Financial assets, linear and nonlinear policy rules : An in‐sample assessment of the reaction function of the South African Reserve Bank

Purpose – The purpose of this paper is to investigate how the South African Reserve Bank (SARB) sets monetary policy rate. Design/methodology/approach – Given the controversial debate on whether central banks should target asset prices for economic stability, the authors analyse whether the SARB policy‐makers pay close attention to asset and financial markets in its policy decisions in the context of both linear and nonlinear Taylor type rule models of monetary policy. Findings – The main findings are that the nonlinear Taylor rule provides the best description of in‐sample SARB interest rate setting behaviour as the financial crisis unfolds. The SARB policy‐makers pay close attention to the financial conditions index when setting interest rates. The SARB's response of monetary policy to inflation is greater during business cycle recessions with not much weight on output and seems to place high importance on inflationary pressures of output during boom periods. The 2007‐2009 financial crisis witnesses an overall decreased reaction to inflation, output and financial conditions amidst increased economic uncertainty. Originality/value – This paper introduces a financial condition index into a Taylor monetary policy rule and examines whether nonlinear models can provide additional information over a linear model.