Inflation or Output Targeting? Monetary Policy Appropriateness in South Africa

Abstract

The design and implementation of monetary policy in South Africa has been based on the idea of a trade-off between inflation and output growth. However, in the empirical literature there is no consensus on the existence of a Phillips curve in present times. This study aims to estimate the Hybrid New Keynesian Phillips Curve model with a view to determine whether a Phillips curve exists for South Africa and to ascertain whether backward-looking or forward-looking components drive inflation dynamics. Employing both OLS and GMM estimation techniques and using various measures of the demand-side variables, we do not find evidence of a Phillips curve in South Africa. These findings are robust across estimation methodologies as well as different measurements of inflation expectations and data frequency. Our findings therefore support the argument that monetary policy ought to aim at targeting growth rather than inflation. While our findings indicate that economic agents in South Africa are both rational and adaptive in predicting inflation, the results clearly indicate the dominance of forward looking variables over the backward looking ones in driving inflation.

Keywords: Inflation Targeting, Monetary Policy, Hybrid New Keynesian Phillips Curve

JEL Classification: E31