Does difference in monetary policy framework matter for interest rate Pass-through? Evidence from TVP-VAR with stochastic volatility

Abstract

The relative success of Inflation Targeting (IT) amidst widespread rising inflation globally is motivating the Central Bank of Nigeria (CBN) to renew its desire for an IT framework. This paper applies the Time-Varying Parameter Structural Vector Autoregression with the Stochastic Volatility model (TVP-SVAR-SVM) to examine the potential benefits and provide hindsight for the CBN within the interest rate channel. The paper draws parallels between the CBN's Monetary Targeting (MT) and South Africa's Reserve Bank (SARB) IT. The result of the SVM uncovers a disparity regarding inflation uncertainty associated with interest rate pass-through. At the same time, two distinct parallels were unveiled regarding the impulse response function (IRF) result. Although CBN was found to have experienced decelerating inflation uncertainty, the SARB's IT shows no potential benefit. Meanwhile, compelling distinctiveness from the results of the IRF is: first, relative consistency in short-term inflation forecast and the future expected inflation (8-period and 12-period) found in the SARB's IT. This was accompanied by an observed absence of distortions over the declining trajectory of inflation, which allows it to build monetary policy credibility over time, while the strong indication of achieving rapid long-run disinflation over time was also detected. Thus, confirming the relatively greater degree of expectation anchoring. In contrast, the CBN's MT showed manifestation of distortions over time, with difficulties in suppressing impending inflationary pressure, whereas the expected inflation forecast deviated from its short-term (4-period) inflation forecast. Secondly, evidence of speed in the SARB's IT during the initial impact of interest rate pass-through was twice as fast as the CBN's MT. Consequently, the total impact of the pass-through to inflation under MT was also found to be delayed by 8 periods relative to the IT. This paper concludes that the characterized evidence uncovered constitutes a relatively effective SARB's IT, and a key benefit resides in the comparatively faster interest rate pass-through in the IT. This could potentially restrain the rapidness with which nominal adjustable inflation-indexed wages under short contracts have on inflation.