Inflation and output forecasts for South Africa: monetary transmission implications

Abstract

South Africa’s recent adoption of inflation targeting increases the need for good forecasting models of inflation and models for understanding the monetary transmission mechanism. This paper presents multi-step models for inflation and output, four-quarters ahead. The inflation model has an equilibrium correction form, which clarifies medium- or longer-run influences on inflation, including opening the economy to foreign imports. The model confirms the importance of the output gap and the exchange rate for forecasting inflation; and the influence from recent changes in the current account surplus to GDP ratio, which is also sensitive to short-term interest rates. However, a rise in interest rates can also raise inflation in the short-run, via a rise in mortgage interest payments (a component of the consumer price index). The unfortunate policy implications for South Africa are discussed. The output model uses a stochastic trend to measure long-run changes in the capacity to produce. On the demand side there are important negative interest rate effects, though these have been altered by changes in the monetary policy regime. The trade surplus and government surplus to GDP ratios, which also respond to interest rate changes, and improvements in the terms-of-trade, all have a positive effect on future output.

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