Inflation Targeting in South Africa

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What is inflation targeting?

Inflation targeting within the goals of a monetary policy framework must be to attain and preserve a low and stable rate of inflation(Scott Roger, Jorge Restrepo, n.d.). The benefits of inflation targeting include greater certainty and transparency of central bank price stability and interest rate decisions provided CPI inflation can be managed with a reasonable range.

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The appropriateness of Inflation Targeting

All Central banks across the world is concerned with inflation. As a primary policy of their mandate to contain inflation and protect the value of their currency it has become more prevalent to implement measures that will contribute to stable inflation movements within over periods of uncertainty.

The mission statement of the SARB back in August 1990 was “to protect the internal and external value of the rand” (Jannie Rossouw, n.d.) and after the new constitution in 1996 the objective was modified to include the protection “of the value of the currency in the interest of balanced and sustainable economic growth in the Republic”. The main reason for the change was the Banks intention to replace the possible inconsistencies between the twin objectives that existed of maintaining the internal and external value of the currency.

There are some Economists that believe inflation targeting is harmful to economic activity, while others believe the opposite. Inflation targeting support long term economic growth and stability in general during periods where there is excessive growth in demand.

Over the last 25 years most central banks in the world have applied flexible inflation targeting allowing for shifts outside the target range and returning within certain time cycles to accommodate factors of output.

Overall transparency and flexibility of inflation targeting has been key and produced a sound objective for monetary policy in pursuit of price stability where this policy has been implemented.

During the sub-prime crisis there were question raised as to the suitability and relevance of inflation targeting in the aftermath of the crisis that took place. During 2008, the financial market turbulence and volatility in rising food and energy prices led to increases in headline CPI inflation over this period. During this financial crisis, many global economies entered a recession as well as experiencing disinflation. Inflation targeting does not just operate within an upper bound but also with a lower bound. The severity of the economic crisis and the recession experienced in fact strengthened the arguments in favour of inflation targeting. This helped reduce the risk of deflation.

The role of the intervention in the foreign exchange market and the exchange rate, whilst having an explicit CPI inflation target appears to be changing since the crisis in 2008. Under inflation targeting, the credibility of this policy entails a commitment to price stability such as the exchange rate subordinated to price stability. The view has been that inflation targeting was incompatible with intervention in the foreign exchange market. Many debates pursuit and acceptance of this practise where some economies have moved from floating exchange rates towards a form of managed float.

Emerging economies generally suffer from high exchange rate volatility and for this reason exchange rates should not be neglected. Many of these economies may adjust interest rates to contain temporary exchange rate shocks on inflation. Since 2008, many emerging economies intervened in the foreign exchange market to limit exchange rate volatility that they have been experiencing. What central banks have learned is that foreign exchange intervention could reduce exchange rate volatility and could lead to more favourable trade-off between stable inflation and real economic activity.

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Inflation Targeting in South Africa

The SARB explicit inflation targeting since inception has been a positive one. In the second half of 2008, South Africa’s inflation rate was close to 14 per cent, with a repo rate of 12 per cent. Towards the end of 2008, when the US sub-prime crisis was to have a much more devastating impact on the South African economy, the Monetary Policy Committee began a cycle of reducing the repo rate. Over the coming months inflation pressures had started to decline and by 2010, the repo rate had been reduced to 5.5 per cent. Over the coming months the repo rate was kept at this low level in response to the crisis while keeping an eye on the rise in inflation over this period. The inflation rate has since maintained a level within the 3 – 6 per cent target range. South Africa as an emerging market can draw some lessons from the financial crisis and the changing role of central banks. Their mandate has been to explicitly include a financial stability responsibility and is working on the role of financial stability in monetary policy formulation and implementation.

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Figure 2: Consumer Price Inflation: South Africa

The South African rand has been one of the most volatile currencies globally and also has a significant effect on inflation. As a policy the SARB does not intervene in foreign exchange markets to influence the value of the rand. While foreign currency inflows have been used to build up the reserves, a level of foreign exchange reserves places the SARB in a positive position to manage any turbulent movements in the foreign exchange market should conditions warrant in future.

While in an inflation targeting framework the strategies applied by the central bank is to determine the like path of inflation going into the future. Emphasis is place on indicators which in the past have affected inflation through some sophisticated models in the prediction of future inflation and factors that could affect it. The central banks efforts to predict inflation accurately is important as part of monetary policy due to the impact it can have on future price developments.

One of the main concerns with inflation targeting in that the reliance on forecasting could be unreliable which has led to some criticism of the technique. Monetary policy frameworks have to consider that any policy changes taken now will have some effect on inflation in the future. If financial stability is an objective of any central bank then any policy stance will affect future price developments, irrespective whatever monetary policy framework

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