SOUTH AFRICA’S OPTIMAL MONETARY POLICY

AND THE EXCHANGE RATE

Word count: 3 510

INTRODUCTION

In his 2010 budget speech, Mr Pravin asserted the South African government’s commitment to a low
rate of inflation and a competitive exchange rate, while “providing a buffer against global volatility”.
These remain highly desirable goals but in a world where a regulator cannot control all facets of the
economy at once, certain trade-offs must inevitably be negotiated in order to meet the ultimate aim
of sustainable economic growth.

According to the Mundell-Fleming model, a country allowing free capital mobility cannot
simultaneously control its exchange rate and its monetary policy – a trilemma known as the
“impossible trinity”. This has become a source of tension between priorities of many emerging
economies, not least South Africa, who are especially concerned about exchange rate fluctuations.
While it may be tempting for South Africa to tighten its control of the exchange rate, this would
necessitate a loss of central bank monetary autonomy. Inflation targeting by definition requires the
ability to affect monetary variables and thus allowing the exchange rate to float.

This paper explores whether some form of exchange rate regime would be more effective than
inflation targeting for controlling inflation and maintaining economic stability in South Africa, while
bearing in mind each policy’s trade-offs, in the context of South Africa’s international trade
competitiveness and vulnerability to global and domestic shocks. While there is no perfect solution,
given the ramifications that flow from the inability to affect monetary policy, inflation targeting
appears to be the most appropriate choice for South Africa.

WHY TARGET INFLATION?

Low inflation is commonly regarded as being essential for sustainable economic growth. Freedman
and Laxton (2009:3-8) provide a comprehensive list of the costs of inflation:

(i) High inflation is associated with high inflation volatility.

Page 1 of 12
 (ii) High inflation yields a greater likelihood of asset-price bubbles as investors confuse the
nominal asset-price increases for rises in real value when in fact they are merely a result
of persistant inflation.
(iii) High inflation is associated with lower levels of potential output and output growth. This
could be because inflationary distortians negatively effect incestment decisions, which
leads to a smaller and/or less productive capital stock. Inflation infects investment
decisions by promoting uncertainty and therefore higher risk premiums in bond
markets.
(iv) Social costs result from the distortions causes by high inflation. Firms find difficulty in
synchronising price increases and relative prices thus tend to misrepresent the real costs
of production. This leads to sub-optimal decisions by economic entities.
(v) There are distortionary tax implications. “It is likely that some firms will be overtaxed
and others undertaxed...and consequently that there will be distortions in investments
as firms seek to maximise their after-tax profits” (Freedman & Laxton, 2009:5).
(vi) Inflation erodes savings, which is especially detrimental to pensioners and low-income
individuals who will likely find it more difficult than higher income individuals to protect
themselves from the affects of inflation.
(vii) The uncertainty surrounding future prices associated with high inflation makes wage
setting and negotiation a difficult and precarious task, which might lead to a higher
number of days lost to strikes.

There is also some evidence to suggest that high inflation is positively correlated with business cycle
volatility. Freedman and Laxton (2009:7) offer Canada and the United Kingdom as examples of
countries that experienced sharp cyclical movements in unemployment during times of high inflation
which became less erratic after the countries entered periods of lower inflation. Further evidence
comes from Kumhof and Laxton (2007) who have shown that 50% of the improvement in the
performance of macro variability in the US can be attributed to better macro policies. This is relevant
because US monetary policy is preoccupied with maintaining a low rate of inflation (Freedman and
Laxton, 2009:8). Time and again, high inflation appears to be detrimental to a healthy economic
environment. This underscores the importance of controlling it. There is some debate, however, of
how best to accomplish this.

THE CASE FOR CONTROLLING THE EXCHANGE RATE

While maintaining low inflation is imperative to ensure a stable economy, there is a large body of
evidence that shows that real exchange rate misalignments are also detrimental to economic

Page 2 of 12
performance and growth. This finding has been confirmed by, among many others, Ghura and
Grennes (1992), who focused exclusively on Sub Saharan Africa.

Emerging market economies are particularly vulnerable to exchange rate fluctuations. Mishkin
(1996) notes that such countries tend to rely more heavily than developed countries on foreign debt
and depreciation in the value of the home currency multiplies this burden. This is true for both
public and private debt. This is relevant in South Africa’s case as it had an estimated public debt
standing at 35.7% of GDP as of 2009, according to the CIA World Factbook (2010). A further
consideration is the exchange rate’s effects on global competitiveness and the balance of payments.
This is especially relevant given the rand’s recent strength. A strong rand causes South African
exports to be relatively more expensive to the rest of the world, which, ceteris paribus, depresses
international demand for domestic goods and leads to a decrease in GDP, according to the Marshal
Lerner condition. At the same time, foreign imports become more attractive to South Africans as
they become relatively cheaper. This causes deterioration in the current account balance.

Another important impact of exchange rate volatility, which is linked to inflation, is what is known as
pass-through. Pass-through occurs when import prices increase due to currency depreciations and
lead to lasting higher inflation expectations [ CITATION Mis04 \t \l 7177 ], thereby countering the
effect of monetary policy designed to rein in inflation. This is a problem for developing countries
with a patchy track record and low monetary policy credibility as the public is more likely to be
sceptical of the government’s ability to control the second-round effects of inflation, leading to a
self-fulfilling spiral of increasing prices. South Africa’s imports amounted to an estimated 25% of GDP
in 2009 (CIA World Factbook, 2010).

Frankel (1999) recognises that a major advantage of fixed exchange rates is the reduction of
exchange rate risk and transaction costs. While hedging can mitigate such risks, they remain a great
concern. However, currency crises have emanated from countries with fixed exchange rates, such as
Mexico in 1994 and in the 1997 Asian currency crisis. Therefore, while fixed rates might placate
investors in times of government confidence, they do not necessarily have the same effect during
tumultuous economic periods.

A CRITICAL ANALYSIS OF INFLATION TARGETING

Inflation targeting (IT) firmly sets the inflation rate as the official nominal anchor. The nominal
anchor provides a focal point to which expectations of the public and policy objectives of the
government and central bank converge. This provides clarity and focus to all economic actors of the

Page 3 of 12
objectives of the central bank. It encourages transparency and an open line of communication as
policy makers commit to meeting targets based on the anchor (Freedman and Laxton, 2009).

According to Bernanke et al (1999), full-fledged IT (FFIT) is characterised by (i) public announcements

of target inflation rates or ranges over a specific period of time, (ii) common knowledge that low
inflation is the priority of monetary policy, (iii) strong communication of the central bank’s objectives
and plans with the public, and often (iv) processes that solidify central bank accountability for these
objectives. Mishkin (2007) adds that it entails more than merely publicly announcing a target for
inflation. He also contends that it should be a holistic policy, which includes considerations of the
exchange rate and monetary aggregates in rolling out its policies.

Besides for being a convenient method for keeping inflation low, Freedman and Laxton (2009)
identify two “intellectual roots” for its adoption:

(i) The absence of an exploitable long-run trade-off between inflation and output
There is a well-documented short-run relationship between inflation and output, which
is captured in the short-run Phillips Curve (SRPC) – an increase in output beyond its
natural level is associated with an increase in inflation. However, Friedman (1968) and
Phelps (1968) observed that the SRPC would shift up over time as people expected
higher future inflation. This would eventually cause output to shift to its original level
but at a higher inflation level. Therefore, merely stimulating production beyond its
natural level is harmful in the long-run. By focusing the authority’s attention on inflation,
it would prevent such myopic policy implementations.
(ii) The time-inconsistency problem
While policy makers might be aware of the follies of increasing output beyond its natural
level in the long run, they might none-the-less be tempted to do so for short-run gains.
That IT demands a commitment to keeping inflation at or within a specific qualitative
level acts to sterilise such temptations.

Mishkin and Schmidt-Hebbel (2005) have found that inflation targeters have experienced significant
improvements compared to their own historic economic performance and fare better than most
non-inflation targeters. This confirms empirical findings of such researchers as Ball and Sheridan
(2003) Hyvonen (2004). According to the IMF (2006), “[non-industrial] countries that adopted
inflation targets have, on average, outperformed countries with other frameworks.” However, we
cannot infer a causal relationship between IT and superior performance and the results are based on

Page 4 of 12
relatively short time periods. However, the results do add to the body of circumstantial evidence
that points to the success of IT.

The IMF (2006) conducted a statistical analysis comparing performance improvements of emerging
market economies that adopted inflation targeting to those that adhered to alternative monetary
policies. 13 inflation targeters and 29 comparable emerging market economies were included in the
study over the period 1984 to 2004. The results are displayed in Table 2. The table supports the
IMF’s (2006) findings that “improvements in key measures of macroeconomic performance in
emerging market economies under inflation targeting have been greater than under other monetary
regimes.” The IMF concedes, however, that this was a relatively benign economic period and
therefore the experience under a more volatile period might prove to be different. Interestingly,
however, the results suggest that inflation targeters did not have to sacrifice output stability, in fact
experiencing slightly lower output volatility over the period.

In the same report, the IMF (2006) cites examples of countries that fared well during crises under an
inflation targeting policy, noting the experiences of Brazil, Hungry and South Africa in 2002, and
going on to say that “Shocks of similar magnitude have destabilized these countries in the past,
suggesting at least that the framework has contributed to the economy’s resilience to shocks.” In
addition, there appears to be a significant negative correlation between inflation targeting and
financial market volatility. These positive results are mirrored by the findings of Schmidt-Hebbel et al

Page 5 of 12
(2002), who examine the experiences of Chile, Mexico and Brazil since their adoption of IT. They
found that these countries performed better than their historical levels would predict.

There are, however, some disadvantages to inflation targeting (apart from an inability to set the
exchange rate). Monetary policy has uncertain effects on inflation (Mishkin and Posen, 1997), which
makes it more difficult for authorities to precisely make an inflation target than one based on a more
graspable figure, such as the exchange rate or aggregate money supply. This is exacerbated by
monetary instruments’ lagged effects on inflation. Policies effecting the exchange rate and money
supply do not experience such lags, making such policies easier to assess.

A policy that rigidly targets inflation, with no consideration for the causes and likely second-round
effects of shocks to the economy, is likely to cause other problems. For example, automatically
increasing the interest rate in the face of a temporary inflationary supply shock has become
recognised as a faux pas. While this is more likely to bring inflation under control than a less
stringent policy, it will also increase output volatility and deepen economic turmoil. For this reason,
Mishkin (2004) asserts that countries should be flexible in their approach of IT. For instance, a “dirty
float” is often advantageous to smooth exchange rate fluctuations. The lesson here is that countries
should not use a strict, set rule for when to lower or raise interest rates based on headline inflation
but should also consider the effects that interest rate changes will have on output volatility and
whether price shocks are likely to affect future inflation expectations. In addition, Freedman and
Laxton (2009) find that even “in the face of supply shocks, medium-term expectations remained
anchored...there was less or no need to raise interest rates in the face of a temporary supply shock.”

INFLATION TARGETING IN SOUTH AFRICA

Mishkin (2004) points out that emerging market countries differ in their ability to implement IT in
that they have ”weak fiscal institutions; weak financial institutions including government prudential
regulation and supervision; low credibility of monetary institutions; currency substitution and
liability dollarization; vulnerability to sudden stops (of capital inflows).” Inflation targeting is
commonly considered to require strong central bank credibility to affect expectations and a stable
financial system to be able to accurately target interest rates and the money supply. The absence of
such criteria in emerging market countries raises questions as to the viability of an IT policy. SARB
has managed to achieve “transparency, accountability, credibility” (Reid and du Plessis, 2009), which
is supported by findings of Aron and Muellbauer (2008). Furthermore, South Africa has robust
financial and fiscal institutions. As already mentioned, other developing countries, such as Chile and

Page 6 of 12
Brazil, have had successes with inflation targeting (Mishkin, 2002) despite questionable institutional
integrity and central bank credibility.

Figure 1 is reproduced from a paper by Heintz and Ndikumana (2010), showing CPIX inflation since
the adoption of inflation targeting in 2000 to the first quarter of 2009. It shows that SARB has had
some success in bringing inflation within the targeted band of 3-6% between the fourth quarter of
2003 and the first quarter of 2007. The target was met roughly half of the time. The first spike in
inflation is due to rapid currency depreciation while the second is attributed to high food and energy
costs. In both cases, inflation has been reigned in, without spiralling out of control. This lends
credibility to South Africa’s ability to sustain a successful inflation targeting policy. Heintz and
Ndikumana (2010) also note that GDP growth and economic performance were strong compared to
the years before IT was adopted. Interestingly, this has been accompanied by a declining real
exchange rate, as figure 1 illustrates. One must be careful not to draw a causal relationship.
However, it is suggestive of the potential of IT in South Africa.

THE EXCHANGE RATE REGIME AS AN ALTERNATIVE TO INFLATION TARGETING

The full spectrum of conceivable monetary policies is broad. However this paper explores the most
popular and frequently proposed alternative: an exchange rate target – prioritising the level of the
exchange rate over domestic variable targets, such as the monetary aggregate or inflation rate. This

Page 7 of 12
involves fixing the exchange rate to some degree but between the extremes of floating and hard
pegged exchange rates, there lies intermediate policies. These include adjustable pegs, crawling
pegs and target bands. In addition, targets can be based on a single currency or a basket of
currencies. Other extremes are currency boards or monetary unions such as the arrangement in the
EU. However, the “common currency” in these cases must still be governed by some sort of
monetary policy. For example, the euro is still allowed to float relative to other currencies. This
paper does not examine the effectiveness of each specific regime but rather looks at the concept of
controlling the exchange rate to keep inflation low.

A fixed exchange rate allows a country to “import inflation” from the country or basket of countries
to which the domestic currency is pegged (Thakur & Greene). For this reason, it has been proposed
that a fixed exchange rate can lead to less inflation volatility at a given level of output. The
mechanism by which inflation is imported from overseas is derived from the lack of domestic central
bank monetary autonomy (Frankel, 1999). Recall that the impossible trinity states that capital
mobility and a fixed exchange rate makes controlling monetary policy impossible – because any
change in the interest rate would also affect the exchange rate. Therefore, the authority’s hands are
effectively tied in decisions relating to money supply and the interest rate – it is committed to
following the domestic monetary policy of the targeted country (Hoggarth, 1996). If there is
credibility that the government will abide by its exchange rate target then expectations of future
inflation will converge to those of the foreign country to whom the exchange rate of the domestic
currency is pegged. This results from the credibility of the fixed exchange rate as a nominal anchor
and its high visibility.

The advantages to a fixed exchange rate have already been discussed. However, while being able to
fix the exchange rate might allow South Africa to correct for any real exchange rate misalignments, it
does not guarantee that fixed rates will do any better to align the real exchange rate with its
equilibrium level (Edwards, 1989). Mishkin (2004) notes independently, as well as in a paper with
Posen (1997) that IT can lower the incidence of pass-through by helping to focus inflation
expectations and therefore decrease the likelihood that price shocks will lead to inflationary second-
round effects. While fixing the exchange rate might mitigate pass-through by preventing
depreciations, its advantages are overrated compared to a flexible exchange rate under a credible IT
regime that can fix inflationary expectations.

Page 8 of 12
As noted by Thakur and Greene, fixed exchange rates have indeed succeeded in some cases in
lowering inflation, citing Argentina, Chile and Uruguay in the late 1970s as examples. They also note
several pitfalls of such a policy:
(i) Convergence to the inflation rate of the targeted country is typically slow, because of
the slow rate of adjustments in the labour and goods markets and wage price stickiness.
(ii) The slow rate of inflation means that the level of inflation in the home country is higher
than that of the country being targeted, yielding a higher real exchange rate, which
might harm demands for exports and contribute to deterioration in the current account
balance. If this becomes unsustainable, a forced devaluation is inevitable.
(iii) The improved economic activity following the adoption of a fixed exchange rate is
typically followed by a sharp downturn in output and employment.

Many countries have abandoned fixed exchange rates due to the inability of central banks in such
countries to affect monetary policy or because of currency crises resulting from unsustainable
current account imbalances (Freedman & Laxton, 2009). Examples include industrialised countries
(for example, the UK, Sweden and Finland) and emerging market economies, such as Brazil and
Chile.

ASSET-PRICE BUBBLES, INFLATION TARGETING AND EXCHANGE RATE TARGETING

An asset-price bubble appears when an asset becomes overvalued and “irrational exuberance” and
credit market imperfections interact to create a self-fulfilling upward spiral in the nominal price of
that asset (Bernanke et al, 2000). A bubble can be “popped” in theory by tightening monetary policy
(Kent & Lowe, 1997). However, when a bubble is not associated with high average inflation, IT can
be somewhat ineffectual at controlling bubbles.

However, Kent and Lowe (1997), Gruen et al (2003) and Bean (2003) maintain that IT can, and at
times should, be used to pop asset-price bubbles before they become too large. “Other things equal,
the case for ‘leaning against’ a bubble with monetary policy is stronger the lower the probability of
the bubble bursting of its own accord, the larger the efficiency losses associated with big bubbles”
(Gruen et al, 2003).

There is no evidence that a fixed exchange rate would be any more effective at pricking asset-price
bubbles. In fact, it might serve to indirectly promote bubbles through the subsequent inability of the
central bank to deal with a bubble using monetary policy. In any case, it is often difficult to identify
bubbles from rational price increases based on underlying fundamentals (Bean, 2003). While more

Page 9 of 12
sophisticated methods for detecting bubbles would allow authorities to better deal with them, there
is no reason to believe that other monetary policy frameworks would fare better in this regard.

CONCLUSION

As with most complex problems, there is no one perfect solution. South Africa has a credible central
bank and a robust financial system. This bodes well for an IT policy. South Africa’s relative economic
stability and successes in the face of economic shocks, since the adoption of inflation targeting,
suggest little reason to abandon it. The advantages associated with a fixed exchange rate are
outweighed by the negative consequences of a loss of central bank monetary autonomy. Inflation
targeting does not preclude using monetary policy to control the exchange rate to some extent and
many economists support doing so. The argument supporting the adoption of a fixed exchange rate
in emerging market countries – that it is the only means of providing a credible nominal anchor –
does not apply to South Africa because of its strong financial system and credibility. Inflation
targeting thus remains the appropriate monetary policy for South Africa to achieve low inflation and
stable economic growth.

Page 10 of 12
References
Aron, J., & Muellbauer, J. (2008). Transparency, Credibility and Predictability of Monetary Policy
under Inflation Targeting in South Africa. Oxford, Department of Economics and Nuffield College.

Ball, L., & Sheridan, N. (2004). Does Inflation Targeting Matter? National Bureau of Economic
Research, NBER Working Paper No. W9577, Cambridge.

Bean, C. (2003). Asset prices, financial imbalances and monetary policy: are inflation targets
enough? Monetary and Economic Department. Basel: Bank for International Settlements.

Bernanke, B., & Gertler, M. (2000). Asset Prices and Monetary Policy. NBER Working Paper.

Bernanke, B., Laubach, T., Mishkin, F., & Posen, A. (1999). Inflation Targeting: Lessons form the
International Experience. Princeton: Princeton University Press.

Central Intelligence Agency. (2010, May 27). The World Factbook. Retrieved June 5, 2010, from
South Africa: https://www.cia.gov/library/publications/the-world-factbook/geos/sf.html

Edwards, S. (1989). EXCHANGE RATE MISALIGNMENT IN DEVELOPING COUNTRIES. World Bank

Research Observer , 4, 3-21.

Frankel, J. A. (1999). NO SINGLE CURRENCY REGIME IS RIGHT FOR ALL COUNTRIES OR AT ALL TIMES.
NATIONAL BUREAU OF ECONOMIC RESEARCH, Working Paper No. 7338, Cambridge.

Freedman, C., & Laxton, D. (2009). Why Inflation Targeting? IMF Working Paper No. 09/86.

Friedman, M. (1968). The Role of Monetary Policy. American Economic Review Papers and
Procedings , 58 (1), 1-17.

Ghura, D., & Grennes, T. Y. (1993). The Real Exchange Rate and Macroeconomic Performance in Sub-
Saharan Africa. Journal of Development Economics (42), 155-174.

Gruen, D., Plumb, M., & Stone, A. (2003). HOW SHOULD MONETARY POLICY RESPOND TO.
Macroeconomic Group, Australian Treasury and Economic Group, Reserve Bank of Australia.

Hoggarth, G. (1996). Introduction to Monetary Policy. London: Bank of England.

Hyvonen, M. (2004). Inflation Convergence Across Countries. Reserve Bank of Australia, Economic
Research Department, Sydney.

IMF. (2006). Inflation Targeting and the IMF. Monetary and Financial Systems Department, Policy
and Development Review Department and Research Department.

Judson, R., & Orphanides, A. (1999). Inflation,Volatility and Growth. International Finance , 2 (1),
117–138.

Kent, C., & Lowe, P. (1997). ASSET-PRICE BUBBLES AND MONETARY POLICY. Reserve Bank of
Australia, Economic Research Department, Research Discussion Paper No. 9709.

Kubota, M. (2009). Real Exchange Rate Misalignments. University of York, Department of Economics,
York.

Page 11 of 12
Kumhof, M., & Laxton, D. (2007). Improving Macroeconomic Performance - Good Luck or Good
Policies. October 2007 World Economic Outlook .

Mishkin, F. S. (2004). Can Inflation Targeting Work in Emerging Market Countries? Cambridge:
National Bureau of Economic Research.

Mishkin, F. S. (1996). Understanding Financial Crises: A Developing Country Perspective. Annual

World Bank Conference on Development Economics, (pp. 29-62).

Mishkin, F. S., & Posen, A. S. (1997). Inflation Targeting: Lessons from Four Countries. Cambridge:
National Bureau of Economic Research, Working Paper 6126.

Phelps, E. (1968). Money Wage Dynamics and Labor Market Equilibrium. Journal of Political
Economy , 76 (4, Part 2), 678-711.

Razin, O., & Collins, S. M. (1997). Real Exchange Rate Misalignments and Growth. Georgetown
University.

Reid, M., & Plessis, S. d. (2009). Loud and Clear? Can we hear when the SARB speaks? University of
Stellenbosch, Working Paper No. 155 , Department of Economics.

Schmidt-Hebbel, K., Werner, A., Hausmann, R., & Chang, R. (2002). Inflation Targeting in Brazil, Chile,
and Mexico: Performance, Credibility, and the Exchange Rate . Economía , 2 (2), 31-89.

Stone, M. (2003). Inflation Targeting Lite. IMF Working Pape No. 03/12.

Thakur, S., & Greene, J. Exchange Rate Policy and Exchange Rate Regimes: A Broad Perspective. IMF.

Valladares, F., & Terra, C. (2004). Real Exchange Rate Misalignments. Econometric Society 2004 Latin
American Meetings 191. Econometrics Society.

Viegi, N. (2006). Economic policy framework and asset price dynamics . SARB Conference 2006, (pp.
179-191).

Page 12 of 12