Rand volatility and inflation in South Africa

The floating exchange rate regime, coupled with a more open trade policy and the growth in imports, leaves South Africa vulnerable to the effects of exchange rate behaviour on import, producer and consumer prices, which all contribute to inflation. Given the central role that inflation targeting occupies in South Africa’s monetary policy, this paper examines the effect of exchange rate shocks on consumer prices using monthly data covering the period January 1994 to December 2013. Consistent with developing countries story, results show a modest exchange rate pass-through to inflation, although inflation is mainly driven by own shocks. The variance decompositions also reveal that foreign exchange rate shocks (REER) contribute relatively more to inflation than money supply shocks (M3). This suggests that South African inflation process is not basically influenced by money supply changes. The practical implication is that that the volatility of the rand is not a serious threat to inflation. The SARB should therefore focus on price stability and not be unduly worried about the volatility of the rand.