Financial markets and the response of monetary policy to uncertainty in South Africa

This paper assesses the impact of uncertainty about the true state of the economy on monetary policy in South Africa since the adoption of inflation targeting. The paper also analyses the impact of uncertainty about the conditions in financial markets on the interest rate setting behavior that describes the South African Reserve Bank’s monetary policy decisions over and above using inflation and output as indicator variables. The results indicate that the effect of uncertainty on the interest rates has led to a more cautious monetary policy stance by the monetary authorities consistent with a large body of literature that recognizes that an excessively activist policy can increase economic instability. The results further show that uncertainty about the state of the economy clusters around the financial crisis periods in 2003 and from 2007 to 2009. The uncertainty about inflation was important to the interest rate setting behavior in 2003, while the uncertainty about the conditions in financial markets was important to the interest rate setting behavior between 2007 and 2009.