The theoretical foundation of Inflation targeting
The development of inflation targeting was influenced by three theories: New Classical
Macroeconomics, Monetarism, and new Keynesian theory.
Monetarism
Monetarism is a macroeconomic framework that holds that governments may promote
stability in the economy by controlling the growth rate of the money supply. It is essentially
a set of beliefs founded on the assumption that the total amount of money in an economy
is the primary factor of economic growth. Monetarism gain popularity in the 1970s and
brought down inflation in the United States and Great Britain, and greatly influenced the
U.S. (Jahan, 2014)
The main idea behind monetarism is that variation in money supply is the main
determinant of nominal income. As according to Monetarist theory, fluctuations in the
money supply affect price levels in the long run and, therefore, economic output in the
short run. Changes in the money supply directly affect prices, output, and employment.
Monetarists further argue that excessive growth of money supply is the source of inflation;
thus, central banks should regulate the growth rate of money to fight against inflation.
New Classical Macroeconomics
New classical macroeconomic theory came as a response to the inflation of the 1960s and
1970s and to the monetarist analysis of this very inflation. It attempted to restate
Monetarist analysis. One of the main points New Classicals worked on was monetary
policy. They thought that, even though monetary policy does not have an effect in the long
run, it had to be managed under targets; if authorities missed the monetary target,
economics agents could face a lack of information about monetary policy and therefore
the economy might suffer long cycles of recession. (Laidler, 1997)
The rational expectations hypothesis (REH), first developed in microeconomics by John
Muth (1961), is a basic component of new classical macroeconomics. Which assumes
that individuals form expectations about the future based on the information available to
them, and that they act on those expectations (Snowdon, 2005). New Classical
economists support rules-based monetary policies to avoid uncertainty and create
predictable environments for inflation control. Inflation targeting, under this theory, can be
seen as a rules-based approach to manage inflation expectations and maintain long-term
price stability.
The New Keynesian Theory
The New Keynesian model became one of the main frameworks from which to analyse how
to inject stimulus into the economy during an economic crisis, including both through
fiscal policy and through unconventional monetary policies. It was taught in economics
programs worldwide as the framework of reference for understanding fluctuations in
economic activity and inflation and their relation to monetary and fiscal policies (Gordon,
1990)
The New Keynesian model offers normative insights into monetary policy. Among these is
the idea that if the central bank follows a rule that modifies the policy interest rate in
response to changes in inflation and production, the economy will attain a unique
equilibrium. This is known as the Taylor Principle.
It also introduces the concept of the natural rate and argues that the optimal policy is to
stabilize inflation at zero. According to the New Keynesian Phillips Curve, strict inflation
targeting has the added benefit of stabilizing the output gap at zero, meaning the economy
operates at its natural level of output. However, this optimal policy depends on how
credibly the central bank can commit to long-term, state-contingent plans. (Gali, 2018)
Another important lesson of the New Keynesian model is that there is a difference between
commitments and discretion in monetary policy. When a central bank commits to a longterm plan, it can shape expectations about future inflation and output gaps, which helps
reduce inefficiencies and smooth economic fluctuations. In contrast, discretionary
policies, which lack commitment, can lead to inefficient outcomes or biases.
Inflation targeting adoption by SARB.
The South African Reserve Bank officially adopted inflation targeting as its monetary policy
framework in February 2000 (Van der Merwe, 2004). Prior to implementing the inflationtargeting approach, the SARB used a variety of monetary policy models. From 1960 to
1998, included an eclectic approach, discretionary monetary policy, monetary-aggregate
targeting, as well as exchange-rate targeting. The implementation of an inflation-targeting
monetary policy was supposed to not only keep inflation within the target range, but also
minimize volatility. According to the reserve bank, Tito remarked in 1999 it is better to go
from the electric or informal targeting monetary policy framework to formal inflation
targeting (Muhanna 2006). The main goal of inflation targeting system is to maintain low
and steady inflation within the target band of 3% -6%, using the rate of change of the
overall consumer price index (CPIX) measures. The expectation of reaching a narrower
band of 3-5% had been set as the goal for targeting between the years 2004 and 2005, but
later developments have allowed the initial target range of 3-6% to stand today. Since the
implementation of the inflation-targeting monetary policy framework, the objective has
been reassessed on several times. It was rerevised and after November 2003, the target
range became constant, and it remained at 3-6%. In 2021, the Governor of the South
African Reserve Bank, Lesetja Kganyago, proposed the reduction of the 3-6% inflation
target to a 3%-point target. Since March 2017, the inflation rate has fallen below 6%, and
since 2010, the production gap was negative.
TRENDS IN INFLATION
Analyse the recent trends in South African inflation
After holding steady for ten months in the 5–6% range, annual consumer price inflation
slowed to 4,6% in July from 5,1% in June 2024. The July inflation print is the lowest in three
years since July 2021, when the rate was also 4,6%. Lower annual rates were recorded for
several product groups, most notably food & non-alcoholic beverages, transport, and
housing & utilities. The housing & utilities index increased by 2,6% between June and July,
leading to an annual increase of 5,3%. This contributed 1,3 percentage points to the overall
inflation rate. Electricity tariffs increased by 12,1% (compared with 15,3% in 2023), water
tariffs by 7,5% (compared with 9,6% in 2023) and property rates by 10,7% (compared with
8,4% in 2023). Electricity tariffs recorded an average growth rate of 10,5% per year from
2009 to 2024, outpacing water tariffs (up by an average of 10,2% per year) and property
rates (up by an average of 6,8% per year). The national Residential Property Price Index
increased by 3,5% in the 12 months to March 2024, up from a revised 3,1% in February
2024. Residential property inflation has trended upwards since a low of 1,6% in May
2023.Headline inflation edged lower to 5,1% in June from 5,2% in May 2024. Fuel was 4,6%
cheaper in June 2024 compared with May. A litre of inland 95-octane petrol was R24,25 in
June 2024, down from R25,49 in May 2024. The all-time high was R26,74 in July 2022. Softer
fuel prices helped pull overall transport inflation down in June 2024.
The consumer price index (CPI) recorded an annual increase of 5,2% in April 2024, down
from 5,3% in March and 5,6% in February 2024. Housing & utilities, miscellaneous goods &
services, food & non-alcoholic beverages and transport were the main drivers behind the
headline rate in April. The monthly change in the CPI was 0,3% in April, softer than the
0,8% rise recorded in March. Annual inflation for food moderated further from 5,1% in
March to 4,7% in April 2024, representing a fifth consecutive month of decline. The annual
rate for restaurants & hotels rose to 7,5% in April from 5,7% in March 2024. Fuel prices
increased by a monthly 1,9%, pushing the annual rate to 9,0%. Inland 95-octane petrol was
R25,12 per litre in April 2024, up from R22,97 in April 2023.Annual consumer inflation
quickened in February, rising to 5,6% from 5,3% in January 2024 and 5,1% in December
2023. Product categories that drove much of the upward momentum include housing &
utilities, miscellaneous goods & services (insurance), food and non-alcoholic beverages
and transport. Inflation for food slowed to 6,1% in February. The rate for hot beverages was
driven higher by annual price increases for instant coffee (up 12,1%), black tea (up 10,1%)
and Rooibos tea (up 8,1%). The rate for oils & fats remained in negative territory, mainly
due to a 12,9% annual decline in the price of sunflower oil. The impact of rising egg prices
continues to affect the milk, eggs & cheese category, with eggs 30,7% more expensive than
a year ago. Although the current average price of a tray of 6 eggs (R25,48) is down from its
peak in December 2023 (R25,85), it is higher than the February 2023 price tag (R21,13). The
transport category registered an annual increase of 5,4%, driven higher mainly by
increases in vehicle and fuel prices.
After two consecutive months of decline, annual consumer inflation crept up in January
2024, rising to 5,3% from 5,1% in December 2023. The monthly change in the consumer
price index was 0,1% in January. The categories in the CPI basket with the largest annual
price increases were restaurants & hotels at 8,0%, food & non-alcoholic beverages at
7,2%, and health at 6,5%. A monthly decline of 5,2% in fuel prices between December
2023 and January 2024 was not enough to subdue the annual rate for fuel, which jumped
from 2,5% in December to 3,3% in January. This contributed to a sharp rise in annual
transport inflation to 4,6% from 2,6% in December. An increase in bank fees contributed to
a 5,5% annual rise in financial services. The impact of the pandemic and the related
measures led to a severe contraction in economic activity as many people were unable to
go to work or search for work. South Africa had number of employed persons decreasing by
over 2,2 million in the second quarter of 2020. Businesses started to move to normality and
to hire again. This is reflected in the fourth quarter of 2021, where employment levels
started to increase. Since then, employment has shown a positive trend, with the largest
change being recorded in the second quarter of 2022. Before the COVID-19 pandemic,
employment levels were recorded at 16,4 million in the first quarter of 2020. According to
the Quarterly Labour Force Survey for the third quarter of 2023, the number of employed
persons increased by 399 000, as compared to the second quarter of 2023. This is the
eighth consecutive increase in employment since Q4:2021 and the first to surpass the preCOVID employment levels of 16,4 million. Not only have employment levels shown
improvement in the labour market, the volume of actual hours worked have also improved
drastically post-COVID. Beginning of the pandemic, South African gross domestic product
tumbled by 17,1% that quarter (April‒June), with economic activity in the trade industry
(retail) falling by 27,0% in 2022.
Annual consumer inflation slumped to 4,7% in July from 5,4% in June. This is the lowest
reading since July 2021, when the rate was 4,6%. Consumer prices increased on average
by 0,9% between June 2023 and July 2023. This is up from the monthly rise of 0,2%
recorded in both May and June. The housing and utilities index increased by 2,8% between
June and July 2023. On average, households are paying 14,5% more for electricity. Water
tariffs increased by 9,6% and property rates by 2,9%. Consumer inflation hit its highest
level in 13 years during 2022. Inland 95-octane petrol reached an all-time high of R26,74
per litre during July. A car with a 45-litre tank, a complete top-up would have set you back
R1 203. This dwarfs the R783 you would’ve paid twelve months earlier, at R17,39 per litre.
The price of petrol eased after July, with 95-octane ending the year at R23,46 per litre.
Diesel reached its highest average price of R27,29 per litre in November. The rise in oils &
fats was mainly driven by the price of sunflower oil. Poor harvests in 2021 restricted global
supply, a situation that was further worsened by the Russian invasion of Ukraine, the
world’s two leading producers of sunflower oil. In April 2022, the crippling shortage forced
major retailers Woolworths and Pick n Pay to impose buying limits on shoppers. At the till,
a bottle of sunflower oil (750 ml) cost an average of R28,20 in August 2021, rising to an eyewatering R44,51 a year later. The annual price increase for oils & fats in August 2022
(37,6%) is the highest on record for this category since the current consumer price index
series began in 2008.
CHALLENGES FACED BY SARS USING IMPERICAL EVIDENCE.
The South African Revenue Service faces multiple challenges every year in its quest to
effectively collect revenue and manage tax compliances. Below is a list of some of the
challenges that SARS faces using empirical evidence;
-Tax Evasion
Tax evasion is the illegal method used by taxpayers to pay less taxes to the government,
which is one of the challenges faced by SARS. Studies and statistics show that a
considerable number of the taxable population does not comply with tax laws, usually
people falsify statements or present false information to SARS to reduce their tax liability.
Taxpayers argue that they are taxed on a double tax system, for example those that are
shareholders are taxed on their dividends while the business still pays tax on corporate
level. In 2021, SARS reported tax evasion cases of 38 billion. SARS deals with tax evasion
through the legislation as it empowers SARS to impose penalties of up to 200% of the tax
due, as well as interest from the due date to the date of payment. They can also take
criminal sanctions against tax evaders resulting in imprisonment.
-Loss Of Skilled Workers
Over the past few years SARS has suffered a huge loss of highly skilled workers, from what
has been reported in the press some of investigative Divion's within SARS have been shut
down in the last few years. This is a big challenge to SARS as their capacity to properly
apply the tax legislation and conduct tax audits and investigations is hampered. According
to studies this harms both taxpayers and the fiscus. In the eyes of the fiscus unlawful
behavior or tax evasion could easily get overlooked by the reduced capacity of SARS. The
loss of workers increases tax evasion; hence it is necessary for SARS to ensure that they
have enough workers and capacity to identify and assess risk areas.
- Digital Transformation
In 2020-2021 SARS report showed that their digital systems were outdated. In the past few
years sars has embarked on a digital transformation journey to modernize and enhance its
tax administration capabilities. The aim is to improve tax compliance, efficiency, and
effectiveness and to fight against tax evasion and fraud. Despite the improvement on
digitalization, SARS still faces challenges such as cybersecurity threats and data
protection issues.
-Tax Compliance
Studies show that a significant number of South Africans operating in informal sectors do
not comply with tax regulations and fall outside the tax system. SARS tries to provide
incentives and regulatory changes to ensure that the informal sector transitions to the
formal sector smoothly so they can fall into the tax system. In the South African 2023 Tax
statistics report, an annual report issued jointly by National Treasury and SARS, published
in December 2023 it is noted that as of 30 September 2023 approximately 1.06 million
companies assessed for the 2021 tax year, 159307 were small business corporations who
paid tax at the preferential graduated income tax rate. Despite this progress, the regulatory
burden and the cost of tax compliance remains a significant challenge for small
businesses enterprises as they often do not have the staff resources and skill to navigate
the complex tax rules to comply with all their tax obligations fully. Given the importance of
the informal sector to the South African economy, it's imperative that the government and
SARS continue to reduce the tax complains burden on small businesses, provide
incentives that benefit small business, provide support so it easy easier for the SMES to
comply with tax regulations.
-Public Perception
Surveys conducted by several organisations, including Afrobarometer show that the
general publics trust in SARS has fluctuated due to
- high profile scandals during the leadership of Tom Moyane raised concerns about
corruption and mismanagement within SARS
- ⁠The lack of transparency of how tax revenues are used
- ⁠Poor customer service and inadequate communication.
This becomes a challenge to SARS as it led to lower compliance rates , as taxpayers
question the fairness of the system. Low-quality service also means that many people are
not helped with their queries, which in turn also contributes to the lower compliance rates.
Implications and expectations of the Phipps curve for South African Monetary Policy
The Philip’s curve states that there is a consistent negative relationship-between
unemployment and inflation. It suggests that the inflation rate of a country is directly
proportional to its growth rate, which in turn will lead to a reduced rate of unemployment.
The Reserve Bank of South Africa has a range for target inflation. Following this can help to
maintain goals, but if expectations for inflation stay fixed, it might make it more difficult to
lower unemployment in the near run.
A high level of unemployment and sluggish development are two fundamental issues
facing
SA. The simultaneous existence of inflation and prolonged unemployment could make the
Phillips curve's predictions less reliable and complicate the implementation of policy
measures.
Various external factors interrupt the smooth ride for example changes in commodity
prices. If the market is sensitive to the problems of supply chain, increases in interest rates
as an anti-inflationary policy Could lead to the opposite effect of increasing the number of
unemployed workers in the market.
No matter if it turns out to be only linear or it gives up the ghost and subsides activated,
the relationship between unemployment and inflation can well be described Buy the
Phillips curve at the moment.
Purpose and recommendations for the South African Reserve Bank
It is crucial that SARB keeps the inflation target at a low and steady rate in order for the
Rand to lose its value. If the rand value us not protected lowered bond values and high
interest rates will be a result of downward pressure on the Rands value. Marginal spreads
and volatility increases would be a result of the rand's decline. These same elements
create pressure on the bond and interest derivative markets, which results in losses.
Recommendations for the SARB
Adaptive monetary response policies: The state of the world economy, particularly the
price of commodities and foreign interest rates, has an impact on South Africa's economy.
The trajectory of the Phillips Curve can be shifted by external shocks, which will alter the
way that both inflation and unemployment are related and necessitate flexible monetary
policy solutions.
Maintaining credibility: Maintaining credibility in monetary policy is crucial. If the SARB is
perceived as unable to manage inflation effectively, it could lead to higher inflation
expectations, shifting the Phillips Curve and making it harder to achieve desired economic
outcomes.
Join forces with Fiscal policies: Make sure fiscal measures support the objectives of
monetary policy by cooperating with the government. Coordinated actions can lessen the
pressure on inflation brought on by budgetary imbalances.
Inflation targeting: Keep your inflation aim open and understandable. This promotes trust
in the structure of monetary policy by managing expectations among firms and consumers.
Currency appreciation: Take action to fortify and stable the Rand, as this will aid in
containing import inflation.
Inflation is more frequently the cause than a fosterer of the devaluation of a currency and
the movement of exchange rates. An over adopted inflation rate is unlikely to contribute
toward a rise of an exchange rate with other countries as it may stand for. The low inflation
is not always the best answer to a country’s exchange rates. The inflation and the
exchange rates are all related.