MACROECONOMIC MANAGEMENT AND FINANCIAL MANAGEMENT INSTITUTE OF EASTERN AND SOUTHERN AFRICA (MEFMI)

Transcription

1 MACROECONOMIC MANAGEMENT AND FINANCIAL MANAGEMENT INSTITUTE OF EASTERN AND SOUTHERN AFRICA (MEFMI) HAS INFLATION TARGETING BY THE SOUTH AFRICAN RESERVE BANK REDUCED THE RATE OF ECONOMIC GROWTH IN NAMIBIA? - EVIDENCE FROM THE SACRIFICE RATIO. BY POSTRICK LIFA MUSHENDAMI, BANK OF NAMIBIA MENTOR: PROFESSOR SYLVANUS.I. IKHIDE A TECHNICAL PAPER SUBMITTED IN PARTIALFULFILLMENT OF THE AWARD OF MEFMI FELLOWSHIP. SUBMITTED ON THE 25 JUNE 2009

2 ABSTRACT This main objective of the study was to establish whether the disinflation monetary policy of the South African Reserve Bank (SARB) due to inflation targeting (IT) impacted negatively on output in Namibia. The study used the sacrifice ratio to examine the impact of IT on output in Namibia. The analysis was also extended to cover Botswana and Swaziland. The study found that inflation targeting in South Africa brought price stability to Namibia without increasing the output loss. Similar results were observed for Swaziland which is also a member of the Common Monetary Area (CMA). For Botswana which is not a member of the CMA, the output loss increased during the period of inflation targeting in South Africa. The study therefore recommend that MEFMI member counties which have serious reservations with monetary targeting frameworks as anchors for monetary policy must begin to consider inflation targeting. Moreover, MEFMI member countries which are experiencing high inflation could consider currency board arrangements which will involve pegging of their national currencies to a low inflation country such as South Africa as an enforceable price control mechanism. In either case, the fear of a loss in output which could be destabilizing can be avoided while prices remain stable and long run growth is guaranteed. The approach could serve as part of the actions aimed at a broader approach to the issue of regional integration in the SADC region. Page 2

3 Table of Contents ABSTRACT... 2 LIST OF ACRONYMS... 5 CHAPTER 1: INTRODUCTION Background Advantages and disadvantages of inflation targeting Statement of the problem Objectives of the study Significance of the study Hypothesis of the study Methodology Scope and limitations Organization of the study CHAPTER 2: LITERATURE REVIEW Theoretical and Empirical Literature Review CHAPTER 3: MONETARY POLICY IN SOUTH AFRICA AND NAMIBIA Monetary Policy in South Africa Monetary Policy in Namibia Transmission Mechanism of SARB monetary policy decisions in Namibia CHAPTER 4: EMPIRICAL ANALYSIS Introduction Model formulation Model specification Empirical analysis Data sources and conversions Selection of episodes Measuring the output gap Interpretation of Results CHAPTER 5: EVIDENCE FROM BOTSWANA AND SWAZILAND Introduction Page 3

4 5.2. BOTSWANA Monetary policy in Botswana Data analysis and Results SWAZILAND Monetary policy in Swaziland Data Analysis and Results CHAPTER 6: POLICY IMPLICATIONS OF THE FINDINGS Introduction Findings Implications of the findings for Namibia Implications for other MEFMI member countries Prerequisites for inflation targeting Institutional arrangements Macroeconomic and Financial Preconditions CONCLUSIONS References: Page 4

5 LIST OF ACRONYMS CBS : Central Bureau of Statistics CFE : Cumulative Forecasting Error CMA : Common Monetary Area CPI ; Consumer Price Index CPIX : Consumer Price Index-Mortgage Interest Rates EC : Executive Committee EU : European Union GDP : Gross Domestic Product HP : Hodrick- Prescott IT : Inflation Targeting IRA : Impulse Response Analysis MAS : Monetary Authority of Swaziland MEFMI : Macroeconomic and Financial Institute of Eastern and Southern Africa MPC : Monetary Policy Committee RMA : Rand Monetary Area REPO : Repurchase Rate SADC : South African Development Community SARB : South Africa Reserve Bank VAR : Vector Auto Regression Page 5

6 CHAPTER 1: INTRODUCTION 1.1. Background The historic developments of inflation targeting (IT) could be traced back to the gold standard and latter the Bretton Woods System in which price stability was achieved by pegging to gold and a strong currency respectively. With the collapse of the Bretton Woods system, there was a strong search for a new anchor for monetary policy. Coupled with the high inflation of the 1970s, many central banks adopted monetary aggregate and exchange rate targeting arrangements. The monetary aggregate targeting frameworks began to fail in the mid 1980s, partially as a result of the unstable money demand function. In the early 1990 s, inflation targeting monetary policy framework thus emerged. Inflation targeting is a monetary policy framework which entails public announcement of official quantifiable target(s) for the inflation rate over a period of time. Thus, inflation targeting focuses on price stability as the primary objective of monetary policy. In an IT framework, monetary policy decisions are guided by expectations of future inflation relative to the announced target. Inflation targeting is therefore based on five elements: (i) Public announcement of the medium term targets for inflation, (ii) An institutional commitment to price stability as a primary goal of monetary policy, to which other goals are subordinated (iii) An information inclusive strategy, in which many variables, and not just monetary aggregates or exchange rate, are used as decision variables. (iv) Increased transparency of the monetary policy strategy through communication with the public and market about Page 6

7 the plans, objectives and decisions of the monetary authority, and (v) Increased accountability of the central bank towards attaining its inflation objectives. According to Svensson (1999a), there are two types of inflation targeting- strict and flexible inflation targeting. In a strict inflation targeting framework, the monetary authority attempts to reduce the variation of inflation around a target level. In this case no other variable apart from inflation enters the objective function of the monetary authority. In a flexible inflation targeting however, other variables are allowed to enter the objective function of the policy makers; normally the variation of output. In the case of flexible inflation targeting therefore, the central bank is charged with dual mandate: output growth and price stability. In terms of the theoretical background; inflation targeting could be classified under the historical perspective of the rules-vs.-discretion debate. The distinction of monetary policies as either rules or discretion has its roots in the Chicago School of the 1930s. Rules refer to monetary policies which are automatic, involving no or less macroeconomic analysis or judgment by the monetary authorities. An example of a rule based monetary policy is the gold standard; in which the conduct of monetary policy involved maintaining the price of gold at the official parity. On the contrary, a purely discretion based monetary policy regime is where the monetary authority makes no public commitment about its objectives or future course of action. Thus it sets monetary policy from time to time based on the assessment of current economic conditions or look at everything strategies. Page 7

8 IT would be considered a rule if a clear mechanism linking policy instruments to intermediate target or future inflation is clearly established. Inflation targeting however, does not provide operating instructions which the central bank could use. This requires central banks to use judgment and discretion in addition to the information it collects in the pursuance of its objectives. The discretion available to policy makers is however guided by the medium to long-term inflation targets. Thus inflation targeting combines the elements of both rules and discretion based monetary policies. Inflation targeting is therefore thought not as a policy rule, but a framework for policy in which constrained discretion can be exercised, Bernanke at al By focusing clearly on inflation, IT reflects the understanding that the major contribution of monetary policy to economic growth is the attainment of price stability. This realization has been backed by the evidence of the negative effects of higher inflation on economic growth. Moreover, it has been proven that in the long-run there is no trade off between inflation and economic growth Advantages and disadvantages of inflation targeting Inflation targeting has a number of advantages in contrast to other monetary policy strategies. These include among others: (1) unlike monetary targeting, IT does not need a stable relationship between money supply and inflation as a critical factor to its success. IT therefore uses all available information to decide the best path of monetary policy. (2) Inflation targeting is transparent and thus it is easy for the public to understand. Moreover, because of its explicit numerical target, inflation targeting increases the accountability of the central bank; thus it reduces the likelihood that the central bank will Page 8

9 fall into the time-inconsistency trap. (3) Since the source of time-inconsistency is often found in political pressure on the central bank to undertake overly expansionary monetary policy, IT has the advantage of focusing the political debate on what a central bank can do in the long run (price stability), rather than what it cannot do (raise output growth, lower unemployment, and increase external competitiveness). Despite the advantages, inflation targeting however, has a number of weaknesses or disadvantages. These weaknesses are (1) IT is too rigid; once the framework and targets has been adopted it is relatively difficult to deviate from them. (2) IT has the potential to increase output instability which could lower economic growth. (3) Inflation rate cannot be easily controlled by the central bank alone, unlike the exchange rate and monetary aggregates. In the cases where inflation forecast errors are large, inflation targets will tend to be missed, which could render it difficult for the central bank to gain credibility Statement of the problem South Africa adopted inflation targeting in 2000 in order to enhance policy transparency, accountability and predictability. Like in other IT frameworks, monetary policy decisions in South Africa are guided by expectations of future inflation relative to the announced targets. The targets were specified as the achievement of an increase in inflation in the overall consumer price index, which excludes mortgage interest cost, of between 3-6 per cent on average. The operating target is the repo rate which is adjusted from time to time to reduce inflation to desired levels. South Africa s adoption of inflation targeting in 2000 Page 9

10 has implications for Namibia through the country s membership of the Common Monetary Area (CMA 1 ). The CMA has characteristics of a monetary union, given the fact that the currencies of CMA member states are pegged to the South African Rand. Moreover, the movement of capital between member states is also free. This has implications for monetary policy formulation given that interest rates within the CMA countries must be kept aligned to that of South Africa to guard against capital flowing especially to South Africa. Moreover, South Africa which is a bigger economy takes the lead in setting monetary policy in the CMA. Therefore monetary policies of Lesotho, Namibia and Swaziland are subordinated to the exchange rate policy. Given the supremacy of SARB in determining the path for monetary policy in the CMA and high level of financial integration, monetary policy decisions in South Africa (including disinflationary policy decisions due to the inflation targeting framework) are often transmitted into Namibia as well. While this is a welcome development especially from the point of view of stable prices; inflation targeting has been criticized for its exclusive focus on inflation as the only objective for monetary policy, thus excluding other goals particularly output growth. Though the long-run negative trade-off between inflation and growth may not exist, the impact of IT on the volatility of output has been documented in a few studies (Eichengreen et al 1999; Jadresic, 1999).The short-run trade off is often represented by the short-run Phillips curve. 1 The CMA comprises of Namibia, Lesotho, Swaziland and South Africa. Page 10

11 By implication disinflationary monetary policy measures such as inflation targeting will consequently reduce output in the short run. There have been concerns in the CMA countries that IT may have led to fluctuations in output and employment. Given the inability of these central banks to adopt any short-term stabilization measures because of the erosion of independent monetary policy, policy makers have been wary of the adoption of IT by South Africa since Though IT has led to price stability in these countries, the question has been raised as to whether it has not come with a cost in the form of output loss Objectives of the study Given the above backdrop, the objectives of the study are: To determine the existence of a relationship between inflation targeting and economic growth. To establish if there are output losses in fighting inflation in Namibia. To estimate the output losses of fighting inflation in Namibia, and where such losses are established, suggest ways of dealing with such losses. To draw lessons from the results of the study for other MEFMI countries including those outside the CMA Significance of the study The study makes an attempt to determine whether the inflation targeting framework adopted by the South African Reserve Bank in 2000, had impacted negatively on output in Namibia. This objective will be achieved by estimating the cost of fighting inflation or sacrifice ratio. Thus, should it be found that the sacrifice ratio in Namibia has increased Page 11

12 due to South Africa adoption of IT, the study will attempt to suggest measures which Namibia could adopt to reduce such costs. The study will also provide insight to other MEFMI countries which intend to adopt IT as to what needs to be done to reduce the short term costs associated with IT. As far as we know there is no such study that has estimated the short run costs of disinflation in Namibia Hypothesis of the study The hypothesis to be tested in this study is that Namibia has suffered output losses since South Africa adopted the IT framework. Thus IT might not be the optimum monetary policy framework for fighting inflation in Namibia Methodology The study will entail a desk review of the theoretical and empirical literature on the relationship between inflation targeting and output growth and an overview of monetary policy in South African and Namibia. The desk review will then be followed by an empirical exercise of estimating cost of fighting inflation in Namibia using sacrifice ratios Scope and limitations The study will use quarterly real GDP and inflation data for the period between 1993 to The data will further be split between 1993 and 1999, the pre-inflation targeting period in South Africa; and 2000 to 2007, the post inflation targeting period Organization of the study The study is organized around 6 Chapters. Chapter 2 reviews the theoretical and empirical literature on the relationship between inflation and output growth. Chapter 3 Page 12

13 highlights Monetary Policy in South African and Namibia. Chapter 4 contains the methodology and empirical results. Chapter 5 documents further evidence from Botswana and Swaziland. Chapter 6 draws policy implications for Namibia, other MEFMI member states and also concludes. Page 13

14 CHAPTER 2: LITERATURE REVIEW 2.1. Theoretical and Empirical Literature Review The theoretical underpinning of the trade-off between inflation targeting and output can be represented by the Phillips curve. Accordingly, there is a negative trade-off between output and inflation variability in the short run. The trade-off stems from the fact that there is a positive correlation between output and inflation. Accordingly, disinflation monetary policy such as inflation targeting which aims at reducing inflation must brace for reduction in output also. The Phillips curve emanated from the work of William Phillips. Phillips measured the relationships between wage and price inflation in the UK in Other versions of the Phillips curve consider the relationship between unemployment and output (Okun, 1962) or inflation and output (Okun, 1978; Gordon and King, 1982). A number of studies have empirically examined the existence of trade-off between inflation targeting/disinflation and economic growth. Sargent (1983) argued that faster disinflation process indicates a strong commitment to fight inflation and thus reduces the loss to output given that expectations tend to adjust much quicker than in the case of low disinflation. Romer and Romer (1989) concluded that disinflation was a major cause of recessions in the USA. Their study analyzed the recessions which took place in the mid-1970s and early 1980s and found that the economic downturns in those periods coincided with Page 14

15 falling inflation due to tight monetary policy. Ball (1994) took it further to investigate what the determinants of the sacrifice ratio are. He developed a model to measure the sacrifice ratio, which he applied to moderate inflation OECD countries. He defined the sacrifice ratio as the cost of reducing inflation one point through a contraction in aggregate demand. He found the sacrifice ratio to be lower when the disinflation is quick, and when the setting of wages are more flexible. Further, trade openness was found to have no effect on the ratio, while the effects of initial inflation and income policies were not clear. Others studies suggest that the output-inflation trade-off is determined by economic environment. Romer, (1991) suggest that it depends on the openness of the economy, while (Gordon, 1982) attribute it to the nature of labor contracts. Posen (1995), Debele and Fisher (1995), using different proxies for central bank independence and different samples found that more independent central banks were associated with higher sacrifice ratios. They were testing the hypothesis that the more independent central banks will cushion the central bank from politicians who seek to manipulate monetary policy for short run gains. Thus a more independent central bank would influence private sectors inflation expectation and thus reduce the sacrifice ratio. Bernanke et al (1999) found no credibility bonus from the adoption of inflation targeting. They considered four inflation targeting countries (New Zealand, Canada, the United Kingdom, and Sweden). Two approaches were used; the first one was to compare each country s economic performance before and after the adoption of inflation targeting. The second approach was to compare the economic performance of an inflation-targeting Page 15

16 country with a similar country but which did not adopt inflation targeting during the study period. For Canada and New Zealand, the corresponding non-inflation targeter was Australia using the data before the country adopted inflation targeting. For Sweden and United Kingdom, the corresponding non-inflation targeter was Italy. They found that inflation rates were lower than would have been in countries that adopted inflation targeting. The disinflation was however not costless given that it was accompanied by declines in output growth. This therefore suggests that inflation targeting does not eliminate the costs of reducing inflation. In contrast, Corbo et al (2001) found that the average sacrifice ratio of countries that adopted inflation targeting was lower compared to that of non-targeters during the 1990s. Their study found however, that for countries which adopted inflation targeting, their sacrifice ratios were lower before adopting the inflation targeting compared to the post inflation period. The latter dispute the observation that inflation targeting reduces output costs. Their study was based on nine countries which adopted inflation targeting, five others which were considered as potential targeters of inflation and 11 others which did not target inflation. Similarly, Goncalves et al (2006) found that countries which implemented inflation targeting managed to reduce inflation in a less costly manner than non inflation targeters. Their study used quarterly real GDP data and consumer price inflation (CPI) for OECD countries for the period 1970 to In terms of the methodology, they used the HP Page 16

17 filter and the sacrifice ratio. Thus, they concluded that the adoption of inflation targeting may facilitate the attainment of lower inflation levels and reduce costs of doing so. Apergis et al (2005) evaluated inflation targeting by assessing the merits of alternative policy rules and alternative inflation targets in a macroeconomic model. They used quarterly observations on real output and core prices for selected EU countries (Germany, France, Belgium, the Netherlands, the United Kingdom, Italy, Luxembourg, Spain, Portugal, Denmark, Austria, Finland, Sweden, and Greece) from More precisely, they evaluated the performance of the forward-looking and spontaneous adjustment-under alternative inflation targets of 0, 2, and 4 percent in relation to loss of output. They found a negative trade-off between output gap and the mean inflation rate as well as the variances between the output gap and the inflation. They concluded that forward looking rules (inflation targeting) contribute to the stability of the macro economy, reduce the volatilities in the business cycle and enhance the credibility of monetary policy. In addition, they found that a positive inflation target brought more output losses than a zero inflation target. In summary, international evidence on the relationship between inflation targeting and output is mixed; with some studies postulating that IT increases the output loss in the process of disinflation, while other studies argue that inflation targeting reduces the output costs associated with disinflation by promoting price stability. Our study intends to contribute to the debate by testing the impact of IT on economic growth in a developing country. To do this the study will employ the sacrifice ratio to examine output Page 17

18 costs which Namibia incurred when South Africa introduced inflation targeting framework. CHAPTER 3: MONETARY POLICY IN SOUTH AFRICA AND NAMIBIA 3.1. Monetary Policy in South Africa The most commonly used instruments of monetary policy in South Africa are the money supply and interest rates. During most of the 1970s, credit ceilings were used to control monetary expansion. The system of direct control was replaced with the monetary targeting in The monetary policy framework underwent a comprehensive change in the mid 1990s. The accommodation system which was adopted then was replaced with the Repo system in March Under this system, the Bank rate was replaced by the repo system. The repo is a process whereby banks enter into repurchase agreements in respect of the various securities sold by tender to the Reserve Bank on a daily basis. South Africa formally adopted inflation targeting in The main objective was to enhance the transparency, accountability and predictability of monetary policy formulation. The current inflation target is to achieve a rate of increase in the overall consumer price index (CPIX), which excludes mortgage interest costs of between 3 and 6 percent per year. Initially, the target was set by the Ministry of Finance, but has since changed and it is now set by the National Treasury in consultation with the South African Reserve Bank and finally Cabinet. The National Treasury is a department in the Ministry of Finance. Page 18

19 The monetary policy stance is the prerogative of the Monetary Policy Committee (MPC). Despite the fact that the target is set by the National Treasury, SARB has autonomy to decide on the instrument of monetary policy. Thus, in terms of central bank independence, SARB has instrument independence though not necessarily goal independence. Accordingly, the Reserve Bank uses the Repo or Repurchase Rate as an instrument of monetary policy formulation. The MPC consists of eight members: the governor, three deputy governors and four senior officials of the South African Reserve Bank. The frequency of the meetings was changed from four as at the strategic meeting in June 2003 to six. The MPC meetings normally spans two days. On the first day, the committee is apprised by the staff members of the Reserve Bank, on developments in the international and domestic markets. The presentation by the staff members include variables such as: the growth in money supply, credit extension of the banking sector, fluctuations in nominal and real salaries and wages, labor productivity, nominal unit labour costs, the gap between potential and actual output, development in final demand, the balance of payments, exchange rate changes, short and long term interest rate, the yield curve, government finances and producer and imported prices, (Van der Merwe, 2004). Other variables taken into account include the global economic growth and inflation, international commodities prices, global interest rates and international and national oil prices. Moreover, developments in agricultural conditions both locally and internationally, administered prices are also examined. Page 19

20 In addition a forecast of how the current monetary stance will affect the developments in prices in the future is presented. On the subsequent day, the MPC then decides on the monetary policy stance. But before such a decision is reached, members of the MPC have to agree on the likely path of inflation in the future. This is often achieved after a thorough assessment of factors which could affect inflation. To this effect a statement is prepared which is then released at a press conference, which is subsequently broadcast live on the national television. To enhance the transparency in monetary policy formulation, SARB organises forums in major cities in the country. These forums are held twice a year and are attended by labour movements, business, government and academics. Moreover, a monetary policy review is always prepared twice a year. The review is a detailed account of both domestic and international developments as well as the monetary policy stance. Furthermore, the Governor of the Reserve Bank is required to submit a report to the Minister of Finance on the implementation of monetary policy. The inflation-targeting framework has since November 2003 introduced an explanation clause, replacing the escape clause. The explanation clause provide for circumstances in which the Bank could be derailed from meeting the target. Accordingly, the Bank must inform the public about the expected exogenous shock, its likely impact on inflation as well as the monetary policy that the SARB will instrument to bring inflation to its target Monetary Policy in Namibia. In Namibia the monetary policy stance since independence in 1990 has been to maintain a fixed exchange rate of one to one between the Namibia Dollar and the South African Page 20

21 Rand, under the CMA. Countries in the CMA have harmonized their monetary and exchange rate policies (Ikhide and Uanguta 2006). Thus there is a free flow of capital between CMA countries. South Africa which is the bigger economic player in the CMA is therefore responsible for taking the lead in setting monetary policy. Consequently, Namibia has forfeited the freedom of conducting independent monetary policy. Monetary policy at the Bank of Namibia is a prerogative of the Executive Committee (EC), but it is conducted closely in line with that of SARB. The EC comprises of the Governor, the Deputy Governor, the Assistant Governor and three other members appointed by the Governor of the Bank of Namibia. There are six monetary committee meetings in each year similar to the MPC meetings in South Africa. The sequencing of EC meeting was changed from being held simultaneously to that of the MPC, to a week after the MPC meeting in South Africa in The EC meetings normally span over two days. On the first day, the committee is apprised by the staff members of the Bank of Namibia, on international and domestic economic developments. The presentation by the staff members include variables such as: the growth in money supply, credit extension of the banking sector, development in final demand, the balance of payments, exchange rate changes, short and long term interest rate, the yield curve, government finances and imported prices. Other variables taken into account include the global economic growth and inflation, international commodities prices, global interest rates and international and national oil prices. Moreover, developments in agricultural conditions both locally and internationally, administered prices are also examined. In future the intentions are to include variables such as the fluctuations in nominal and real Page 21

22 salaries and wages, labor productivity, nominal unit labour costs, the gap between potential and actual output. The main instrument of monetary policy used by the Bank of Namibia is the repo rate. The Bank of Namibia adjusts the repo rate in line with the monetary policy stance of the South African Reserve Bank. Moreover, commercial banks are allowed to keep their excess balance with the Bank of Namibia through the call deposit facility. The Bank of Namibia also accommodates the commercial banks with an overdraft facility, after exhausting other sources of short-term funds in the market Transmission Mechanism of SARB monetary policy decisions in Namibia. Given that the study involves the evaluation of the impact of the South Africa monetary policy decisions (inflation targeting) on output in Namibia it becomes imperative to determine how monetary policy decisions of the SARB are transmitted into the Namibian economy. Monetary transmission mechanisms refer to the channel through which monetary policy decision passes through from monetary variables to real output and inflation in the economy. Literature cites various channels through which monetary policies get transmitted to the real output and inflation. These channels include the interest rate channel, the credit channel, the exchange rate channel and the broad money channel. It should be noted that because of the fixed exchange arrangement and the high integration between the Namibia and South African financial markets, monetary policy decisions of the South African Reserve Bank are transmitted into the Namibian economy. This claim was tested by Uanguta and Ikhide in Their study examined whether a Page 22

23 tightening of monetary policy by the SARB is transmitted to the Namibian Economy. The study employed the Cumulative Forecasting Error (CFE) and the Vector Auto Regression (VAR) and Impulse Response Analysis (IRA). The study used monthly data for the period 1990 to 1999 of the following variables, repo rate/bank rate, lending rates and bank credit, money supply, consumer prices and private investments. The study found out that changes in the South African Reserve Bank repo are transmitted into the Namibian economy 2. This is primarily through the interest rate channel and the credit channels. More specifically, the study found that monetary policy tightening undertaken by SARB through increase in the repo rate caused the lending rates in Namibia to increase almost immediately 3. Commercial banks in Namibia respond to the increase in the SARB repo by increasing the prime lending rate which subsequently causes the private sector to change their investment and consumption patterns. Moreover, it was established that the decline in private credit is more pronounced in the private sector credit to business sector than private sector credit to individuals. The former accounts more to investment spending than the latter and hence the decline in the total private investments and ultimately output. The study established that a shock on the lending rates caused consumer prices to fall. This point is further substantiated by evidence on inflation rates in Namibia. Accordingly, with the introduction of inflation targeting in South Africa, inflation rates in Namibia declined from 9.3 percent in 2000 to 2 In a similar study Ikhide and Uanguta (2006) conclude that the South African repo rate has significant effects on the lending rates and real variables in the economies of Lesotho, Namibia and Swaziland; than the respective bank rates of those countries. 3 These results are corroborated by Ikhide and Uanguta study for Page 23

24 7.3 percent in 2003 and 5.1 in Thus it can be concluded that inflation targeting in South Africa induced price stability in Namibia as well. This is expected given the fact that 65 percent of Namibia s inflation is imported from South Africa (Gaomab,1998). Therefore a decline in South African inflation rates as well as the disinflationary monetary policy has direct effect of reducing inflation rates in Namibia also. In addition, it was found that an increase in the South African repo caused Namibian firms to reduce their investment plans, thus reducing the overall investments in the Namibian economy. This impact though similar to the first, works though the credit channel. Accordingly, higher interest rates reduce the net worth of business and make lending to these institutions much stringent given the asymmetric information. Subsequently, businesses reduce their investment spending which ultimately reduces output and increase unemployment. From the foregoing, it may be inferred that the inflation targeting framework in South Africa caused output losses during the disinflationary periods; this has implication for unemployment and income inequality in Namibia. Namibia has identified increased and sustained economic growth, reduction of unemployment and reduction of income inequality as some of its national objectives. Economic growth has however averaged below 5 percent since 2000, unemployment has remained stubbornly very high (36.7 percent as per the labour force survey of 2003/04); while the Gini coefficient was estimated at 0.6 as in 2003/04. Thus, monetary policies which tend to reduce economic output and increase unemployment may not augur well with the Namibia policy makers. Moreover such monetary policy may be seen to be Page 24

25 working against the attainment of the above mentioned national objectives. The objective of monetary policy in Namibia is price stability; with an understanding that this will support long term economic growth. From the foregoing, therefore, it becomes imperative therefore to determine the output loss or sacrifice ratio in Namibia on account of inflation targeting framework of the SARB. Page 25

26 CHAPTER 4: EMPIRICAL ANALYSIS 4.1. Introduction This study uses the sacrifice ratio as developed by Ball (1994) to determine whether the inflation targeting adopted by SARB has made disinflation more costly in Namibia. The sacrifice ratio measures output or employment forgone for the economy to achieve low inflation. Ball (1994: 7) defines the sacrifice ratio as the cost of reducing inflation one point through an aggregate demand contraction Model formulation Model specification It is imperative at the onset to explain the technique (sacrifice ratio) which is used in the analysis The Sacrifice Ratio 4 There are a number of techniques which measure the trade off (positive correlation) between economic activity and inflation. The most common of these measures is the (expectations- augmented) Phillips curve. * t Y Y ) u 0 (1) t WhereY t and ( t t 1 t; * t Y is the actual and potential output and ) is the disinflation in ( t t 1 timet. The cost of inflation is expected to increase as becomes larger. The drawback of the expectations augmented Phillip curve approach is that the output-inflation trade off 4 This part borrows from Cetinkaya et al (2002) and Durham (Undated). Page 26

27 will be the same during disinflations as well as during increases in trend inflation and temporary fluctuations caused by demand factors (Ball 1994). A better way is to use a method which measures specific output losses which occur in individual disinflation episode. The sacrifice ratio is given by equation 2 and 3. Ball s method shown below has been used by other economists such as Cetinkaya et al (2002), Durham and Bernanke et al (1999). SR Y / (2) Where SR = sacrifice ratio; Y is change in output; is the change in inflation. The sacrifice ratio is the total deviation in output from its trend over the change in trend inflation. SR * ( Y t Y t ) /( t t 1) ) (3) WhereY t and * t Y is the actual and potential output and ) is the disinflation in ( t t 1 timet. From equations 2 and 3, the denominator of the sacrifice ratio is the change in inflation over an episode, while the numerator is the deviations between actual output and its trend level or full employment level. Thus the sacrifice ratio is the amount of aggregate real output lost due to a percentage decline in inflation Empirical analysis After identifying the technique this section proceed with the analysis of data Data sources and conversions To estimate the sacrifice ratio for Namibia, the study used quarterly data on inflation and GDP at constant prices for the period 1993 to The data was obtained from the Central Bureau of Statistics (CBS). The data was then split into two samples, 1993 to Page 27

28 1999; and 2000 to The first sample period corresponds with the pre-inflation targeting period of the SARB, while the second period corresponds with the inflation targeting period of the SARB. The objective was to calculate the sacrifice ratio during the two periods and then compare them to determine whether the ratio increased or decreased. This approach was adopted from Bernanke et al (1999). The collected data was then put into the excel files and then imported into E-views. The basic idea was to identify disinflation episodes from the inflation data, estimate the correspondent output gaps from the GDP data and ultimately calculate the sacrifice ratio Selection of episodes The first step in calculating the sacrifice ratio was to identify episodes in which trend inflation fell significantly. Ball (1994) uses the following definition to define inflation. Trend inflation is a centred nine quarter moving average of actual inflation rate. Trend inflation in time (t) is then the average of inflation rates between the previous four quarters (t-4) and the next four quarters (t+4). We also included a second definition of Trend inflation as a centred five quarter moving average of actual inflation rate. By shortening the period from nine to five quarters we expected to identify more periods of disinflations. Inflation peak is the point where trend inflation is higher than the previous four and next four quarters. Inflation trough, refer to a point where trend inflation is lower than the previous and the next four quarters. Disinflation episode is defined as the time range which starts with an inflation peak and ends with an inflation trough with an annual rate at least two points lower than the peak. Ball s procedure is used to identify shifts which are caused by Page 28

29 policy from changes resulting from external shocks. Accordingly, the sacrifice ratio is the cost of inflation by one point which is achieved by way of causing demand to shrink. The above definitions assume the following (1) There are no visible supply side shocks; disinflation is only caused by demand; (2) trend output is not affected by persistent disinflation: hysteresis is assumed not to exist Measuring the output gap 5. The second step was to measure the output gap. It is required to estimate the potential GDP in order to obtain the output gap. There are several methods used to estimate the output gap. For this exercise we used the Hodrick Prescott (HP) filter method and the linear trend method to measure potential output. These methods are explained below The Hodrick-Prescott Method The Hodrick-Prescott (HP) method is used to smooth out data. The main assumption underlying this method is that there exists a prior knowledge that growth varies smoothly over time. Using an example of a time series Y t (output) which may be expressed as the sum of a growth component or trend output gap C t, which can be expressed as * Yt is (potential output) and a cyclical component or Y = Y * + t t Ct (4) The variance between C t from time, while the measure of smoothness of * Y t is assumed to be close to zero over a long period of * Y t is the sum of the squares of its second 5 This part is based on the work of Njuguna et al (2005). Page 29

30 difference. The programming problem is to find the growth components by minimising the following expression. Min L = T t 1 c 2 1 T t 2 * * ( y t yt 1 ) 2 T * * * * = ( y y ) 2 y y ) ( y y ) 2 (5) t 1 t t T ( * t t 1 t 1 t 2 t 2 The parameter is a positive number, which penalizes the variance in the growth component series. Therefore the larger the, the smoother is the solution series. In addition as approaches infinity, the limit of the solutions for equation (5) is the least squares of a linear time trend model. As the smoothening factor approaches zero, the function is minimized by eliminating the difference between actual and potential output. In the empirical work, we choose the value of =1,600 given that we were using quarterly data. The output gap was obtained by subtracting potential from actual GDP. The HP method is very popular given that it is flexible in tracking the characteristics of the volatilities in output The Linear Trend Method The linear trend method is based on the assumption that potential output is a deterministic function of time; therefore the output gap is a residual from the trend line. Accordingly, over time output is at its potential level on average. Thus the trend output or potential output may be estimated as follows * Y t aˆ ˆ Trend (6) 0 1 Page 30

31 Where * y t is output trend, ˆ 1, i=0,1 are the estimated coefficients from the regression of the actual output on time trend variable. The output gap is therefore obtained through C t y y (7) t * t Where time index. C t is the output gap, y t is the actual output, * y t is the potential output, t=1; T is a 4.4. Interpretation of Results The actual analysis and interpretations of the data is presented here. We report initially the results of the estimated output gap for Namibia using the linear trend method equation 6. * t Y Trend (8) (S.E) (T. Ratio) R DW= From equation 8, the results show that both coefficients of the estimated equation are significant. The explanatory power of the equation is also high at 0.96 percent. The only problem is that the Durbin-Watson statistics is very low suggesting that the residuals are auto correlated. By implication the model may be misspecified. This is however expected given the fact that a number of variables explain GDP (output) which were not captured by the model. The estimated potential output based on the linear trend equation 6 and the HP filter is reported in Tables 4.4 and 4.5. Page 31

32 Table 4. 1: Different Episodes for Alternative Definitions: Namibia Frequency Trend inflation centred moving average Peak Trough Number of Episodes Quarterly 9 Quarters π t > 4 Quarters π t < 4 Quarters 2 Quarterly 5 Quarters π t > 4 Quarters π t < 4 Quarters 3 From Table 4.1, the nine quarters centred moving inflation average for Namibia yielded two disinflation episodes; while the five quarters centred moving inflation average resulted into three disinflation episodes. Table 4.2: Disinflation Episode for Namibia Inflation Data: Quarterly (Centred 9 Quarters Moving Average). Episode Start End Duration Trend decline in inflation Episode I 1994:Q4 1999:Q1 18 Quarters 2.74 Points Episode II 2002:Q1 2004:Q4 12 Quarters 7.10 Points Table 4.2 shows that the first episode started in the last quarter of 1994 and lasted for 18 quarters ending the first quarter of Accordingly, the disinflation brought about a decline in inflation amounting to 2.74 points. The second episode caused a decline in inflation which amounted to 7.10 points. One major observation here is that our identified disinflation episodes coincided with the occurrence of two major shocks in the global Page 32

33 economy the spike in oil prices after the Gulf war in 1991 and the Asian financial crisis in 1999 which gave rise to high level of prices and necessitated a disinflation policy. Thus the disinflationary monetary policies particularly especially in episode I, was not necessarily induced by the SARB but was in response to external shocks. Table 4.3: Disinflation Episode for Namibia Inflation Data: Quarterly (Centred 5 Quarters Moving Average). Episode Start End Duration Trend decline in inflation Episode I 1995:Q1 1996:Q4 8 Quarters 3.03 Points Episode II 1997:Q4 1999:Q1 6 Quarters 2.41 Points Episode III 2003:Q1 2006:Q1 13 Quarters 8.10 Points Table 4.3, depicts the disinflation episode using the 5 quarter moving average method. The first episode which began in the first quarter of 1995 lasted for eight quarters and ultimately brought a reduction in inflation which amounted to 3.03 points. The second episode yielded a decline in inflation equal to 2.41 points. The two episodes were similar to the first episode of the 9 quarters centred moving inflation average. The third episode began in the first quarter of 2003, running through the first quarter of The episode yielded the highest decline in inflation amounting to 8.10 points. Page 33

34 Table 4.4: Results: Quarterly (Centred 9 Quarters Moving Average for Namibia). Episode Trend Output Gap: Output Gap: Sacrifice Sacrifice Inflation HP Method Trend Ratio:HP Ratio: Trend decline Method Method Method Episode I Episode II Table 4.4, shows the sacrifice ratios using the nine quarter moving average inflation. Accordingly, negative sacrifice ratios were obtained when using the HP filter method for all episodes. When closely examined however, the sacrifice ratio in the second episode was lower compared to that of the first episode. Using the linear trend method, the first episode brought a positive sacrifice ratio amounting to 0.37 percent; while the second episode resulted in a negative sacrifice ratio, implying a decline in the sacrifice ratio in the second period. Accordingly, the inflation targeting framework by the South African Reserve Bank as represented by the second episode resulted in a lower sacrifice ratio in Namibia, than pre-targeting framework as represented by the first episode. Page 34

35 Table 4.5: Results: Quarterly (Centred 5 Quarters Moving Average for Namibia). Episode Trend Output Gap: Output Gap: Sacrifice Sacrifice Inflation HP Method Trend Ratio: HP Ratio: Trend decline Method Method Method Episode I Episode II Episode I & II Episode III Table 4.5 illustrate the results of the 5 quarter centred moving average for Namibia. Accordingly, using the HP filter method; all the episodes I, II and III resulted in negative sacrifice ratios. The sacrifice ratio for the episode III however shows a lower negative ratio than episode I and II. Given the fact that episode I and II correspond to one period, we sum their results and compare it with that of episode III. Using the linear trend method; episode I and II produced positive sacrifice ratios, while the sacrifice ratio from episode III was negative. Thus the sacrifice ratios from episode III which correspond with the inflation targeting period of the SARB indicate that the sacrifice ratio declined. These results are consistent with the results from the nine quarter moving inflation average. Based on these results therefore, it could be deduced that the loss in output in Namibia due to the disinflation episodes fell after the introduction of inflation targeting in South Africa. Page 35

36 CHAPTER 5: EVIDENCE FROM BOTSWANA AND SWAZILAND 5.1. Introduction After calculating the sacrifice ratio for Namibia; the study seeks further evidence from other neighbouring countries in the region. This was achieved by calculating the sacrifice ratios of Botswana and Swaziland, which were ultimately compared with those of Namibia. Swaziland is a member of the CMA together with Namibia. Thus it is assumed that the impact of inflation targeting on Swaziland is similar to that of Namibia. Botswana is similar to Namibia in terms of economic structure and size. Unlike Namibia and Swaziland however, Botswana was chosen as a counterfactual case because of two reasons: (i) Botswana pulled out of the CMA in 1974 to be able to conduct independent monetary policy; (ii) Botswana targets money stock instead of directly targeting inflation. Thus, it is expected that the adoption of inflation targeting in South Africa impacted less severely on Botswana compared to Namibia and Swaziland. Ikhide and Uanguta (2006) for example observe that the monetary and real variables in Botswana do not respond instantaneously to a shock in the SARB repo rate BOTSWANA Monetary policy in Botswana Botswana was a member of the Rand Monetary Area until Thus before 1976, the South African Rand was the only currency used in Botswana. Discretionary monetary policy was only attained in 1976 following the setting up of the Bank of Botswana. The objectives of monetary policy in Botswana by then were to support the balance of Page 36