A recent working paper by Eric Parrado of the International Monetary Fund’s (IMF) monetary and financial systems department argues that flexible inflation targeting, which takes into account inflation as well as output, is superior to strict inflation targeting, where meeting the inflation target is the unique objective.
In South Africa, the central bank has a strict inflation target mandate, but in practice, it does also consider the impact on output, and applies monetary policy in a gradualist manner, so as to not shock the national economy too much.
Inflation targeting was only formally adopted in February 2000 with a two-year phase-in period. In response to the collapse in the rand from R9,79 a dollar on November 29 2001 to a worst level of R13,86 a dollar on December 20 2001, a move of 41,6% in only 16 trading days, the South African Reserve Bank (SARB) increased interest rates gradually by 400 basis points, so that the prime rate rose from 13% to 17% in four separate moves between January 2002 and September 2002.
This gradualist response to an exchange rate shock was in stark contrast to the panic reaction in the second half of 1998, when another exchange rate crisis had seen the prime rate rise from 18,25% to 25,5% in only four months between June 1998 and September 1998.
The rand then staged a dramatic recovery in 2002 and 2003. The rand strength has continued in the first weeks of 2004, and has averaged R6,86 a dollar so far this year compared with an annual average of R7,55 in 2003 and R10,59 in 2002.
On December 3 2003, the rand moved to its best level since January 2000 when it touched R6,09 a dollar.
The gradualist approach also applied on the way down when the SARB cut by 550 basis points in 2003 in five separate cuts between June and December compared with the rapid decline in 1999, when the prime rate was cut eight times from 23% in January to 15,5% in October.
The panic reaction in the third quarter of 1998 meant that the South African economy contracted in that quarter, while under the Tito Mboweni governorship, the South African economy has grown for a record 21 consecutive quarters in the fourth quarter of 2003. The previous record was 16 quarters in the 1960s.
In May 2003, South Africa entered its longest “upward economic phase”, as the previous longest upward phase lasted from September 1961 to April 1965. The current upward phase started in September 1999.
The Parrado paper developed a simple dynamic neo-Keynesian model of a small open economy, such as Chile and South Africa, in which inflation targeting plays a key role for monetary policy.
In particular, the model is based on explicit utility and profit maximisation, and explicit treatment of market structure.
It includes a formal examination of the effects of different exchange rate regimes and inflation targets indicators, considering simple forecast-based monetary policy rules.
The main findings of the Parrado paper are that, depending on what shocks affect this economy, the effects of inflation targeting on output and inflation volatility depend crucially on the exchange rate regime and the inflation index being targeted.
With regard to the exchange rate, the analysis concludes that the social loss is much higher under managed exchange rates than under flexible rates if there are foreign and real shocks, while for nominal shocks, the reverse is true.
As far as the definition of the inflation-targeting index is concerned, domestic inflation appears to outperform the consumer price index.
Finally, and somewhat predictably, Parrado’s model found that flexible inflation targeting is superior to strict inflation targeting. — I-Net Bridge