Exchange Rate, Second Round Effects and Inflation Processes

Evidence From South Africa

Eliphas Ndou, Nombulelo Gumata, Mthokozisi Mncedisi Tshuma

• Publisher: Palgrave Macmillan
• Year: 2019
• ISBN:
  9783030139322
• Topic: Business
• Subtopic: International Business
• Index: Business

This book focuses on the exchange rate pass-through (ERPT), second round effects and the inflation process in South Africa. The authors demonstrate that magnitudes of the second round effects of the exchange rate depreciation and oil price shocks depend on inflation regimes. The impact of positive oil price shocks on inflation is weakened by monetary policy credibility. Evidence shows the influence of oil price on unit labour costs and correlation between exchange rate changes and inflation has weakened. In addition, ERPT is reduced by low business and consumer confidence, high trade openness, low inflation and high exchange rate volatility which weaken real economic activity. Both monetary and fiscal policy credibility lowers the sizes of ERPT to inflation and inflation expectations. Fiscal policy via fuel levies, administered prices and public transport inflation channel impacts the responses of monetary policy to inflation shocks. The authors show that second round effects contribute very little to wage inflation following an exchange rate depreciation shock. Both lending rate and household consumption responds asymmetrical to repo rate changes.

This book will appeal to policymakers, students, academics and analysts.

Part IThe Changing Size of Second-Round Effects

© The Author(s) 2019

Eliphas Ndou, Nombulelo Gumata and Mthokozisi Mncedisi TshumaExchange Rate, Second Round Effects and Inflation Processeshttps://doi.org/10.1007/978-3-030-13932-2_1

Begin Abstract

1. Introduction

Eliphas Ndou¹ , Nombulelo Gumata² and Mthokozisi Mncedisi Tshuma³

(1)

South African Reserve Bank, Pretoria, South Africa

(2)

Pretoria, South Africa

(3)

National Planning Commission Secretariat, Pretoria, South Africa

Eliphas Ndou (Corresponding author)

Nombulelo Gumata

Mthokozisi Mncedisi Tshuma

End Abstract

Recently several notable macroeconomic developments with huge economic significance impacted the South African economy compelling us to examine whether certain relationships have changed in line with varying economic regimes. Of note, has been the prevalence of the muted inflation and average wage settlements response to the persistent exchange rate depreciation post 2009. The gross loan debt-to-GDP ratio in 2018 is nearly double the level observed in 2008. Petrol prices reached new record high levels such that government intervened by absorbing the expected price increase for one month. In addition, there are discussions about whether the deregulation of petrol prices will bring much needed relief to consumers. At the same time, there are calls to review high fuel levies. Cognisant of the fact that labour market rigidities , developments and wage inflation are not the only factors that contribute to inflationary pressures, persistence and poorly anchored inflation expectations . Figure 1.1 shows some other factors that affect inflation.

Fig. 1.1

Various measures of inflation

(Source South African Reserve Bank )

In this regard, we assess the costs associated with fuel levies and administered prices. We show that they are amongst the significant factors like “tax-push inflation ”. These factors exert a persistent and sizeable upward distortion in headline inflation with negative effects on domestic demand, living costs and social welfare. The direct and indirect transmission of heightened administered price inflation directly affects the cost of living as service price inflation and input costs increase. The indirect effects or “second-round effects” arise as these inflationary pressures induce demand for compensatory wage increases and an increase in inflation expectations . It is at this point that there are additional macroeconomic costs, which include higher sacrifice ratios associated with disinflation monetary policies. The sacrifice ratio is the lost output when monetary policy reduces inflation by 1%. Evidence points to the need to lower the proportion and growth of administered prices in the CPI basket coupled with transport inflation. In addition the reduction will lower the cost of living and reduce the costs of contractionary monetary policy on output when curbing rising inflation. This will contribute to raising social welfare and protect the consumers’ purchasing power including the rural areas’ inflation and lower expenditure deciles.

The varying economic regimes impact the exchange rate pass-through (ERPT) second-round effects and the inflation formation process. The book covers the economic developments which have significant implications for the ERPT , second-round effects and the inflation formation process. The factors include fiscal, monetary and other macroeconomic policies in South Africa.

Given this background the policy and academic thematic areas covered in the book include:

• Determining whether the magnitudes of the second-round effects of the exchange rate depreciation and oil price inflation shocks are dependent on inflation regimes .
• Assessing whether the magnitudes of the second-round effects of oil price inflation shocks on inflation and other variables vary with inflation regimes and monetary policy credibility.
• Determining whether improved monetary and fiscal policy credibility matter for the size of the exchange rate pass-through to inflation and inflation expectations , and if inflation regimes play an important role.
• Explaining whether the interaction between monetary and fiscal policy credibility impacts the exchange rate pass-through and could anchor inflation expectations .
• Determining whether fiscal policy affects the inflation process and the monetary policy response to inflation shocks via fuel levies, administered prices and public transport inflation.
• Establishing if wage inflation is primarily due to second-round effects following the exchange rate depreciation shock or labour market adjustments which resets the higher wage rate.
• Exploring whether the time-varying pass-through of the repo rate changes to the weighted lending rates varies during policy tightening and loosening phases.
• Assessing if bank competition and concentration matters for loan mark ups and the interest rate pass-through .
• Determine whether the mark ups of the repo rate changes on weighted lending rates vary during policy tightening and loosening phases .
• Examining whether the repo rate exerts asymmetric effects on lending rates and household consumption and household financial wealth.

The analysis in the book applies the counterfactual analysis to enable the disentangling of the direct and indirect effects of shocks. This approach enables the empirical analysis conducted in the book to arrive at appropriate policy implications and recommendations. As such, the analysis in the book does not solely rely on the impulse response functions or historical decompositions. These approaches do not capture fully the essence of the second-round effects as the source of shocks that induce changes, for example, the trigger for the upward adjustment in unit labour cost is missing. In addition, the book examines the extent to which the second-round effects depend on monetary policy regimes and inflation regimes .

1.1 Heightened Inflation Persistence Matter for Sacrifice Ratios

Improved fiscal, monetary and other policy interventions will contribute to lowering the degree of high inflation persistence . A high degree of inflation persistence raises the disinflatio...

Table of contents

• Cover
• Front Matter
• Part I. The Changing Size of Second-Round Effects
• Part II. Monetary Policy Credibility and Time-Varying Exchange Rate Pass-Through
• Part III. Trade Openness, Consumer and Business Confidence and the Exchange Rate Pass-Through
• Part IV. Fiscal Policy Credibility and Time-Varying Exchange Rate Pass-Through
• Part V. Regulated Prices, Inflation Process and the Influence on Monetary Policy
• Part VI. Asymmetric Interest Rate Pass-Through
• Back Matter