Symmetric and asymmetric exchange rate pass through in South Africa: The role of nominal rigidities and exchange rate volatility

Abstract

The goal of attaining low inflation levels and price stability has led many countries to adopt inflation targeting policy frameworks. Through its monetary authorities, South Africa implemented an Inflation Targeting policy in 2000 to monitor and, where necessary, influence the factors affecting inflation using short-term monetary policy tools. The aim of this study was to (1) measure the degree of exchange rate pass-through to both import and consumer prices, (2) examine the existence of asymmetric exchange rate pass-through to import and consumer prices between appreciation and depreciation episodes, and (3) examine the extend to which exchange rate volatility impact on inflation in South Africa. The study used a multi-model approach. The auto-regressive distributed lag (ARDL) approach was used to analyse the exchange rate pass-through (ERPT) to both import and consumer prices. The Vector Error Correction Model (VECM) was employed to analyse the short and long-run pass-through effects of exchange rate changes on domestic prices (import and consumer). Using Quarterly data from 1980Q1 to 2019Q4, the study concluded that ERPT was incomplete in South Africa. The ARDL results show a significant positive exchange rate pass-through to import prices of 42 percent and a positive but insignificant exchange rate pass-through to inflation of 31 percent. This implies that firms absorb some of the exchange rate changes to maintain market share. A Hybrid New Keynesian Phillips-Augmented Expectation (HNKPC) equation showed that Inflation Inertia as well as inflation expectations significantly impacted on current inflation. The study recommends continuation of the current policy of flexible exchange rate. However, there is need to take measures to dampen inflation-expectations by economic agents through Inflation-Targeting policy . The Asymmetry model showed that pass-through to import prices in South Africa was higher during appreciation (47percent) than during depreciation (41 percent), indicating the existence of asymmetric pass-through. Generally, the incomplete and low exchange rate pass-through supported the Local Currency Pricing (LCP) strategy by firms that import rather than the Producer Currency Pricing (PCP) strategy. In a flexible exchange rate environment, the PCP strategy results in a complete exchange rate pass-through since prices would reflect any exchange rate changes one-on-one. In the inflation model, the Inflation Targeting dummy revealed a low and insiginifcant exchange rate pass-through. This suggests that firms engaging in Pricing-to-Market behaviour undermined the monetary policy. The Regime-Switching model was used to evaluate how import price evolves as exchange rate regimes were increased using suitable thresholds. The result was that as exchange rate bands increase, other factors like local cost of production have a higher and more significant impact on import prices. This effectively means progressive significance of local cost of production in the determination of import prices. Policy recommendations include maintaining the current inflation-targeting policy as the econometric results show its efficiency in reducing inflation in a significant way as shown by the HNKPC results. The implementation of a managed float exchange rate regime with smaller bands to avoid large exchange rate swings that have asymmetrical effects on import and consumer prices is also recommended.