Inflation targeting and exchange rate pass-through to domestic prices: evidence from South Africa

Abstract

Inflation targeting is increasingly seen as a crucial monetary policy by many economies in their quest for economic growth. The choice of an appropriate exchange rate regime, continue to be crucial in macroeconomic policy. Using data from 1970q1 to 2015q4, the paper examines the effects of inflation targeting on exchange rate pass-through. Applying a VAR model, the results show that inflation targeting has significant impacts on the movements of inflation, output and the exchange rate. The pass-through to consumer prices decreased and there was a reduction in the influence of foreign producer costs on imports prices after adopting inflation targeting. IntroductionThis paper examines the effects of inflation targeting on exchange rate pass-through in South Africa. After the currency crashes of the late 1990s, a growing number of emerging economies moved away from exchange rate rigidity towards a combination of flexible exchange rates and inflation targeting (IT). Inflation targeting is increasingly seen as a crucial monetary policy by these economies in their quest for economic growth. Since exchange rate is a major determinant of inflation, the choice of an appropriate exchange rate regime, and the broad thrust of exchange rate policy continue to be crucial in macroeconomic policy. The nature and timing of linkages among nominal exchange rate, prices and inflation to a large extent determine the effectiveness of the exchange rate policy. Although exchange rate pass-through (ERPT)-the degree to which changes in exchange rates are transmitted to the domestic prices of both tradable and non-tradable goods and services-has been the subject of several empirical studies, the focus has disproportionately been on industrialized countries and studies that have examined the effects of IT on ERPT in developing countries are relatively few.Exchange rate is one of the macroeconomic fundamentals that significantly affect consumer price inflation. This effect occurs via two channels-direct and indirect. Directly, the exchange rate affects, with a relatively small lag, prices of imported goods, i.e. goods intended directly for the consumer market as well as raw materials and semi-manufactures intended for production of consumer goods of domestic origin. The exchange rate affects not only prices of imported goods, but also-indirectly via import arbitrage-prices of domestic goods which are under competitive pressure from imported goods. With the indirect channel, the change in the exchange rate, all other things being equal, affects the change in the real exchange rate. This, in turn, affects the economy via aggregate demand and a changed output gap. In IT countries, the monetary authority does not directly regulate the exchange rate. However, since changes in the exchange rate also affect inflation, the monetary authority conducts detailed analyses of the exchange rate, and each macroeconomic forecast also contains the internally consistent outlook for the exchange rate. On the one hand, the exchange rate forecast affects futur...

Exchange rate pass-through to inflation in South Africa: is there non-linearity?

“…Our findings also confirm the empirical findings obtained by Kassi et al. (2019), Ehsan and Dalia (2001), Oladipo (2017) and Oluwasheyi (2017).…”

“…Besides, after the adaptation of inflation targeting, the pass-through to consumer prices from exchange rate movements has decreased substantially. Furthermore, using a VAR model, Oladipo (2017) also investigated the effect of inflation targeting on ERPT in South Africa for 1970Q1–2015Q4. According to the results, inflation targeting has significant impacts on inflation fluctuations, output and exchange rate change.…”

Inflation Targeting and Pass-Through Effect in Mongolia

“…The majority of subsequent studies supports the argument of Gagnon and Ihrig (2004) by providing the evidence of the decline in pass-through effect by the adoption of inflation targeting such as: Coulibaly and Kempf (2010) with the samples of 27 emerging market economies (15 inflation targeters and 12 inflation non-targeters), Dilla et al (2017) with 19 countries (8 high income countries and 11 middle income countries), Edward (2006) with 7 countries (Australia, Brazil, Canada, Chile, Israel, Korea and Mexico), Daboussi and Thameur (2014) with 6 emerging markets in Latin America and Asia (Thailand, Philippines, Peru, Mexico, Indonesia and Brazil), Siregar and Goo (2008) with Indonesia and Thailand, Odria et al (2012) with Peru, Guillermo and Brindis (2014) with Mexico, Oladipo (2017) with South Africa, and Karahan (2017) with Turkey. Some studies, however, identify the unchanged or lasting pass-through effects even after adopting inflation targeting such as: Nogueira (2007) with 8 countries (Canada, United Kingdom, Sweden, Czech Republic, South Korea, Mexico, Brazil, and South Africa), Kuncoro (2015) with Indonesia, and Dube (2016) with South Africa.…”

Inflation Targeting and the Pass-through Effect in Mongolia

“…The majority of subsequent studies supports the argument of Gagnon and Ihrig (2004) by providing the evidence of the decline in pass-through effect by the adoption of inflation targeting such as: Coulibaly and Kempf (2010) with the samples of 27 emerging market economies (15 inflation targeters and 12 inflation non-targeters), Dilla et al (2017) with 19 countries (8 high income countries and 11 middle income countries), Edward (2006) with 7 countries (Australia, Brazil, Canada, Chile, Israel, Korea and Mexico), Daboussi and Thameur (2014) with 6 emerging markets in Latin America and Asia (Thailand, Philippines, Peru, Mexico, Indonesia and Brazil), Siregar and Goo (2008) with Indonesia and Thailand, Odria et al (2012) with Peru, Guillermo and Brindis (2014) with Mexico, Oladipo (2017) with South Africa, and Karahan (2017) with Turkey. Some studies, however, identify the unchanged or lasting pass-through effects even after adopting inflation targeting such as: Nogueira (2007) with 8 countries (Canada, United Kingdom, Sweden, Czech Republic, South Korea, Mexico, Brazil, and South Africa), Kuncoro (2015) with Indonesia, and Dube 2016with South Africa.…”