INFLATION TARGETTING IN SOUTH AFRICA: A
VAR ANALYSIS
G Woglom*
Abstract
T
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 techniques to study the relative frequencies of different kinds of
shocks impinging on the South African, New Zealand and Canadian
economies. The results suggest that South Africa is not a good candidate
for an inflation target relative to the other two countries because of the
relative importance of foreign shocks and of the weak linkage between
monetary policy and inflation.
1.
Introduction
A number of industrial countries have recently adopted inflation targets with an
apparent degree of success (see Bernanke and Mishkin (1997)). This 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
South Africa. The idea of an inflation target for South Africa has, in fact, drawn
growing support as a practical response to the increasing difficulty of monetary
targeting with a liberalised capital account (see Casteleijn (1999), Stals (1999) and
Mboweni(1999)).
This paper looks at the historical evidence to judge whether South Africa is a good
candidate for an inflation target. In particular, the South African evidence is compared
to the evidence from Canada and New Zealand, two countries that have adopted
inflation targets in 1991 and 1990, respectively. The main conclusion of the paper is
negative primarily for two reasons: 1) The exchange rate is highly volatile in South
Africa, and some of this volatility appears to be stabilising the effects of external
*
Visiting Fulbright Scholar (University of the Western Cape), Department of Economics, Amherst College,
Amherst, MA 01002, United States of America. Email: grwoglom@amherst.edu
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
1
shocks. Under inflation targeting, monetary policy would have to dampen these
exchange rate movements which are affecting the consumer price index (CPI); 2) The
linkage between monetary policy instruments and future inflation rates in South Africa
is weak. As a consequence wide swings in policy instruments would be needed to
fulfill an inflation target.
The rest of the paper comprises the next three sections. In the first of these sections the
complications of inflation targeting in an open economy are analysed. It is shown that
inflation targeting has the disadvantage of making the exchange rate less flexible in
response to shocks to the goods market. The subsequent section uses vector
autoregression techniques to provide a description of the dynamic behavior of the South
African economy and the Canadian and New Zealand economies for the period before
their adoption of an inflation target. The performance of the South African economy is
then compared to the pretarget performance of the other two economies with regard to
the importance of the exchange rate and to the strength and predictability of the linkage
between policy instruments and subsequent rates of inflation. The paper’s major
conclusions are summarised in the last section.
2.
The theoretical analysis monetary policy procedures
2.1
The traditional literature on inflation bias and nominal anchors
Ever since Kydland and Prescott (1977) introduced the time inconsistency problem into
macroeconomics, the analysis of monetary policy regimes has focused on two aspects
of any rule or procedure (e.g., Rogoff (1985)): 1) The inflationary bias inherent in the
rule or procedure and 2) the stabilisation properties of the rule or procedure. Thus
discretionary monetary policy with the dual objectives 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. The
stabilisation advantage of totally discretionary policy, however, only exists to the extent
that the central bank can use its discretion effectively to offset the effects of shocks.
The disadvantage of the inflationary bias can be lessened by adopting a monetary
policy rule aimed at a single nominal objective, e.g., the money stock, the inflation rate,
or nominal GDP (although not the nominal interest rate). The most popular of the
single nominal targets, or nominal anchors, is a CPI inflation target. Relative to
discretion with dual objectives, inflation targeting has less of an inflationary bias.
Inflation targets do, however, decrease the potential for active stabilisation, at least with
regard to supply shocks.1 For demand shocks, both monetary policy based on an
1
In principle, it is possible to adopt an inflation target with no loss in stabilisation. Walsh (1995) has shown
that “optimal” stabilisation can be achieved by writing a contract with an independent central bank that
imposes an added cost to inflation. Svenson (1997) has shown that the same result can be achieved by
2
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
inflation target and on dual objectives will attempt to offset shocks to aggregate
demand. With supply shocks, however, inflation targeting mandates a totally
nonaccommodative response that maintains the inflation rate, whereas a fully
discretionary policy response may find it optimal to accommodate at least some of the
supply shock.
While the advantage of nominal targets like the inflation rate is a reduction in
inflationary bias, the extent of the reduction depends on how credible the target is.
Recent discussions of credibility (see for example, Goodhart and Vinals (1994) and
Debelle and Fisher (1994)) have focused on the transparency of the targeting procedure
and the extent to which the procedure can make the central bank accountable for its
actions.2 Greater transparency and accountability increase credibility, but they decrease
a central bank’s flexibility in responding to unforeseen circumstances.
The inflation targeting regimes that have been adopted, however, have tried to preserve
at least some central bank flexibility. For example, the inflation targets that have been
adopted specify that the target is to be met over long horizons (1-2 years) with
substantial tolerance bands for acceptable inflation rates (2-3 percentage points).
Finally, some countries have adopted explicit escape clauses, where the central bank
can ignore the inflation target because of adverse consequences of achieving the target
(e.g., hitting an inflation target in the face of an adverse supply shock; see Masson et al
(1997) for a description of specific procedures). The variety of institutional procedures
that have been adopted to provide flexibility 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 flexibility and the
benefits from the inflation target. For example, long targeting horizons 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 subsequent shocks?
Tolerance 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 horizons, tolerance
bands, and escape clauses reintroduce an element of discretion into how actively the
central bank pursues the nominal target. The benefits from inflation targeting in terms
of transparency and accountability as well as in a reduction in inflationary bias,
setting the inflation target sufficiently below the socially optimal inflation rate. The inflation targets that
have been adopted have not used these methods, and consequently imply a loss in active stabilisation of
supply shocks.
2
Accountability and transparency issues have led many (see for example Debelle and Fisher (1994)) to favor
inflation targets over nominal GDP targets, in spite of the greater stabilisation potential of nominal GDP
targets.
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
3
however, can only achieved if the targets place some constraint on central bank
behavior.
In 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
objectives is high and/or rising; 2) aggregate supply shocks are not an important
source of instability, or 2’) monetary policy makers are ineffective in making
discretionary changes in the policy instrument to offset the effects of shocks, and 3)
the linkages between the monetary instrument and future inflation are sufficiently
strong and predictable, so that targeting horizons can be short enough and tolerance
bands narrow enough to substantially reduce the inflation bias.
2.1
Inflation targeting on open economies
Most of the theoretical analysis of policy procedures and policy rules has been
conducted in a closed economy context.3 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 index (CPI) and the price of domestically
produced goods. For simplicity, the CPI can be written as:
CPE  (1  )p   / e,
… (1)
where P is the price of domestically produced goods.  is the weight of imported goods
in the CPI and e is the nominal exchange rate expressed as foreign currency per unit of
domestic currency (with the foreign price level normalised to 1).
This simple equation immediately implies a distinction between stabilising the inflation
rate as measured by the price of domestically produced goods versus as measured by
the CPI. This distinction is important when the central bank must change the exchange
rate in order to stabilise the price of domestic goods and the level of output. For
example, the distinction is not important in the case of shocks to the money market
(e.g., an autonomous change in the velocity of money). Shocks to the money market
affect both the price of domestic goods and the exchange rate by changing the level of
aggregate demand. Therefore the central bank, by offsetting the effect of the velocity
shock on aggregate demand, can stabilise both the exchange rate and the domestic price
level, and therefore also the CPI.
3
The literature on time inconsistency and inflation bias has been extended to the open economy context (see
Romer (1993)). Romer 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 2) 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
4
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
The distinction between the price of domestic goods and the CPI is important for goods
market shocks, say an autonomous drop in export demand. The importance of this
distinction is illustrated in the figures on the next page. These figures depict a simple
textbook, ISLM version (e.g., Mankiw (1997)) of the Mundell Fleming model of a
small open economy. The LM 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. In this simple model, a perfectly flexible
exchange rate provides complete, automatic stabilisation of IS shocks. Notice,
however, that while the depreciation of the currency completely offsets the effects of
the IS shock on output and the price of domestic goods, the CPI still increases because
of the rise in the local currency price of imported goods. Under a binding CPI inflation
target, the central bank would have to enact a contractionary monetary policy to offset
the increase in the CPI, as is illustrated in the bottom figure. The offsetting monetary
policy leads to a net decline in the exchange rate, but also to a fall in output and the
price of domestic goods, so that the net change in the CPI is zero. A comparison of the
two figures shows that relative to a perfectly flexible exchange rate, CPI inflation
targeting makes the exchange rate less flexible in response to external shocks.
[Figures 1 and 2 About Here]
Thus CPI inflation targeting partially abandons some of the stabilisation advantages
provided by completely flexible exchange rates. It is important to note that the
stabilisation advantage of flexible exchange rates is due to the automatic stabilisation
of goods market shocks including external shocks, such as volatility in the demand for
traded goods and country risk premia.4
It should be noted that at least one country, New Zealand, has attempted to deal
explicitly with the potential problem of the linkage between the exchange rate and the
CPI. New Zealand adopted an “escape clause” that allows the Reserve Bank of New
Zealand to exclude 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 Posen (1997)). But escape clauses from changes in the
terms of trade are another example of the tradeoff between maintaining flexibility while
trying to achieve the benefits of an inflation target. CPI inflation targets will only
provide benefits if they put some constraints on central bank behavior. Escape clauses
can lessen, but not eliminate the loss in automatic stabilisation relative to perfectly
flexible exchange rates. Thus considerations of an open economy add one more
attribute for a good candidate for a CPI inflation target: 4) Automatic
stabilisation from the exchange rate is unimportant either because IS shocks are
unimportant, or because the central bank is currently not allowing the exchange rate to
float freely.
An increase in a country’s risk premia cause shifts in the LM curve as well as the IS curve, as the domestic
interest rate increases. In this case, the central bank must use discretion to offset the shift in the LM curve
so that the exchange rate can fall far enough to stabilise output and employment
4
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
5
A decision for South Africa to switch to inflation targeting would presumably be based
on the judgement that the South African economy fulfills most if not all of the 4
attributes of a good candidate for an inflation target. To make judgments on these 4 key
issues one must use the imperfect evidence provided by the historic performance of the
South African economy. The historic evidence is imperfect because of the Lucas
critique: changing the policy rule will affect the way people use past information to
form expectations of the future (and, in particular, their expectations of future monetary
policy, which is the whole point of adopting an inflation target). While the historical
evidence on the dynamic behavior of the economy is imperfect, it is not irrelevant. In
particular, a measure of the relative sizes of the shocks hitting the economy should be
independent of the policy regime.
In addition, one can also put the historic evidence in perspective by comparing the
South African performance to the performance of other countries immediately prior to
their adoption of an inflation target. In particular, the pretarget experiences of Canada,
which adopted an inflation target at the start of 1991, and of New Zealand, which
adopted an inflation target at the start of 1990, seem relevant. While clearly Canada,
New Zealand and South Africa are at different stages of economic development, they
are all relatively open economies (with exports 25% of GDP in South Africa and 33%
in New Zealand and 37% in Canada) with some similar features (manufacturing is
about 25% of GDP in Canada and South Africa and 18% in New Zealand).
Consequently, it is useful to compare the current South African evidence relating to the
key issues concerning the desirability of inflation targeting to the pretarget evidence for
Canada and New Zealand.
3.
The historical evidence for South Africa, Canada and New
Zealand
In this section, vector autoregressions (VARs) are used to provide historic evidence on
the dynamic interaction of the key variables of interest.
3.1
Empirical methodology
A VAR model is a reduced form of an unidentified structural model, which provides a
simple description of the dynamic behavior of the economy. Any VAR can be written
as:
… (2)
X t  B(L)X t   t X ,
where X is a vector of the variables of interest. In this case, one is interested in the
dynamic interaction of a monetary instrument, M, the price level as measured by the
CPI, the level of real GDP, Y, and the nominal exchange rate, e. B(L) is a matrix of
6
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
coefficients; L is the lag operator; X is a vector of VAR shocks which are assumed to
be i.i.d.. The VAR shocks will in general be linear combinations of all of the structural
shocks (i.e., external shocks to the goods market, velocity shocks, technology shocks,
etc.). The estimated coefficients in B(L) and the estimated residuals allow one to draw
inferences about 2 out of the 4 key issues (issues #3, and #4).
For example, the estimates from the VAR 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. The analysis depicted in Figure 1 suggests that in the
simplest model, IS shocks (a structural shock) should have no influence on output but
should cause an inverse relationship between shocks to the CPI (a VAR shock, CPI)
and the exchange rate (a VAR shock, e). LM shocks should cause an inverse
relationship between shocks to output and the exchange rate and also between shocks
to the CPI and the exchange rate. Therefore, if automatic stabilisation is important, the
correlation between the CPI and exchange rate shocks should be negative and the
correlation between output and exchange rate shocks should be small or negative.
If the exchange rate is less than perfectly flexible, then the correlations between output
and exchange rate shocks and between CPI and exchange rate shocks (as is illustrated
in Figure 2 for inflation targeting5) become ambiguous. In the case of a less than
perfectly flexible exchange rate, the correlations will depend upon the relative
frequency of IS and LM shocks. The greater the relative importance of IS shocks, the
more likely are these correlations to be negative. Thus there are two ways one might
observe negative correlations between the exchange rate shocks and the CPI and Y: 1)
the exchange rate is flexible so that most IS shocks are being automatically stabilised;
2) the exchange rate is imperfectly flexible but the economy is being hit by a
preponderance of LM shocks.
Measuring the relative importance of lagged exchange rates for determining the CPI
and Y can help to distinguish between these two cases. If automatic stabilisation from
the exchange rate is important, then lagged exchange rates should not be an important
determinant of Y, while they will be an important determinant of the CPI. In the case
of imperfectly flexible exchange rates, lagged exchange rates should be an important
determinant of Y, no matter what the relative frequency of IS and LM shocks. If there
are a preponderance of LM shocks, one would expect that the lagged exchange rates
would also be an important determinant of the CPI. If there are a preponderance of IS
shocks, whose effects on the CPI are being fully (as is illustrated in Figure 2) or
partially offset by monetary policy, then one would expect that lagged exchange rates
5
Figure 2 is illustrating the imperfect flexibility of the exchange rate under a CPI inflation target in which
case IS shocks would cause zero correlation between shocks to the CPI and to the exchange rate. With even
less flexibility in the exchange rate, so that the exchange rate doesn’t fall as far as e1, one would observe a
positive correlation.
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
7
would not be an important determinant of the CPI. The results of this analysis are
summarised in Table 1.
The economic importance of a variable in a VAR equation can be measured in two
ways: 1) by the size of the sum of the estimated coefficients, and 2) by the forecast
error variance decomposition or FEVD. For example, the FEVD of the CPI measures
the response of the CPI over time in response to a VAR shock to the CPI equation (i.e.
CPI). The FEVD breaks down the variation in output over any horizon into the
variation that is caused by the lagged values of all of the endogenous variables in the
model. If one finds that most of the variation in CPI is due to lagged values of the CPI
itself, and to lagged values of M and Y, this would suggest that lagged exchange rates
are not important for explaining the variations in CPI.
FEVD’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 (1992) for further
discussion of the strengths and weaknesses of FEVDs). Unfortunately, the results may
differ substantially depending on the assumed ordering. One can, however, present the
FEVDs for various ordering assumptions to show their sensitivity to the ordering
assumption.6 All the FEVD calculations reported in the paper list values at an 8 quarter
horizon for two different orderings of the variables: 1) the exchange rate first: e, M, P,
Y, and, 2) the exchange rate last: M, P, Y, e.
Finally, the CPI equation in the VAR is also relevant for measuring the strength and
predictability of the policy linkage and changes in inflationary bias. If there is a strong,
predictable relationship between monetary instruments and future CPI inflation, then
this equation should be estimated precisely and lagged changes in the monetary
instrument should be economically important and statistically significant in explaining
the CPI.
3.2
Data and diagnostics
Data on the CPI, real GDP, the nominal exchange rate, and monetary policy
instruments for South Africa were gathered from The South African Reserve Bank and
Statistics South Africa, for Canada from the IMF’s International Financial Statistics
(IFS) and Statistics Canada and for New Zealand from the IMF’s IFS. The available
South African data are from the first quarter of 1979 (1979:1) to 1999:1. For Canada,
the available data are from 1980:1 to 1998:3, and for New Zealand 1982:2 to 1998:3.
The money supply used for South Africa and New Zealand was M3 and for Canada a
6
The causal orderings used in the paper are block recursive or Choleski decompositions. It is important to
recognise that in general, the “true” structural model will not imply a block recursive ordering. It 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 “true” structural model. Again,
see Bernanke and Blinder (1992) for more discussion.
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J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
similarly broad measure was used, M2 plus deposits at institutions such as credit
unions. The exchange rate for South Africa is the nominal effective exchange, whereas
for Canada and New Zealand it is the US$ rate (although using a multilateral rate for
Canada, like the C6, rate had little effect on the results). The interest rate is the 3-month
Treasury bill rate for Canada and South Africa. A long enough time series for interest
rates was not available for New Zealand from the IFS (and for reasons discussed below,
interest rate data for New Zealand were not pursued). All variables are measured as
natural logs with the exception of interest rates.
Table 1: VAR results and the importance of automatic stabilisation
Predictions:
Automatic
Stabilisation from e is
important (bad
candidate for CPI
inflation targeting)
COV (  )  0, COV ( e  Y ) small or lagged exchange rates unimportant for Y,
lagged exchange rates important for CPI
Automatic
Stabilisation from e is
unimportant (good
candidates for CPI
inflation targeting)
CASE I (IS shocks more important)
COV( e  Y ) small or +, COV( e  CPI ) small or +
lagged exchange rates important for Y,
lagged exchange rates relatively unimportant for CPI
e CPI
Case II (LM shocks more important):
COV ( e  Y )  0, COV ( e  CPI )  0
lagged exchange rates important for Y,
lagged exchange rates important for CPI
COV is the covariance.
Unit root tests were conducted for the full sample periods, and these tests suggested
that first differencing of all variables except interest rates is necessary to provide
stationary time series. First differencing transforms logs into growth rates, which have
a natural interpretation: the first difference of the log of the CPI is the CPI inflation
rate. From here on CPI will stand for the inflation rate; Y for the rate of real GDP
growth, e the rate of nominal appreciation of the exchange rate, and M the rate of
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
9
money growth. Interest rates were not differenced because of their more modest “p”
value for unit roots, and also because the Fisher 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 equations was consistently positive. Presumably, this reflects the Fisher effect
and the problem of an uncontrolled “third variable” in the VAR methodology: Shocks
that are not contained in CPI, Y and e cause an expectation of higher inflation which
leads the central bank to raise the nominal rate. Therefore the positive coefficients
reflect the influence of the third factor, not the effect of a change in monetary policy on
inflation. The positive coefficient was robust to choice of time periods, interest rate
(i.e., the bank rate for Canada), and also persisted when the real interest rate was
substituted for the nominal rate.
Table 2 presents the variance/covariance matrix for the detrended growth rates. For
all countries data from two periods are presented. For South Africa, the full sample
period is from the beginning of Chris Stals’ tenure as Govenor of the Reserve Bank of
South Africa. The shorter period is the period since the first all-democratic election.
For Canada and New Zealand the two periods are the periods prior to the adoption of
an inflation target (the pertarget period) and the period since (the target period).
The most striking aspect of the data is the tremendous volatility of the nominal
variables in South Africa and pretarget New Zealand, most notably the volatility in the
exchange rate. South Africa has relatively low volatility in real GDP growth (although
this may be sensitive to the different sample periods), particularly in the comparison
with New Zealand. Both countries with inflation targets show a decrease in the
volatility of both nominal and real variables after the adoption of the inflation target. It
is important to note, however, that a similar decrease in volatility was experienced by
the industrial countries that didn’t adopt inflation targets (see Jonsson (1999))
3.3
VAR evidence on automatic stabilisation
Table 3 presents the VAR evidence from a 2 lag specification on the importance of
automatic stabilisation from the exchange rate (a full set of VAR results is available
from the author upon request). 7 In the table the covariances of the VAR shocks are
7
The Schwarz Bayes and Akaike criteria were not helpful in choosing lag lengths. For South Africa, the
Schwarz Bayes statistic rose monotonically with lag length and the Akaike information criterion fell
monotonically. Consequently the VARs were estimated with specifications of 2 and 4 lags. For South
Africa, the 2 lag specification yielded higher “F” statistics for all equations with the exception of the
exchange rate equation, which was statistically insignificant for either lag specification. Consequently, the
results of the 2 lag model are used for the remaining analysis. The results in most cases were broadly
similar. Finally, all VARs included a time trend and a constant term.
10
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
measured by correlations to make the covariances comparable across countries. The
evidence for South Africa and for the pretarget periods in New Zealand and Canada
seem to fit the three separate cases listed in Table 1. South Africa corresponds to the
case where automatic stabilisation appears to be important: 1) The correlation of
exchange shocks with CPI shocks is negative and large in absolute value and the
correlation with Y is relatively small. 2) Lagged exchange rates are important for the
CPI, but relatively unimportant for Y. Pretarget New Zealand seems to fit the case of
imperfectly flexible exchange rates with a preponderance of LM shocks: 1) Both
exchange rate correlations are negative and relatively large. 2) Lagged exchange rates
are an important determinant of both CPI and Y. Finally, pretarget Canada seems to fit
the case of imperfectly flexible exchange rates with a preponderance of IS shocks: 1)
The negative correlation of exchange rate shocks and CPI is relatively small, while the
correlation of exchange rate shocks with Y is positive and large. 2) Lagged exchange
rates are important for Y, but relatively unimportant for CPI.
Table 2: Variance/Covariance of detrended growth rates (in percentage pts per
quarter)
South Africa: 1990:1-1999:1
M
CPI
M
2,60
CPI
0,848
7,86
Y
0,036
0,161
e
-0,797
-1,82
South Africa: 1994:3-1999:1
M
CPI
M
2,54
CPI
-0,160
7,24
Y
0,068
-0,114
e
-2,46
-3,99
Canada Pretarget Period: 1981:2-1990:4
M
CPI
M
0,470
CPI
0,117
0,302
Y
-0,039
-0,340
e
-0,153
-0,125
Canada Inflation Target: 1991:1-1998:3
M
CPI
M
0,303
CPI
0,143
0,296
Y
-0,150
-0,160
e
0,224
0,388
New Zealand Pretarget Period: 1983:3-1989:4
M
CPI
M
9,90
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
Y
e
0,469
-0,190
16,1
Y
e
0,213
-0,181
29,1
Y
e
1,10
0,233
4,33
Y
e
0,301
0,109
4,54
Y
e
11
CPI
2,39
2,87
Y
-5,17
-3,06
e
-2,13
1,46
New Zealand Inflation Target: 1990:1-1998:3
M
CPI
M
8,17
CPI
0,327
0,177
Y
-1,02
-0,053
e
-1,29
0,394
16,67
-8,89
58,4
Y
e
2,01
1,74
13,0
Thus in terms of the importance of automatic stabilisation, pretarget Canada and New
Zealand appear to have been better candidates for a switch to inflation targeting than
does current South Africa. In pretarget Canada automatic stabilisation does not appear
to have been important because the exchange rate was not allowed to offset IS shocks.
In pretarget New Zealand, automatic stabilisation does not appear to have been
important because the economy was suffering from a preponderance of LM shocks (and
a switch to inflation targeting could very well have reduced the frequency of these
shocks).
The last two columns in Table 3 provide the same information for the two inflation
targeting countries during the targeting period. These columns are of interest because
they reflect how the change in the monetary policy regime has affected the dynamic
behavior of the economy. Unfortunately, these columns may also reflect the different
nature of shocks impinging on these economies in the pre and post-targeting periods.
In spite of this complication, the change in exchange rate correlations is striking. The
correlations of exchange rate shocks and CPI rise substantially and become positive in
both countries during the targeting period. The correlation of exchange rate shocks
with Y rises in New Zealand and is large and positive in both countries during the
targeting period. In addition, in New Zealand, the importance of the lagged exchange
rate for CPI falls dramatically and the importance for Y rises dramatically. All of
these changes are consistent with a rise in the frequency of IS shocks relative to LM
shocks during the targeting period, where the effects of the IS shocks on the exchange
rate are being offset by changes in monetary policy. Thus New Zealand and Canada
seem to be making less use of the automatic stabilisation of IS shocks from the
exchange rate since switching to inflation targeting.
The increasing relative importance of lagged exchange rates for CPI and the decreasing
relative importance for Y in Canada during the targeting period is not consistent with
this interpretation. Again, this partial inconsistency may be due to a change in the
relative frequencies of shocks impinging on the Canadian economy during the targeting
period. In addition, of course, one must note that in spite of the possible loss of
automatic stabilisation, Y became much more stable in the two countries during the
targeting period. Recall, however, that the industrial countries that did not adopt
inflation targets also experienced more stable output growth during the 90s.
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J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
Consequently 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. On the other hand, it
seems hard to posit that the changes in the correlations in Table 3 from the pre to post
targeting period are solely due to changes in the relative frequency of different kinds of
shocks. CPI inflation targeting seems to make these correlations more likely to be
positive, thereby implying a loss in exchange rate flexibility and a loss in automatic
stabilisation.
Table 3: VAR evidence on the importance of automatic stabilisation from the
exchange rate
 2
18,1
SA
NZ, pre
69,3
CA, pre
4,66
NZ, post
9,72
CA, post
4,73
 ( e ,  CPI )
 ( e ,  Y )
-0,39
-0,33
-0,25
0,17
0,37
0,13
-0,22
0,35
0,32
0,22
sum of coeff. in CPI
F statistic on coeff.
FEVD of e in CPI
sum of coeff. in Y
F statistic on coeff.
FEVD of e inY
-0,02
F(2,27)=0,46
18,1-3,7%
-0,02
F(2,27)=0,21
6,2-1,1%
-0,13
F(2,16)=0,94
36,9-15,2%
0,13
F(2,16)=1,16
24,2-8,1%
0,01
F(2,29)=0,12
4,3-2,7%
0,09
F(2,29)=0,62
15,3-3,6%
0,00
F(2,25)=0,06
9,0-0,8%
0,25
F(2,25)=3,66
17,0-11,3%
-0,10
F(2,21)=0,72
12,9-5,6%
-0,00
F(2,21)=0,03
6,3-1,9%
3.4
VAR evidence on the strength and predictability of the policy linkage
Table 4 present the VAR evidence on the linkage between money growth and CPI
inflation. On this dimension, South Africa comes out in the middle between pretarget
Canada and New Zealand. Relative to pretarget Canada the policy linkage is somewhat
less strong and much less predictable. However the comparison is exactly reversed
with pretarget New Zealand.
The large standard error in the South African CPI equation along with the relatively
small importance of the money supply suggests that inflation targeting may be difficult
to implement. In particular, wide swings in the policy instrument may be needed to
achieve the inflation target, a problem that New Zealand has experienced with inflation
targeting (see Mishkin and Posen (1997)). Yet, the CPI equation is more unpredictable
in South Africa than in New Zealand during the targeting period. It is somewhat ironic
that growing instability in the relationship between monetary aggregates and inflation is
frequently cited as an argument for inflation targeting. It is true that increasing
financial instability makes targeting monetary aggregates less attractive, but it also
makes the implementation of inflation targeting increasingly difficult.
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
13
Table 4: VAR evidence on the strength and predictability of policy linkage
std error of CPI equation
sum of the coeff on M
F statistic on coeff.
FEVD of M
3.5
SA
0,86
0,09
F(2,27)=1,48
8,6-7,5%
NZ, pre
1,34
0,02
F(2,16)=0,06
2,2-3,5%
CA, pre
0,18
0,15
F(2,29)=0,89
12,9-13,5%
NZ, post
0,38
-0,05
F(2,29)=0,86
11,7-11,4%
CA, post
0,54
0,29
F(2,21)=1,89
31,9-31,9%
Exchange rate correlations under the random walk hypothesis
On interesting aspect of the VAR results is that for South Africa, Canada, and pretarget
New Zealand, one cannot reject the hypothesis that the exchange rate follows a random
walk. This result is consistent with the view that the exchange 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 exchange rate and to CPI and Y can be measured by the
covariances of the detrended logs. In this case, one doesn’t have to estimate VAR
equations to measure the covariances. This saving of degrees of freedom allows one to
look at covariances with the exchange rate in the most recent period in South Africa,
which is done in Table 5. Again to make the covariances comparable, the covariances
have been expressed as correlation coefficients.8
The top panel in the table shows that it doesn’t matter much for the correlation of e
with CPI if the correlation is measured by VAR residuals or detrended changes in the
log. The correlation of e with Y changes from a small positive to a small negative
correlation. In either case, the correlations tell a story that is consistent with the view
that variations in the exchange rate have provided automatic stabilisation of IS shocks.
In fact, the correlations in the most recent period are consistent with the view that this
automatic stabilisation has become of increasing importance.
The bottom panel explores whether there are other widely used measures of inflation
that might be a more suitable target variable. The panel shows, however, that Core
CPI, which excludes mortgage interest and other volatile prices, has an even larger
negative correlation with the exchange rate. The produce price index lowers this
correlation a bit, but it isn’t until one adopts a price measure that excludes imports, viz.,
8
While 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. In
our VAR models there are 3 covariances of exchange rate shocks for each country and each time period.
Therefore there are a total of 18 covariances. The signs of the exchange rate covariances as measured by
the VAR residuals agrees with the sign as measured by the corresponding covariance of the detrended
change in the logs in 16 out of the 18 cases.
14
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
the producer price index for South African goods that this correlation falls
substantially. The last entry shows that the covariance actually becomes positive for
the GDP deflator. Thus the only way to implement an inflation target without forgoing
the benefits of automatic stabilisation from the exchange rate requires targeting a
measure of inflation that excludes imported goods. Any move away from headline
inflation as the target variable, however, implies a loss in “transparency.”
Table 5: Exchange rate variances and covariances in South Africa
M
VAR Residual, 90:1-99:1
detrended variables, 90:1-99:1
detrended variables, 94:3-99:1
Covariance of e with other
measures of inflation
CPI
Y
2
-0,39
-0,36
-0,48
0,13
-0,07
-0,07
18,1
16,1
29,1
Core CPI
PPI
PPI SA
IPD
measures of inflation
90:1-99:1
-0,37
-0,22
-0,16
0,29
94:3-99:1
-0,49
-0,42
-0,27
0,08
4.
Conclusion
On the basis of the VAR evidence, Canada and New Zealand appear to have been two
quite different countries in the pretarget periods. Yet, both countries have enjoyed
greater real economic stability since adopting an inflation target. In addition, both
countries enjoyed a reduction in average inflation with the adoption of the inflation
target in a manner that is consistent with a falling inflationary bias. The South African
economy, on the basis of the VAR evidence, looks more similar to pretarget New
Zealand: in both countries exchange rate shocks and CPI shocks were substantially
negative. In both countries exchange rate shocks were an economically important
determinant of the CPI. This might seem to suggest that South Africa could usefully
follow the New Zealand example by adopting an inflation target to lower volatility and
average inflation.
There is, however, one crucial difference between the behavior of the pretarget New
Zealand economy and the recent South African experience. In New Zealand, during
both the pre and post inflation targeting periods, lagged exchange rates were an
important determinant of real output. This suggests that the volatility of the exchange
J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
15
rate was not associated with the automatic stabilisation of IS shocks. In South Africa,
on the other hand, while the exchange rate has been volatile and an important
determinant of the CPI, it has not been an important determinant of output. Thus this
evidence suggests that the exchange rate has been providing important automatic
stabilisation of IS shocks in South Africa. The adoption of an inflation target would
force South Africa to forego this automatic stabilisation, which implies more volatile
real economic activity. In addition, South Africa does not have a strong and predictable
linkage between the CPI inflation rate and monetary aggregates. This could present
problems of instrument instability for South African monetary policy under an inflation
target; problems similar to those experienced by New Zealand (see Mishkin and
Posen(1997)). These results lead me to conclude that South Africa is not a good
candidate for CPI inflation targeting because of the implied loss in the benefits
provided by a fully flexible exchange rate.
The issue of inflation targeting’s effect on the flexibility of the exchange rate is
important because, as was illustrated in Table 5, the correlation between exchange rate
changes and all of the popular measures of inflation in South Africa has been
substantially negative and has become more so most recently. Apparently, IS shocks are
becoming more important in the South African economy. A monetary policy aimed at
stabilising the CPI inflation rate in the face of frequent and severe IS shocks would lead
to more output volatility, not less.
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J.STUD.ECON.ECONOMETRICS, 2000, 24(2)
17
LM
e
Y = P = 0
CPI > 0
e0
e1
IS
IS’
Y0=Y1
Y
Figure 1: Automatic Stabilisation of a Goods Market Shock
e
LM’
LM
Y < 0 P < 0
CPI = 0
e0
e1
IS
IS’
Y1
Y0
Y
Figure 2: CB Response to Goods Market Shock with CPI Targeting
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J.STUD.ECON.ECONOMETRICS, 1999, 23(3)
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