Macroeconomic effects of lowering South Africa’s inflation target: An SVAR analysis

The paper estimates the macroeconomic effects of shifting to a lower inflation target for South Africa, within a Structural Vector Autoregressive (SVAR) framework identified using the Max Share Identification strategy and estimated with Bayesian methods. We find that a decrease of 1% (in terms of percentage points change) in the inflation target leads to output expanding over the next few quarters after an initial muted response, with a peak of about 1.20% after about two years and remains positive and statistically significant for nearly three years after the shock. We also observe a short and medium-term co-movement of inflation and the nominal policy rate in response to the inflation target shock, reminiscent of Neo-Fisherian effects. However, unlike most of the findings in the literature whereby the effects of inflation target shocks are persistent, we find that they are less persistent for the South African economy with this finding being robust to using an alternative identification approach. We find a strongly operative sovereign credit risk and asset price channels through which lower inflation target increases output. These findings are relevant for emerging markets where sovereign credit risks tend to be elevated compared to developed economies.