Rethinking The Current Inflation Target Range In South Africa

Critics argue that inflation targeting is not an appropriate monetary policy framework for developing countries. They maintain that developing countries are more susceptible to the negative effects of external shocks due to the uncertainty perceived by investors with respect to their political and economic stability. It is in this line that this paper assesses whether the 3%-6% inflation target is the optimal inflation target band in South Africa. To determine the optimal level of inflation target in South Africa, this paper follows the methodology developed by Ball and Mankiw (2002), which rests on the premise that there is a short run trade-off between inflation and unemployment. Ball and Mankiw (2002) show that there exists a level of unemployment that is consistent with stable inflation. The unemployment level that corresponds with a stable inflation is known as the non-accelerating inflation rate of unemployment (NAIRU). Thus, this paper uses an expectations-augmented Phillips curve to estimate a time-varying NAIRU for South Africa from 1980 to 2015. We use the headline inflation rate and the official unemployment rate based on the narrow definition to evaluate the appropriateness of the current inflation target range. Quarterly data from 1980 to 2015 sourced from Quantec is used to this end. The results of the empirical analysis indicate that, if South Africa were to put in place an inflation target range based on the NAIRU, it would have to target an inflation rate that ranges from 1.4 to 11.5 percent. This range is different to the official inflation target of 3% to 6% adopted by the South African Reserve Bank (SARB). Furthermore, this paper finds that the Phillips curve is not vertical in South Africa, as actual inflation does not depend solely on inflation expectations. The policy implication of the findings of this paper is that the South African Reserve Bank should think about revising its current inflation target, as it is too narrow for an emerging economy. The current low range of inflation target could have a negative effect on output and unemployment in the country. This paper recommends that the SARB should rely on the realities of the South African economy rather than on external concerns when defining the range of inflation target.