1. WHAT DO YOU UNDERSTAND BY INFLATION TARGETING?
‘ It is a monetary policy strategy used by central banks for maintaining prices at a certain level or within a specific range. Inflation targeting is an economic policy in which a central bank estimate and make public projected, or target inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.
1.1. WHY INFLATION TARGETING?
‘ Many central banks, the makers of monetary policy have adopted the technique called inflation targeting to control inflation
‘ Many central banks adopted inflation targeting as a pragmatic response to the failure of other monetary policy regimes, such as those that targeted the money supply or the value of the currency in relation to another presumable stable, currency.
‘ Many central banks then began targeting the growth of money supply to control inflation
1.2. WHAT IS REQUIRED IN IMPLEMENTING AN INFLATION TARGETING POLICY?
In the implementation of inflation targeting, decisions have to be made on the following matters:-
‘ Who sets the target?
‘ How will the target variable be defined?
‘ How will the target be set?
‘ How will monetary policy decisions be made?
‘ How transparent will monetary policy is and how accountable is the central bank?
The determination and announcement of the target
The determination and announcement of the inflation target differ considerably in the
Countries applying this monetary policy framework. In countries such as Spain, Sweden,
Mexico and Poland the inflation target is set and announced by the central bank. In
countries such as Brazil, Israel, Korea, Peru and Thailand it is set by government in
consultation with the central bank. In some others like Australia, Canada, Columbia and
New Zealand the target is set jointly by government and the central bank. As far as could
be determined, it is only in the United Kingdom that the target is set only by government.
The way the inflation target is determined depends on the autonomy of the central
bank. South Africa is one of a few countries in which the independence of the central
bank has been determined in the Constitution of the country. The governments of most
countries have preferred to rather spell out the independence of their central banks
through an ordinary Act of Parliament.
The Constitution Act of 1996 (Act No 8) as well as the South African Reserve Bank Act
of 1989 (Act No 90) determine the primary goal of the Reserve Bank. In section 224 of
the Constitution and section 3 of the Reserve Bank Act it is stated that the primary
objective of the Bank is to protect the value of the currency of the Republic in the interest
of balanced and sustainable economic growth. Section 224(2) of the Constitution further
determines that the Reserve Bank, in pursuit of its primary objective, must perform its
functions independently and without fear, favour or prejudice. Regular consultation must,
however, take place between the Minister of Finance and the Reserve Bank. This duty to
consult should be regarded as a procedural safeguard of the law. The executive
management of the Reserve Bank nevertheless remains the primary organ responsible
for the achievement of the Bank’s primary objective (
The institutional framework in South Africa allows the South African Reserve Bank a great degree ofautonomy in its operations. The South African Reserve Bank’s functional independence in thedetermination of monetary policy is clearly stated in sections 10 and 35 of the Reserve
Bank Act. Section 35 empowers the Board of Directors of the Bank to make rules ‘for
the good government of the Bank and the conduct of its business’. In section 10 the
powers and duties of the central bank are spelt out in great detail. Most of the functions
described in this section are the functions that one would expect the central bank to
perform. Section 10(2) also clearly states that ‘the rates at which the Bank will discount
or rediscount the various classes of bills, promissory notes and other securities shall be determined and announced by the Bank from time to time’. This gives the Bank the right
to determine the official interest rate, or the repurchase rate(
Although the primary goal of the Reserve Bank is therefore set by government, legislation
provides for instrument independence. In accordance with this legal basis the inflation
target is determined by government in consultation with the Reserve Bank, but the
instruments that need to be applied to achieve this target are left to the discretion of the
Bank. The Minister of Finance announces the level of the inflation target. To facilitate this
process a Technical Committee on Inflation Targeting was established. This committee
consists of officials of the National Treasury and the South African Reserve Bank.
This approach has the advantage that it allows for the co-ordination of monetary and
other policy measures. Government can determine the pace of disinflation consistent with
its other objectives of sustainable high economic growth, employment creation and a
More equal distribution of wealth. At the same time the instrument independence
Insulates (according to section 224 (2) of the constitution further determines that the south African Reserve Bank, in pursuit of its primary objective, must perform its functions independently and without fear or favour from political pressures in the pursuance of its objective of price stability .
The definition of the target variable
In all inflation-targeting countries the target has been specified in terms of the Consumer
PriceIndex or some variant thereof. There are, however, differences in the way that
Inflation is measured. Preferably the index should include a range of products fully
Reflecting the domestic cost of living and should be generally accepted by the public. The
calculation of this index must be accurate and timely. Many countries have opted for a
‘core’ consumer price index, which excludes prices affected by exogenous shocks over
which the central bank has no direct control, the first-round effects of indirect tax
changes and the first-round effects of interest rate changes.
Basically there are three measures of consumer price inflation in South Africa: the headline
Consumer price index(measures changes in the price level of a market basket of consumer goods and services purchased by households) the core consumer price index and the overall index excluding theeffects of changes in mortgage cost (the CPIX). Further versions are provided dependingon the geographical coverage of the index, i.e. whether it refers to metropolitan areas,other urban areas and rural areas. The most comprehensive measure is the totalconsumer price index for all these areas, or for the country as a whole.
For inflation targeting purposes the headline consumer price index has the disadvantage
that it is influenced directly by changes in the Reserve Bank’s repurchase
rate. A reduction in the repurchase rate or a relaxation of monetary policy leads to an
immediate decrease in the overall consumer price index because mortgage interest
payments, which form part of housing costs, decrease. Similarly, an increase in the
repurchase rate or a more stringent monetary policy stance leads to an immediate
increase in the consumer price index. This disadvantage can be eliminated by
changing the method used in the calculation of housing costs. Countries which target
the overall consumer price index generally allow for this adjustment in the calculation
of their indices.
Core inflation is measured in South Africa by excluding the prices of certain food
products, the cost of mortgage bonds and certain indirect taxes from the overall
consumer price index. This index has the advantage that it excludes most prices
directly affected by policy measures, but it includes administered prices. It further
excludes prices over which policy has no control, but which could bring about
misleading signals when these prices are affected by exogenous shocks. However, it
does not exclude the effects of all of these prices, such as changes in international oil
prices. The measurement of core inflation has the further disadvantage that it is difficult
for the general public to understand and less credible than headline inflation.
South Africa opted to target the CPIX in metropolitan and other urban areas because
the public can more readily understand this index than the core index and it excludes
any direct effects that changes in the repurchase rate could have on prices. It was
further argued that the index should be as broad as possible, as leaving out prices for
food and energy would for instance lead to a meaningless measure for most members
of society. The decision was taken to target CPIX, fully realising that such a broad
measure has the disadvantage that it could be affected by exogenous shocks over
which monetary policy has no control.
Prices in rural areas were originally excluded from the target definition due to a lack of
information. Although Statistics South Africa later started to compile the CPIX index
including the rural areas, it was decided to continue defining the inflation target in terms
of the CPIX for metropolitan and other urban areas primarily because rural prices are
mainly estimated by applying rural expenditure pattern weights to the prices surveyed in
major towns and do not reflect the actual prices in a specific rural area. The time series
of the CPIX for the country as a whole is also still relatively short, which impedes the
use of this series in forecasting.
Setting the target
In setting the target a decision has to be made about the level of the target. If the level
of the target is set too high it could give the impression that the authorities are not
serious about combating inflation. If the level is set too low it could initially lead to very
stringent policy measures which could distort domestic production, consumption,
saving and investment. This decision becomes even more difficult when the prevailing
inflation rate at the time of the introduction of the target is relatively high.
The target can be specified in terms of a range, a single point or a ceiling. A fixed singlepoint
target is much more difficult to achieve than a range ( its whereby inflation targeting is between certain percentage ) or ceiling ( whereby inflation should not pass a certain fixed percentage). A single point( is whereby there is a single point of inflation targeting) ,however, provides the best focus for inflation expectations and avoids the disadvantage ofa range or ceiling, which tends to concentrate expectations towards the upper boundaryof the range. A range or ceiling leaves some discretion to the central bank and canprovide flexibility in the case of unforeseen price shocks. A ceiling has the disadvantage incomparison to a range that it places the total focus on the upper boundary of the target,without indicating where the lower boundary should be. Most inflation-targeting countrieshave therefore specified their targets in terms of a range or a single point.
If the target is specified in terms of a range, a decision must be taken about the width
of the band. A wide range reduces the credibility of the target because it acts less as an
anchor of inflation expectations. The disadvantage of a narrow range is that it provides
less flexibility to monetary policy than a wider range and that frequent breaches of the
range could undermine credibility.
The time horizon over which the target is set could also affect its credibility. Monetary
policy measures affect inflation with a long lag. Although there is no certainty about the
exact lengths of these lags in South Africa, changes in interest rates probably take from
18 to 24 months to fully affect inflation. A too short time horizon for an inflation target
could lead to very stringent policy measures and unnecessary instability in domestic
demand and output. If the target is set over a too long period, the public’s interpretation
may be that the authorities are not serious about combating inflation and the target
may not have any impact on inflationary expectations.
To overcome this latter difficulty (the difficulty of short time and long time when setting the target ) it was decided with the introduction of inflation targetingin February 2000 in South Africa to specify the target in terms of an annual average rateof increase in the CPIX for the calendar year 2002. A multi-year target approach wasfollowed by specifying the target as an average annual rate of increase of between 3 and6 per cent in the CPIX for the years 2002 and 2003 and an increase of between 3 and 5per cent for the years 2004 and 2005. When it became clear that the inflation targetwould be missed for a fairly protracted period due to a sharp depreciation in the externalvalue of the rand and a number of other exogenous shocks, the target range for 2005was increased from 3 to 5 per cent to 3 to 6 per cent.
In November 2003 it was decided to terminate the annual average specification of the
target because it complicated the implementation of the inflation targeting framework
and could lead to inconsistencies in monetary policy arising from excessive interest rate
volatility and ineffective management of inflation expectations. The annual average was
then replaced by a continuous target of 3 to 6 per cent for the period beyond 2006. In
other words, the target was specified as an inflation rate of between 3 and 6 per cent
which must be obtained continuously in every month measured over a twelve-month
period in the coming years.
The decision-making process
The decision on the appropriate monetary policy stance is taken by the Monetary Policy
Committee (MPC). This committee was constituted shortly before South Africa adopted
the inflation-targeting framework for monetary policy. It first met on 13 October 1999.
At that time the MPC consisted of 15 members: The Governor, three deputy governors
and 10 officials of the Reserve Bank. Meetings were held every six to eight weeks.
At the beginning of 2002 the MPC was reconstituted to consist of eight members: the
Governor, three deputy governors and four senior officials of the Reserve Bank. It was
also decided to hold quarterly meetings to coincide with the release of the Bank’s
Quarterly Bulletin.However, provision was made for unscheduled meetings if the need
should arise, as was the case with the unscheduled meeting in January 2002.
At a strategic planning meeting of the MPC in June 2003 it was decided that the four
scheduled meetings were too far apart. The frequency of the meetings was then changed
to allow for intervals of about two months between meetings, or six meetings per year.
The MPC meetings are normally held over two days. On the first day staff members of the
Bank inform the committee about international and domestic economic developments
and present a forecast of likely future developments. On the second day a decision is
taken about the monetary policy stance and the statement explaining the decision is
finalized. This statement is then released at a press conference and broadcast live on
At a meeting of the MPC the members of the committee have to agree on the likely
future path of inflation. It is accordingly essential that a detailed assessment is made
of all the factors that could affect inflation based on past experience. A large number
of indicators are monitored for this purpose, including the growth in money supply
and bank credit extension, changes in nominal and real salaries and wages, labour
productivity, nominal unit labour costs, the gap between potential and actual
domestic output, developments in final demand, the balance of payments, exchange
rate changes, short and long-term interest rates, the yield curve, government
finances and producer and imported prices. Developments in exogenous factors
which could have a bearing on inflationary pressures, such as global growth and
inflation, international interest rates, international commodity prices, oil prices,
domestic and international agricultural conditions, and administered prices are also
taken into account.
To further assist the MPC in forecasting inflation a number of models were developed
with the help of the staff of other central banks, comprising a core model, a small-scale
model, vector autoregressive models, Phillips-curve models and a disaggregated
inflation forecasting model. This reliance on forecasting in making decisions is
sometimes regarded as a weakness of the inflation-targeting framework. The forecasts
or views on future price developments have to be made irrespective of the monetary
policy framework that is applied by the authorities. If the objective of the central bank is
the attainment of price stability, it will always have to take a view on how it’s current
policy stance will affect future price developments. The difference between inflation
targeting and other monetary policy frameworks is that inflation targeting makes
forecasting explicit and transparent.
In making a decision on the monetary policy stance, the MPC does not only rely on
forecasts. Every forecast is based on assumptions and the results of models can only be
used as an aid in policy making. For this reason the Reserve Bank relies on a number of
models to minimise these risks and possible limitations of the individual models. The final
decision can nevertheless not be based mechanically on the forecasts, but must be
judgemental after a careful analysis of all economic data and risks.
In making monetary policy decisions the Reserve Bank realizes that exclusive
emphasis on the inflation target could lead to highly undesirable results in the
economy. Although the achievement of the target is the overriding objective of
monetary policy, the MPC also recognizes that decisions which ignore special
circumstances could lead to instability in the real economy. If a severe exogenous
shock affects the economy, extreme measures to reach the inflation target could be
very costly in terms of lost output and employment. In such cases, some discretion is
applied by the MPC, while also taking into account that if the target was consistently
missed by a wide margin, the credibility of the Reserve Bank and the ability to lower
inflation expectations could be compromised.
The inflation-targeting framework at first made allowance for the influence of exogenous
shocks by means of an escape clause which stipulated the circumstances under which
the Bank could not be expected to reach the target. Experience showed that this
escape clause created problems in communicating monetary policy decisions. It was
therefore replaced by the introduction of an ‘explanation clause’ in November 2003. It is
now expected of the Bank to fully inform the public of the nature of any exogenous
shock, its anticipated impact on inflation, the monetary policy response that will be taken
to ensure that inflation returns to the target range and the time horizon over which this is
expected to happen.
The transparency and accountability of monetary policy
The adoption of the inflation-targeting monetary policy framework has substantially
improved the transparency and accountability of monetary policy. The publication of
monetary policy statements and press releases, and live television broadcasts after each
MPC meeting, i.e. six times a year, keep the general public well informed on monetary
In order to further develop a better understanding of monetary policy, Monetary Policy
Forums are convened by the Bank. These forums are held twice a year in the major
centers of South Africa and representatives of the labour movement, business,
government and academic institutions are invited to attend. At these meetings MPC
members provide an overview of recent international and economic developments and
explain the monetary policy stance. At the same time the public is invited to express their
views on monetary policy and economic conditions. This ensures that the MPC takes the
view of interested parties into account in the determination of monetary policy.
The inflation-targeting framework improves the accountability of the Reserve Bank because
it provides an explicit and publicly known benchmark that must be reached over a specific
time frame. In South Africa’s previous monetary policy frameworks the objective of monetary
policy was to bring the domestic inflation rate down to those of the country’s main trading
partners and competitors. A specific numerical target was therefore not provided and it was
not indicated at what time this objective would be achieved.
The Governor of the south African Reserve Bank is required to submit annually a report on the
implementation of monetary policy to the Minister of Finance. In addition, in terms of
section 32 of the Reserve Bank Act, the Bank must, on a monthly basis, submit a
statement of assets and liabilities and annually present its financial statements to the
National Treasury. These reports are then tabled in Parliament by the Minister of Finance.
The Governor also appears regularly in Parliament before the Portfolio and SelectCommittees on Finance to explain the monetary policy stance adopted by the MPC.
Moreover, section 37 of the Reserve Bank Act provides that if at any time the Minister
of Finance is of the opinion that the Bank has failed to comply with any provision of the
Act or a regulation thereunder, he may by notice in writing require the Board of the
Bank to make good or remedy the fault within a specified time. If the Board fails to
comply with such a notice, the Minister may apply to the Supreme Court for an order
compelling the Board to make good or remedy the default, and the Court may make
suchorder thereon as it deems fit.
1.3. IS THE POLICY OF INFLATION TARGETING COMPATIBLE WITH A DEVELOPING COUNTRY LIKE SOUTH AFRICA? JUSTIFY YOUR ANSWER.
‘ Yes, it is compatible on the basis that, uncontrolled inflation may cause hyper-inflation or deflation. Consequences of inflation will reduce domestic demand as the purchasing power of the South African currency will decrease and deflation may lead to an increase in unemployment due to a decrease in production.
2. SHOULD INFLATION TARGETING BE THE MAIN GOAL OF MONETARY POLICY? IF YES, WHY? IF NO, WHY NOT?
‘ No, because it should strike a balance across all other objectives, namely:- poverty eradication, balance of payments, economic growth and unemployment reduction.
3. HOW EFFECTIVE HAS INFLATION TARGETING BEEN IN MAINTAINING PRICE STABILITY IN SOUTH AFRICA?
‘ According to Mishkin (July 2001:1), ‘inflation targeting is a recent monetary policy strategy that encompasses five main elements:
‘ the public announcement of medium-term numerical targets for inflation;
an institutional commitment to price stability as the primary goal of monetary policy,to which other goals are subordinated;
‘ An information inclusive strategy in which many variables, and not just monetaryaggregates or the exchange rate, are used for deciding the setting of policyinstruments;
‘ increased transparency of the monetary policy strategy through communication withthe public and markets about the plans, objectives, and decisions of the monetaryauthorities; and
‘ increased accountability of the central bank for attaining its inflation objectives’.Inflation targeting therefore entails more than the announcement of a numerical targetover a specific time horizon.
Therefore, south Africa has successfully pursued an inflation targeting monetary policy with a range of 3 -6% on a continuous bases since February 2000. The policy has encouraged a stable and sustainable economy that has seen an increase in the annual growth rate to an average of 3,5 % since 1999 and above 5% for 2007. There is no clear evidence how inflation targeting fhas maintained price stability since there is inflexibility in economic activities.
4. EXPLAIN THE MONETARY POLIY OPERATIONAL PROCEDURES IN SOUTH AFRICA LINKING THEM TO INFLATION TARGETING.
The Monetary Policy committee (MPC) consists of eight members: the
Governor, three deputy governors and four senior officials of the Reserve Bank. It holdsquarterly meetings to coincide with the release of the Bank’s
Quarterly Bulletin. However, provisions are made for unscheduled meetings if the need
should arise. At astrategic planning meeting of the MPC in June 2003 it was decided that the fourscheduled meetings were too far apart. The frequency of the meetings was then changedto allow for intervals of about two months between meetings, or six meetings per year.
The MPC meetings are normally held over two days. On the first day staff members of theBank inform the committee about international and domestic economic developmentsand present a forecast of likely future developments. On the second day a decision istaken about the monetary policy stance and the statement explaining the decision isfinalized. This statement is then released at a press conference and broadcast live onnational television.
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