest rate) !he most popular of the single
nominal targets" or nominal anchors" is a $-& inflation target 8elative to discretion with
dual ob%ectives" inflation targeting has less of an inflationary bias &nflation targets do"
however" decrease the potential for active stabilisation" at least with regard to supply
shocks
1
1or demand shocks" both monetary policy based on an inflation target and on
dual ob%ectives will attempt to offset shocks to aggregate demand 2ith supply shocks"
however" inflation targeting mandates a totally nonaccommodative response that
'
&n principle" it is possible to adopt an inflation target with no loss in stabilisation 2alsh (199>) has shown
that @optimalA stabilisation can be achieved by writing a contract with an independent central bank that
imposes an added cost to inflation #venson (1997) has shown that the same result can be achieved by
setting the inflation target sufficiently below the socially optimal inflation rate !he inflation targets that have
been adopted have not used these methods" and conse:uently imply a loss in active stabilisation of supply
shocks
/ 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
maintains the inflation rate" whereas a fully discretionary policy response may find it
optimal to accommodate at least some of the supply shock
2hile the advantage of nominal targets like the inflation rate is a reduction in
inflationary bias" the e+tent of the reduction depends on how credible the target is
8ecent discussions of credibility (see for e+ample" ?oodhart and 0inals (1999) and
3ebelle and 1isher (1999)) have focused on the transparency of the targeting procedure
and the e+tent to which the procedure can make the central bank accountable for its
actions
/
?reater transparency and accountability increase credibility" but they decrease
a central bank;s fle+ibility in responding to unforeseen circumstances
!he inflation targeting regimes that have been adopted" however" have tried to preserve
at least some central bank fle+ibility 1or e+ample" the inflation targets that have been
adopted specify that the target is to be met over long horiBons (1C/ years) with
substantial tolerance bands for acceptable inflation rates (/CD percentage points) 1inally"
some countries have adopted e+plicit escape clauses" where the central bank can ignore
the inflation target because of adverse conse:uences of achieving the target (eg" hitting
an inflation target in the face of an adverse supply shock. see Masson et al (1997) for a
description of specific procedures) !he variety of institutional procedures that have
been adopted to provide fle+ibility under an inflation target has led some authors to
describe inflation targeting as a policy framework rather than a policy rule (Bernanke
and Mishkin (1997))
But surely there must be a tradeoff between the benefits of increased fle+ibility and the
benefits from the inflation target 1or e+ample" long targeting horiBons may make it
more difficult to hold the central bank accountable for missing the target* was the target
missed due to inappropriate central bank actions or to large subse:uent shocksE
!olerance bands allow the central bank some discretion in how to respond to the current
shock" but they thereby make the central bank;s response less predictable" and their
actions become less transparent More fundamentally" long horiBons" tolerance bands"
and escape clauses reintroduce an element of discretion into how actively the central
bank pursues the nominal target !he benefits from inflation targeting in terms of
transparency and accountability as well as in a reduction in inflationary bias" however"
can only achieved if the targets place some constraint on central bank behavior
&n summary" the traditional literature on targeting procedures implies that an inflation
target is desirable when 1) monetary policy makers have little reputation for inflation
stability" so that the inflationary bias of fully discretionary policy with multiple
ob%ectives is high andFor rising. /) aggregate supply shocks are not an important source
of instability" or /;) monetary policy makers are ineffective in making discretionary
changes in the policy instrument to offset the effects of shocks" and D) the linkages
between the monetary instrument and future inflation are sufficiently strong and
(
Accountability and transparency issues have led many (see for e+ample 3ebelle and 1isher (1999)) to favor
inflation targets over nominal ?3- targets" in spite of the greater stabilisation potential of nominal ?3-
targets
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) D
predictable" so that targeting horiBons can be short enough and tolerance bands narrow
enough to substantially reduce the inflation bias
".1 In)l%t!on t%rg$t!ng on o($n $onom!$'
Most of the theoretical analysis of policy procedures and policy rules has been conducted
in a closed economy conte+t
D
An open economy" however" can make the analysis of the
desirability of an inflation target significantly more complicated because of the
distinction between the consumer price inde+ ($-&) and the price of domestically
produced goods 1or simplicity" the $-& can be written as*
" e F p ) 1 ( $-4 + = G (1)
where P is the price of domestically produced goods is the weight of imported goods in
the CPI and e is the nominal e+change rate e+pressed as foreign currency per unit of
domestic currency (with the foreign price level normalised to 1)
!his simple e:uation immediately implies a distinction between stabilising the inflation
rate as measured by the price of domestically produced goods versus as measured by the
$-& !his distinction is important when the central bank must change the e+change rate
in order to stabilise the price of domestic goods and the level of output 1or e+ample" the
distinction is not important in the case of shocks to the money market (eg" an
autonomous change in the velocity of money) #hocks to the money market affect both
the price of domestic goods and the e+change rate by changing the level of aggregate
demand !herefore the central bank" by offsetting the effect of the velocity shock on
aggregate demand" can stabilise both the e+change rate and the domestic price level" and
therefore also the $-&
!he distinction between the price of domestic goods and the $-& is important for goods
market shocks" say an autonomous drop in e+port demand !he importance of this
distinction is illustrated in the figures on the ne+t page !hese figures depict a simple
te+tbook" &#HM version (eg" Mankiw (1997)) of the Mundell 1leming model of a small
open economy !he HM curve has a vertical slope because the demand for money is
assumed to depend only on the price of domestic goods and the interest rate is determined
by the world interest rate &n this simple model" a perfectly fle+ible e+change rate
provides complete" automatic stabilisation of &# shocks 'otice" however" that while the
depreciation of the currency completely offsets the effects of the &# shock on output and
the price of domestic goods" the $-& still increases because of the rise in the local
currency price of imported goods ,nder a binding $-& inflation target" the central bank
would have to enact a contractionary monetary policy to offset the increase in the $-&" as
)
!he literature on time inconsistency and inflation bias has been e+tended to the open economy conte+t (see
8omer (199D)) 8omer argues that the inflationary bias of discretionary policy should be smaller the more
open the economy for two reasons* 1) the slope of the aggregate supply curve is likely to be steeper" so that a
surprise inflation leads to a smaller increase in output" and /) central bankers in open economies are likely to
be more averse to surprise inflations because monetary induced inflations have the added cost of depreciating
the currency
9 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
is illustrated in the bottom figure !he offsetting monetary policy leads to a net decline
in the e+change rate" but also to a fall in output and the price of domestic goods" so that
the net change in the $-& is Bero A comparison of the two figures shows that relative to
a perfectly fle+ible e+change rate" $-& inflation targeting makes the e+change rate less
fle+ible in response to e+ternal shocks
I1igures 1 and / About JereK
!hus $-& inflation targeting partially abandons some of the stabilisation advantages
provided by completely fle+ible e+change rates &t is important to note that the
stabilisation advantage of fle+ible e+change rates is due to the automatic stabilisation of
goods market shocks including e+ternal shocks" such as volatility in the demand for
traded goods and country risk premia
9
&t should be noted that at least one country" 'ew (ealand" has attempted to deal
e+plicitly with the potential problem of the linkage between the e+change rate and the
$-& 'ew (ealand adopted an @escape clauseA that allows the 8eserve Bank of 'ew
(ealand to e+clude the effects of changes in import prices due to significant changes in
the terms of trade And" in fact" this escape clause has been invoked on at least three
occasions (see Mishkin and -osen (1997)) But escape clauses from changes in the
terms of trade are another e+ample of the tradeoff between maintaining fle+ibility while
trying to achieve the benefits of an inflation target $-& inflation targets will only
provide benefits if they put some constraints on central bank behavior 4scape clauses
can lessen" but not eliminate the loss in automatic stabilisation relative to perfectly
fle+ible e+change rates !hus considerations of an open economy add one more
attribute for a good candidate for a $-& inflation target* 9) Automatic
stabilisation from the e+change rate is unimportant either because &# shocks are
unimportant" or because the central bank is currently not allowing the e+change rate to
float freely
A decision for #outh Africa to switch to inflation targeting would presumably be based
on the %udgement that the #outh African economy fulfills most if not all of the 9 attributes
of a good candidate for an inflation target !o make %udgments on these 9 key issues one
must use the imperfect evidence provided by the historic performance of the #outh
African economy !he historic evidence is imperfect because of the Hucas criti:ue*
changing the policy rule will affect the way people use past information to form
e+pectations of the future (and" in particular" their e+pectations of future monetary
policy" which is the whole point of adopting an inflation target) 2hile the historical
evidence on the dynamic behavior of the economy is imperfect" it is not irrelevant &n
particular" a measure of the relative siBes of the shocks hitting the economy should be
independent of the policy regime
&n addition" one can also put the historic evidence in perspective by comparing the #outh
African performance to the performance of other countries immediately prior to their
*
An increase in a country;s risk premia cause shifts in the HM curve as well as the &# curve" as the domestic
interest rate increases &n this case" the central bank must use discretion to offset the shift in the HM curve so
that the e+change rate can fall far enough to stabilise output and employment
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) >
adoption of an inflation target &n particular" the pretarget e+periences of $anada" which
adopted an inflation target at the start of 1991" and of 'ew (ealand" which adopted an
inflation target at the start of 199)" seem relevant 2hile clearly $anada" 'ew (ealand
and #outh Africa are at different stages of economic development" they are all relatively
open economies (with e+ports />L of ?3- in #outh Africa and DDL in 'ew (ealand
and D7L in $anada) with some similar features (manufacturing is about />L of ?3- in
$anada and #outh Africa and 1=L in 'ew (ealand) $onse:uently" it is useful to
compare the current #outh African evidence relating to the key issues concerningrelating
to the desirability of inflation targeting to the pretarget evidence for $anada and 'ew
(ealand
+. T#$ #!'tor!%l $,!d$n$ )or Sout# A)r!%- C%n%d% %nd N$.
/$%l%nd
&n this section" vector autoregressions (0A8s) are used to provide historic evidence on
the dynamic interaction of the key variables of interest
+.1 Em(!r!%l m$t#odolog&
A 0A8 model is a reduced form of an unidentified structural model" which provides a
simple description of the dynamic behavior of the economy Any 0A8 can be written as*
M
t t t
M ) H ( B M + =
" G (/)
where M is a vector of the variables of interest &n this case" one is interested in the
dynamic interaction of a monetary instrument" M" the price level as measured by the $-&"
the level of real ?3-" N" and the nominal e+change rate" e B(H) is a matri+ of
coefficients. H is the lag operator.
M
is a vector of 0A8 shocks which are assumed to be
iid !he 0A8 shocks will in general be linear combinations of all of the structural
shocks (ie" e+ternal shocks to the goods market" velocity shocks" technology shocks"
etc) !he estimated coefficients in B(H) and the estimated residuals allow one to draw
inferences about / out of the 9 key issues (issues OD" and O9)
1or e+ample" the estimates from the 0A8 can be used to infer the relative importance of
automatic stabilisation in the economy" and in particular the nature of the structural
shocks influencing the economy !he analysis depicted in 1igure 1 suggests that in the
simplest model" &# shocks (a structural shock) should have no influence on output but
should cause an inverse relationship between shocks to the $-& (a 0A8 shock"
$-&
) and
the e+change rate (a 0A8 shock"
e
) HM shocks should cause an inverse relationship
between shocks to output and the e+change rate and also between shocks to the $-& and
the e+change rate !herefore" if automatic stabilisation is important" the correlation
between the $-& and e+change rate shocks should be negative and the correlation
between output and e+change rate shocks should be small or negative
&f the e+change rate is less than perfectly fle+ible" then the correlations between output
and e+change rate shocks and between $-& and e+change rate shocks (as is illustrated in
P 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
1igure / for inflation targeting
>
) become ambiguous &n the case of a less than perfectly
fle+ible e+change rate" the correlations will depend upon the relative fre:uency of &# and
HM shocks !he greater the relative importance of &# shocks" the more likely are these
correlations to be negative !hus there are two ways one might observe negative
correlations between the e+change rate shocks and the $-& and N* 1) the e+change rate
is fle+ible so that most &# shocks are being automatically stabilised. /) the e+change
rate is imperfectly fle+ible but the economy is being hit by a preponderance of HM
shocks
Measuring the relative importance of lagged e+change rates for determining the $-& and
N can help to distinguish between these two cases &f automatic stabilisation from the
e+change rate is important" then lagged e+change rates should not be an important
determinant of N" while they will be an important determinant of the $-& &n the case of
imperfectly fle+ible e+change rates" lagged e+change rates should be an important
determinant of N" no matter what the relative fre:uency of &# and HM shocks &f there
are a preponderance of HM shocks" one would e+pect that the lagged e+change rates
would also be an important determinant of the $-& &f there are a preponderance of &#
shocks" whose effects on the $-& are being fully (as is illustrated in 1igure /) or partially
offset by monetary policy" then one would e+pect that lagged e+change rates would not
be an important determinant of the $-& !he results of this analysis are summarised in
!able 1
!he economic importance of a variable in a 0A8 e:uation can be measured in two ways*
1) by the siBe of the sum of the estimated coefficients" and /) by the forecast
error variance decomposition or 1403 1or e+ample" the 1403 of the $-& measures the
response of the $-& over time in response to a 0A8 shock to the $-& e:uation (ie
$-&
)
!he 1403 breaks down the variation in output over any horiBon into the variation that is
caused by the lagged values of all of the endogenous variables in the model &f one finds
that most of the variation in $-& is due to lagged values of the $-& itself" and to lagged
values of M and N" this would suggest that lagged e+change rates are not important for
e+plaining the variations in $-&
1403;s as measures of economic importance suffer from the fact that one must assume a
causal ordering of the structural shocks (see Bernanke and Blinder (199/) for further
discussion of the strengths and weaknesses of 1403s) ,nfortunately" the results may
differ substantially depending on the assumed ordering 7ne can" however" present the
1403s for various ordering assumptions to show their sensitivity to the ordering
assumption
P
All the 1403 calculations reported in the paper list values at an = :uarter
+
1igure / is illustrating the imperfect fle+ibility of the e+change rate under a $-& inflation target in which case
&# shocks would cause Bero correlation between shocks to the $-& and to the e+change rate 2ith even less
fle+ibility in the e+change rate" so that the e+change rate doesn;t fall as far as e1" one would observe a positive
correlation
,
!he causal orderings used in the paper are block recursive or $holeski decompositions &t is important to
recognise that in general" the @trueA structural model will not imply a block recursive ordering &t is assumed"
however" that if the structural inferences don;t vary much with the ordering of the variables" then one has
some hope that the inference would be roughly the same under the @trueA structural model Again" see
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) 7
horiBon for two different orderings of the variables* 1) the e+change rate first* e" M" -"
N" and" /) the e+change rate last* M" -" N" e
1inally" the $-& e:uation in the 0A8 is also relevant for measuring the strength and
predictability of the policy linkage and changes in inflationary bias &f there is a strong"
predictable relationship between monetary instruments and future $-& inflation" then this
e:uation should be estimated precisely and lagged changes in the monetary instrument
should be economically important and statistically significant in e+plaining the $-&
+." 0%t% %nd d!%gno't!'
3ata on the $-&" real ?3-" the nominal e+change rate" and monetary policy instruments
for #outh Africa were gathered from !he #outh African 8eserve Bank and #tatistics
#outh Africa" for $anada from the &M1;s &nternational 1inancial #tatistics (&1#) and
#tatistics $anada and for 'ew (ealand from the &M1;s &1# !he available #outh
African data are from the first :uarter of 1979 (1979*1) to 1999*1 1or $anada" the
available data are from 19=)*1 to 199=*D" and for 'ew (ealand 19=/*/ to 199=*D !he
money supply used for #outh Africa and 'ew (ealand was MD and for $anada a
similarly broad measure was used" M/ plus deposits at institutions such as credit unions
!he e+change rate for #outh Africa is the nominal effective e+change" whereas for
$anada and 'ew (ealand it is the ,#Q rate (although using a multilateral rate for
$anada" like the $P" rate had little effect on the results) !he interest rate is the DCmonth
!reasury bill rate for $anada and #outh Africa A long enough time series for interest
rates was not available for 'ew (ealand from the &1# (and for reasons discussed below"
interest rate data for 'ew (ealand were not pursued) All variables are measured as
natural logs with the e+ception of interest rates
T%*l$ 1: VAR r$'ult' %nd t#$ !m(ort%n$ o) %utom%t! 't%*!l!'%t!on
1r$d!t!on':
Automatic
#tabilisation from e is
important (bad
candidate for $-&
inflation targeting)
) ( $70 " ) ) ( $70
N e $-& e
< small or C
lagged e+change rates unimportant for N"
lagged e+change rates important for $-&
Bernanke and Blinder (199/) for more discussion
= 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
Automatic
#tabilisation from e is
unimportant (good
candidates for $-&
inflation targeting)
$A#4 & (&# shocks more important)
) ( $70
N e
small or R" ) ( $70
$-& e
small or R
lagged e+change rates important for N"
lagged e+change rates relatively unimportant for $-&
$ase && (HM shocks more important)*
) ) ( $70 " ) ) ( $70
$-& e N e
< <
lagged e+change rates important for N"
lagged e+change rates important for $-&

$70 is the covariance
,nit root tests were conducted for the full sample periods" and these tests suggested that
first differencing of all variables e+cept interest rates is necessary to provide stationary
time series 1irst differencing transforms logs into growth rates" which have a natural
interpretation* the first difference of the log of the $-& is the $-& inflation rate 1rom
here on $-& will stand for the inflation rate. N for the rate of real ?3- growth" e the rate
of nominal appreciation of the e+change rate" and M the rate of money growth &nterest
rates were not differenced because of their more modest @pA value for unit roots" and also
because the 1isher effect implies that the nominal rate is already a function of the rate of
inflation
More to the point" however" the interest rates were eventually dropped as measures of the
monetary instrument because the sum of the coefficients on the interest rate in the
inflation e:uations was consistently positive -resumably" this reflects the 1isher effect
and the problem of an uncontrolled @third variableA in the 0A8 methodology* #hocks
that are not contained in $-&" N and e cause an e+pectation of higher inflation which
leads the central bank to raise the nominal rate !herefore the positive coefficients
reflect the influence of the third factor" not the effect of a change in monetary policy on
inflation !he positive coefficient was robust to choice of time periods" interest rate (ie"
the bank rate for $anada)" and also persisted when the real interest rate was substituted
for the nominal rate
!able / presents the varianceFcovariance matri+ for the detrended growth rates 1or all
countries data from two periods are presented 1or #outh Africa" the full sample period
is from the beginning of $hris #tals; tenure as ?ovenor of the 8eserve Bank of #outh
Africa !he shorter period is the period since the first allCdemocratic election 1or
$anada and 'ew (ealand the two periods are the periods prior to the adoption of an
inflation target (the pertarget period) and the period since (the target period)
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) 9
!he most striking aspect of the data is the tremendous volatility of the nominal variables
in #outh Africa and pretarget 'ew (ealand" most notably the volatility in the e+change
rate #outh Africa has relatively low volatility in real ?3- growth (although this may be
sensitive to the different sample periods)" particularly in the comparison with 'ew
(ealand Both countries with inflation targets show a decrease in the volatility of both
nominal and real variables after the adoption of the inflation target &t is important to
note" however" that a similar decrease in volatility was e+perienced by the industrial
countries that didn;t adopt inflation targets (see 6onsson (1999))
+.+ VAR $,!d$n$ on %utom%t! 't%*!l!'%t!on
!able D presents the 0A8 evidence from a / lag specification on the importance of
automatic stabilisation from the e+change rate (a full set of 0A8 results is available
from the author upon re:uest)
7
&n the table the covariances of the 0A8 shocks are
measured by correlations to make the covariances comparable across countries !he
evidence for #outh Africa and for the pretarget periods in 'ew (ealand and $anada
seem to fit the three separate cases listed in !able 1 #outh Africa corresponds to the
case where automatic stabilisation appears to be important* 1) !he correlation of
e+change shocks with $-& shocks is negative and large in absolute value and the
correlation with N is relatively small /) Hagged e+change rates are important for the
$-&" but relatively unimportant for N -retarget 'ew (ealand seems to fit the case of
imperfectly fle+ible e+change rates with a preponderance of HM shocks* 1) Both
e+change rate correlations are negative and relatively large /) Hagged e+change rates
are an important determinant of both $-& and N 1inally" pretarget $anada seems to fit
the case of imperfectly fle+ible e+change rates with a preponderance of &# shocks* 1)
!he negative correlation of e+change rate shocks and $-& is relatively small" while the
correlation of e+change rate shocks with N is positive and large /) Hagged e+change
rates are important for N" but relatively unimportant for $-&
T%*l$ ": V%r!%n$2Co,%r!%n$ o) d$tr$nd$d gro.t# r%t$' 3!n ($r$nt%g$ (t' ($r
4u%rt$r5
Sout# A)r!%: 1667:181666:1
M $-& N e
M /"P)
$-& )"=9= 7"=P
N )")DP )"1P1 )"9P9
e C)"797 C1"=/ C)"19) 1P"1
Sout# A)r!%: 1669:+81666:1
M $-& N e
-
!he #chwarB Bayes and Akaike criteria were not helpful in choosing lag lengths 1or #outh Africa" the
#chwarB Bayes statistic rose monotonically with lag length and the Akaike information criterion fell
monotonically $onse:uently the 0A8s were estimated with specifications of / and 9 lags 1or #outh Africa"
the / lag specification yielded higher @1A statistics for all e:uations with the e+ception of the e+change rate
e:uation" which was statistically insignificant for either lag specification $onse:uently" the results of the /
lag model are used for the remaining analysis !he results in most cases were broadly similar 1inally" all
0A8s included a time trend and a constant term
1) 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
M /">9
$-& C)"1P) 7"/9
N )")P= C)"119 )"/1D
e C/"9P CD"99 C)"1=1 /9"1
C%n%d% 1r$t%rg$t 1$r!od: 16:1:"81667:9
M $-& N e
M )"97)
$-& )"117 )"D)/
N C)")D9 C)"D9) 1"1)
e C)"1>D C)"1/> )"/DD 9"DD
C%n%d% In)l%t!on T%rg$t: 1661:18166::+
M $-& N e
M )"D)D
$-& )"19D )"/9P
N C)"1>) C)"1P) )"D)1
e )"//9 )"D== )"1)9 9">9
N$. /$%l%nd 1r$t%rg$t 1$r!od: 16:+:+816:6:9
M $-& N e
M 9"9)
$-& /"D9 /"=7
N C>"17 CD")P 1P"P7
e C/"1D 1"9P C="=9 >="9
N$. /$%l%nd In)l%t!on T%rg$t: 1667:18166::+
M $-& N e
M ="17
$-& )"D/7 )"177
N C1")/ C)")>D /")1
e C1"/9 )"D99 1"79 1D")
!hus in terms of the importance of automatic stabilisation" pretarget $anada and 'ew
(ealand appear to have been better candidates for a switch to inflation targeting than
does current #outh Africa &n pretarget $anada automatic stabilisation does not appear
to have been important because the e+change rate was not allowed to offset &# shocks &n
pretarget 'ew (ealand" automatic stabilisation does not appear to have been important
because the economy was suffering from a preponderance of HM shocks (and a switch to
inflation targeting could very well have reduced the fre:uency of these shocks)
!he last two columns in !able D provide the same information for the two inflation
targeting countries during the targeting period !hese columns are of interest because
they reflect how the change in the monetary policy regime has affected the dynamic
behavior of the economy ,nfortunately" these columns may also reflect the different
nature of shocks impinging on these economies in the pre and postCtargeting periods &n
spite of this complication" the change in e+change rate correlations is striking !he
correlations of e+change rate shocks and $-& rise substantially and become positive in
both countries during the targeting period !he correlation of e+change rate shocks with
N rises in 'ew (ealand and is large and positive in both countries during the targeting
period &n addition" in 'ew (ealand" the importance of the lagged e+change rate for $-&
falls dramatically and the importance for N rises dramatically All of these changes are
consistent with a rise in the fre:uency of &# shocks relative to HM shocks during the
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) 11
targeting period" where the effects of the &# shocks on the e+change rate are being offset
by changes in monetary policy !hus 'ew (ealand and $anada seem to be making less
use of the automatic stabilisation of &# shocks from the e+change rate since switching to
inflation targeting
!he increasing relative importance of lagged e+change rates for $-& and the decreasing
relative importance for N in $anada during the targeting period is not consistent with this
interpretation Again" this partial inconsistency may be due to a change in the relative
fre:uencies of shocks impinging on the $anadian economy during the targeting period
&n addition" of course" one must note that in spite of the possible loss of automatic
stabilisation" N became much more stable in the two countries during the targeting
period 8ecall" however" that the industrial countries that did not adopt inflation targets
also e+perienced more stable output growth during the 9)s $onse:uently it is hard to
separate out the effect on output volatility from the changes in the severity shocks and the
change in monetary policy regimes 7n the other hand" it seems hard to posit that the
changes in the correlations in !able D from the pre to post targeting period are solely due
to changes in the relative fre:uency of different kinds of shocks $-& inflation targeting
seems to make these correlations more likely to be positive" thereby implying a loss in
e+change rate fle+ibility and a loss in automatic stabilisation
T%*l$ +: VAR $,!d$n$ on t#$ !m(ort%n$ o) %utom%t! 't%*!l!'%t!on )rom t#$
$;#%ng$ r%t$
SA N/- (r$ CA- (r$ N/- (o't CA- (o't
/

1="1 P9"D 9"PP 9"7/ 9"7D

) " (
CPI e

C)"D9 C)"DD C)"/> )"17 )"D7
) " (
Y e

)"1D C)"// )"D> )"D/ )"//
sum of coeff in CPI C)")/ C)"1D )")1 )")) C)"1)
1 statistic on coeff 1(/"/7)S)"9P 1(/"1P)S)"99 1(/"/9)S)"1/ 1(/"/>)S)")P 1(/"/1)S)"7/
1403 of e in CPI 1="1CD"7L DP"9C1>"/L 9"DC/"7L 9")C)"=L 1/"9C>"PL
sum of coeff in Y C)")/ )"1D )")9 )"/> C)"))
1 statistic on coeff 1(/"/7)S)"/1 1(/"1P)S1"1P 1(/"/9)S)"P/ 1(/"/>)SD"PP 1(/"/1)S)")D
1403 of e inN P"/C1"1L /9"/C="1L 1>"DCD"PL 17")C11"DL P"DC1"9L
+.9 VAR $,!d$n$ on t#$ 'tr$ngt# %nd (r$d!t%*!l!t& o) t#$ (ol!& l!n<%g$
!able 9 present the 0A8 evidence on the linkage between money growth and $-&
inflation 7n this dimension" #outh Africa comes out in the middle between pretarget
$anada and 'ew (ealand 8elative to pretarget $anada the policy linkage is somewhat
less strong and much less predictable Jowever the comparison is e+actly reversed with
pretarget 'ew (ealand
1/ 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
!he large standard error in the #outh African $-& e:uation along with the relatively
small importance of the money supply suggests that inflation targeting may be difficult to
implement &n particular" wide swings in the policy instrument may be needed to achieve
the inflation target" a problem that 'ew (ealand has e+perienced with inflation targeting
(see Mishkin and -osen (1997)) Net" the $-& e:uation is more unpredictable in #outh
Africa than in 'ew (ealand during the targeting period &t is somewhat ironic that
growing instability in the relationship between monetary aggregates and inflation is
fre:uently cited as an argument for inflation targeting &t is true that increasing financial
instability makes targeting monetary aggregates less attractive" but it also makes the
implementation of inflation targeting increasingly difficult
T%*l$ 9: VAR $,!d$n$ on t#$ 'tr$ngt# %nd (r$d!t%*!l!t& o) (ol!& l!n<%g$
RSA N/- (r$ CA- (r$ N/- (o't CA- (o't
std error of CPI e:uation )"=P 1"D9 )"1= )"D= )">9
sum of the coeff on M )")9 )")/ )"1> C)")> )"/9
1 statistic on coeff 1(/"/7)S1"9= 1(/"1P)S)")P 1(/"/9)S)"=9 1(/"/9)S)"=P 1(/"/1)S1"=9
1403 of M ="PC7">L /"/CD">L 1/"9C1D">L 11"7C11"9L D1"9CD1"9L
+.= E;#%ng$ r%t$ orr$l%t!on' und$r t#$ r%ndom .%l< #&(ot#$'!'
7n interesting aspect of the 0A8 results is that for #outh Africa" $anada" and pretarget
'ew (ealand" one cannot re%ect the hypothesis that the e+change rate follows a random
walk !his result is consistent with the view that the e+change rate is more of an asset
price than a goods price More importantly" however" if this hypothesis is true" then the
covariances of shocks to the e+change rate and to $-& and N can be measured by the
covariances of the detrended logs &n this case" one doesn;t have to estimate 0A8
e:uations to measure the covariances !his saving of degrees of freedom allows one to
look at covariances with the e+change rate in the most recent period in #outh Africa"
which is done in !able > Again to make the covariances comparable" the covariances
have been e+pressed as correlation coefficients
=

!he top panel in the table shows that it doesn;t matter much for the correlation of e with
$-& if the correlation is measured by 0A8 residuals or detrended changes in the log
!he correlation of e with Y changes from a small positive to a small negative correlation
&n either case" the correlations tell a story that is consistent with the view that variations
in the e+change rate have provided automatic stabilisation of &# shocks &n fact" the
.
2hile the covariances of the detrended variables are unbiased estimates of the covariances of the shocks
under the null hypothesis" the absolute correlation coefficients understate the correlations of the shocks &n
our 0A8 models there are D covariances of e+change rate shocks for each country and each time period
!herefore there are a total of 1= covariances !he signs of the e+change rate covariances as measured by the
0A8 residuals agrees with the sign as measured by the corresponding covariance of the detrended change in
the logs in 1P out of the 1= cases
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) 1D
correlations in the most recent period are consistent with the view that this automatic
stabilisation has become of increasing importance
!he bottom panel e+plores whether there are other widely used measures of inflation that
might be a more suitable target variable !he panel shows" however" that $ore $-&"
which e+cludes mortgage interest and other volatile prices" has an even larger negative
correlation with the e+change rate !he produce price inde+ lowers this correlation a bit"
but it isn;t until one adopts a price measure that e+cludes imports" viB" the producer
price inde+ for #outh African goods that this correlation falls substantially !he last
entry shows that the covariance actually becomes positive for the ?3- deflator !hus the
only way to implement an inflation target without forgoing the benefits of automatic
stabilisation from the e+change rate re:uires targeting a measure of inflation that
e+cludes imported goods Any move away from headline inflation as the target variable"
however" implies a loss in @transparencyA
T%*l$ =: E;#%ng$ r%t$ ,%r!%n$' %nd o,%r!%n$' !n Sout# A)r!%
C1I Y
/

M
0A8 8esidual" 9)*1C99*1 C)"D9 )"1D 1="1
detrended variables" 9)*1C99*1 C)"DP C)")7 1P"1
detrended variables" 99*DC99*1 C)"9= C)")7 /9"1
$ovariance of e with other
measures of inflation

measures of inflation
Cor$ C1I
11I
11I RSA
11I 11I SA I10
9)*1C99*1 C)"D7 C)"// C)"1P )"/9
99*DC99*1 C)"99 C)"9/ C)"/7 )")=
9. Conlu'!on
7n the basis of the 0A8 evidence" $anada and 'ew (ealand appear to have been two
:uite different countries in the pretarget periods Net" both countries have en%oyed
greater real economic stability since adopting an inflation target &n addition" both
countries en%oyed a reduction in average inflation with the adoption of the inflation target
in a manner that is consistent with a falling inflationary bias !he #outh African
economy" on the basis of the 0A8 evidence" looks more similar to pretarget 'ew
(ealand* in both countries e+change rate shocks and $-& shocks were substantially
negative &n both countries e+change rate shocks were an economically important
determinant of the $-& !his might seem to suggest that #outh Africa could usefully
19 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
follow the 'ew (ealand e+ample by adopting an inflation target to lower volatility and
average inflation
!here is" however" one crucial difference between the behavior of the pretarget 'ew
(ealand economy and the recent #outh African e+perience &n 'ew (ealand" during both
the pre and post inflation targeting periods" lagged e+change rates were an important
determinant of real output !his suggests that the volatility of the e+change rate was not
associated with the automatic stabilisation of &# shocks &n #outh Africa" on the other
hand" while the e+change rate has been volatile and an important determinant of the $-&"
it has not been an important determinant of output !hus this evidence suggests that the
e+change rate has been providing important automatic stabilisation of &# shocks in #outh
Africa !he adoption of an inflation target would force #outh Africa to forego this
automatic stabilisation" which implies more volatile real economic activity &n addition"
#outh Africa does not have a strong and predictable linkage between the $-& inflation
rate and monetary aggregates !his could present problems of instrument instability for
#outh African monetary policy under an inflation target. problems similar to those
e+perienced by 'ew (ealand (see Mishkin and -osen(1997)) !hese results lead me to
conclude that #outh Africa is not a good candidate for $-& inflation targeting because of
the implied loss in the benefits provided by a fully fle+ible e+change rate
!he issue of inflation targeting;s effect on the fle+ibility of the e+change rate is
important because" as was illustrated in !able >" the correlation between e+change rate
changes and all of the popular measures of inflation in #outh Africa has been
substantially negative and has become more so most recently Apparently" &# shocks are
becoming more important in the #outh African economy A monetary policy aimed at
stabilising the $-& inflation rate in the face of fre:uent and severe &# shocks would lead
to more output volatility" not less
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#tals" $ (1999)* @&nflation !argeting as an Anchor for Monetary -olicyA" March 17
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#vensson" H47 (1997)* @7ptimal &nflation !argets" T$onservative $entral Banks;" and
Hinear &nflation $ontractsA" American Economic Revie!" =7" 9=C119
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1P 6#!,34$7'4$7'7M4!8&$#" /)))" /9(/)
6#!,34$7'4$7'7M4!8&$#" /)))" /9(/) 17
/01
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/0
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e
2
e
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3
'
3
2
3
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I!
/0
e
e
2
e
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3
2
43
'
3
5igure '6 Automatic !tabilisation of a 7oods 0arket !hock
5igure (6 C8 Response to 7oods 0arket !hock $ith CPI Targeting
3 4 P 4 2
CPI 9 2
3 : 2 P : 2
CPI 4 2
1= 6#!,34$7'4$7'7M4!8&$#" 1999" /D(D)