There has been ardent debate around South Africa regarding the use of Inflation Targeting (IT) and its impact on the economy. This article aims to shed some light on this issue by drawing a clear line between the left and right ideological debates through econometric analysis and economic theory. As a previous management consultant, I understand the need for the use of theory, frameworks and thereafter using robust data analysis to prove or disprove a hypothesis. In this article, I argue that it is well documented that policies need to be adopted in order to decrease inflation and inflation uncertainty in order to mitigate the high levels of macroeconomic instability. This article aimed to test whether higher inflation leads to higher inflation uncertainty and vice versa in South Africa by using quarterly data from 1958Q1 to 2014Q1. Furthermore, I aimed to test inflation targeting’s impact on inflation uncertainty in order to ensure monetary policy minimizes the costs of uncertainty. This analysis was done by formulating and running a generalised autoregressive conditional heteroskedasticity (GARCH) model, Granger causality tests and impulse functions. The nuances and detail surrounding these models will be ignored in this post. That said, the results will be expounded upon. Thereafter these results will be used present pertinent policy implications for the South African Reserve Bank going forward and our need to ensure that this important institution does not fall prey to capture and nefarious agents.
Theoretical frameworks underpinning the analysis
Friedman (1977) hypothesized that higher inflation causes higher inflation uncertainty. Friedman explained that this effect occurs via two channels. Firstly, higher inflation causes higher policy uncertainty. During periods of high inflation, rational economic agents are uncertain as to when the central bank will increase interest rates which decreases the certainty about future rents and increases inflation uncertainty. Secondly, higher inflation uncertainty implies future price uncertainty, which effects consumers’ and producers’ decisions. The cumulative effect of higher inflation uncertainty within an economy is macroeconomic instability, lower investment rates and decreased economic growth.
Ball (1992) formalised Friedman’s (1977) argument by stating that rational economic agents expect two types of policy makers. When the inflation rates are low, a rational economic agent expects that policy makers will endeavor in maintaining low inflation and promoting macroeconomic stability. However, when inflation rates are high, economic agents are uncertain as to when a tough type will come around and disinflate. This argument has led to researchers referring to the Friedman-Ball hypothesis.
Cuckierman and Meltzer (1986) saw the effect happening the other way round. Namely, they purported that higher inflation uncertainty actually results in higher inflation. The Cuckierman-Meltzer hypothesis is based on the premise that monetary authorities have an incentive, during periods of high uncertainty, to create an inflationary shock in order to stimulate the real economy.
Conversely, Pourgerami and Maskus (1987) and Ungar and Zilberfarb (1993) purported that high levels of inflation could actually result in low levels of inflation uncertainty. This argument was rationalized by stating that during periods of high inflation, a rational economic agent might invest more resources in order to obtain a more judicious expectation of inflation, which in turn decreases inflation uncertainty.
Holland (1995) contested the Cuckierman-Meltzer hypothesis and argued that higher inflation uncertainty actually causes lower inflation. Holland (1995) asserted that given that higher uncertainty has a negative impact on economic growth and that it gives rise to higher inflation. Therefore independent central banks have a considerable incentive to increase interest rates in order to reduce inflation.
That said, given this historical context of the relationship between inflation and expectations, which theoretical framework best describes South Africa. Moreover, which theoretical framework should be used to frame our analysis on monetary policy’s impact on the expectations of economic agents within the country? Finally, which framework best describes inflation targeting impact on inflation uncertainty an inflation such that we can understand how to minimize the costs?
Analysis into the South African Reserve Bank’s policy
To answer the aforementiond question, it would be remiss to not include an analysis of SARB’s policy and a graphical representation of the impact of such policies.
The South African Reserve Bank, following the trend within other economies around the world, decided to formally adopt an inflation target of between 3 and 6 per cent in February 2000. This followed the logic that inflation targeting actually decreases inflation persistence by anchoring inflation expectations, which in turn should decrease inflation uncertainty.
Since IT adoption however, there has been ardent debate in South Africa between mainstream economists and ‘leftists’. Mainstream economists argue that IT has ensured macroeconomic stability. Conversely, leftists argue that the high economic cost of IT in a country that has high levels of unemployment and low economic growth makes IT unsustainable. Notwithstanding, this group suggests that inflation targeting has had a negating effect on the SARB’s ability to increase economic growth without fully taking into account, the macroeconomic costs of high levels of inflation. Moreover, this view goes against international best practice regarding monetary policy. It is therefore important to understand which argument holds in this regard. Should we maintain price stability, or should we allow for excessive monetary easing in order to allow for an increase in economic growth?
This papers’ Data analysis
It is important to graphically represent both inflation uncertainty and inflation across a long time horizen. Thereafter, we will be able to draw some inferences that can preempt our models.
Figure 1 below, depicts South African quarterly consumer price index (CPI) data and covers the period from 1958Q1 to 2014Q1 with a total of 223 observations. . The sample period used in this paper was chosen on the basis of availability and is particularly far-reaching as it covers the various monetary policy regimes, the advent of democracy in South Africa, as well as the recent global financial crisis in 2008. The CPI data was sourced from the International Monetary Fund’s, International Financial Statistics (IFS) database. This data is seasonally adjusted with 2010 taken as the base year. The inflation rate was then calculated by taking the year on year changes in the quarterly CPI figures. Moreover, inflation uncertainty was generated running a standard GARCH model. Both quarterly inflation and inflation uncertainty are plotted below. The shaded area represents the inflation targeting period.
It is worth mentioning that both inflation and inflation uncertainty, as displayed in Figure 1 above, tend to move in the same direction. The quarterly CPI as well as inflation uncertainty figures can be seen to spike significantly in the 1970’s. This was mainly due to the effect of the 1973 and 1979 oil crises. The increase in the cost of oil increased production costs, which resulted in higher prices for consumers as producers endeavoured in shifting the burden to them. The next significant spike in inflation and inflation uncertainty was seen in the mid-1980’s coinciding with the debt-standstill agreement and trade sanctions being imposed on South Africa due to the political landscape in the country at the time. Thereafter inflation and inflation uncertainty can be seen to have decreased and become less variable. This trend is in line with economies around the world during the 1990’s. In 2001 however, due to the end of the dotcom boom, inflation and inflation uncertainty spiked once again before the last spike was witnessed in the advent of the global financial crises in 2008, which also impacted South Africa significantly. A final point to note is that it is clear that both inflation and inflation uncertainty have decreased significantly in the inflation-targeting period highlighted above.
Previous research trying to answer this question
As mentioned in the introduction to this post, this article used various econometric techniques to quantify the impact of policy on inflation and economic agents expectations of inflation. The first paper to do this using South African data was Thornton (2006) who formulated similar models to mine but used monthly data from 1957 to 2005 and accepted the Friedman-Ball hypothesis. The acceptance of the hypothesis also follows from research conducted by Kontonikas (2004), Thornton (2008) and Miles (2008), where they tested the Friedman hypothesis using GARCH modeling applied to data for the United Kingdom, Argentina and Canada respectively.
Kaseeram (2012) argued that Thornton’s (2006) results could be erroneous as the paper failed to account for any structural breaks in the data. Kaseeram (2012), after identifying a structural break, found that the Friedman hypothesis also holds in South Africa using monthly data from 1992M6 to 2009M11. Moreover, his research found that inflation targeting has not resulted in lower inflation uncertainty. This result corresponds with research conducted by Gupta and Uwilingiye (2007) and Gupta, Kabundi, and Modise (2010). In these papers, they used the relatively unknown and rather complicated Saphe Cracking model and the vector autoregressive (VAR) models respectively.
In South Africa specifically, evidence supports the fact that inflation causes inflation uncertainty but not the other way around. In essence, we can reject the Cuckierman Meltzer hypothesis.
Further research conducted by Rangansamy (2009); using quarterly data, found that IT has had a significant impact on decreasing inflation persistence in South Africa. His results also suggest that IT has been successful in lowering inflation uncertainty. However his paper used a much shorter time period from 1981Q1 to 2008Q2. Therefore, it is imperative that my research uses an expanded data set in an attempt to reconcile the contrasting results regarding the effect of IT on inflation uncertainty.
Model interpretation and policy implications
Given the aforementioned context, this research found that the advent of IT has indeed decreased inflation uncertainty, but that its effect has been insignificant. This result corresponds with research conducted by Gupta and Uwilingiye (2007), Gupta, Kabundi, and Modise (2010) and Kaseeram (2012) in which monthly data was used with quarterly data. That said, the results obtained from the models accept the Friedman hypothesis, which brings about important policy implications. That is, inflation uncertainty has been seen to cause macroeconomic instability. This in turn decreases both investment and economic growth respectively. Given that higher inflation was found to lead to higher inflation uncertainty in South Africa, it is imperative that the country operates within a low and stable inflationary environment. This implies that the South African Reserve Bank should act swiftly in times of higher inflation in order to mitigate the costs of increased uncertainty on economic growth. The results further imply that inflation targeting has had an impact in creating a stable inflationary environment, which in turn, decreases inflation expectations and its costs to the economy. Therefore, the South African Reserve Bank needs to ensure that it is completely transparent during periods of high inflation using the target of 3 to 6 per cent as its base consistently. Furthermore, it needs to ensure that the market has the same information that the bank has so that inflation uncertainty decreases. This has been referred to as forward guidance and has been widely used by Central Banks across the globe. Given this, it is important that the Reserve Bank remains accountable, credible, independent and transparent in its objective of maintaining price stability. Moreover, inflation targeting policy should be maintained as it has assisted in managing inflation in the country.
We, as young South Africans, need to further ensure that we protect the independence of this institution. A captured institution can no longer ensure its citizens and investors that it will manage inflation and the associated costs within the economy. This will inevitably lead to an increase in inflation expectations that will have severe ripple on effects across the country. More specifically, the subsequent burden of these costs will fall largely on the shoulders of millions of poor and marginalized South Africans. We cannot accept this. Instead, we need to promote balanced monetary policy that 1) protects the poor by managing the cost of inflation and 2) ensures a conducive interest rate environment that promotes economic growth. This goes against or natural inclinations of wanting a consistently excessive low interest rate environment.