Twenty-five years of inflation-targeting in South Africa : going from 6% to 3%?

This paper proposes that the South African Reserve Bank should pursue a 3% inflation target, instead of the current 4.5% midpoint of a 3%-to-6% target range. Doing so may also result in lower inflation volatility, thereby reducing nominal exchange rate risk for investment and trade, and may thus support economic growth. Using a two-regime Markov-switching model, the analysis shows that since the global financial crisis, periods of higher inflation volatility are much shorter. Thus, inflation is relatively better anchored since the global financial crisis. But there are still shocks that coincide with periods of exchange rate volatility. Lastly, the analysis shows that the budget deficit/gross domestic product ratio, constraints on electricity supply, and administered prices contribute significantly to inflation, while the effect of real gross domestic product growth (as a demand variable) is limited. The analysis also argues that the sacrifice ratio, measuring the sacrifice of growth and employment that is required to reduce inflation, is of limited use once the potential role that other variables can play in the reduction of inflation and inflationary expectations is considered. The government has an especially significant role to play in supporting the South African Reserve Bank in lowering the inflation rate to an average of 3% by lowering the level and volatility of administered price inflation, reducing the budget deficit, and improving electricity supply.