The exchange rate passthrough to consumer price inflation in South Africa: has the inflation target band induced a structural change in the size of passthrough?

The South African Reserve Bank adopted a flexible inflation-targeting framework in February 2000 and has maintained an official inflation target band of 3–6% from inception. The effect of the target band on the exchange rate passthrough (ERPT) to headline consumer price inflation in South Africa has not been empirically evaluated. Hence, this study estimates the size of the ERPT coefficient when inflation is within the official 3–6% inflation target band and compare it to when inflation is above the 6% threshold. Evidence from the regime-dependent VAR models reveals that over all the horizons in the sample period, the size of the ERPT is halved when inflation is within the 3–6% band compared to when inflation exceeds the 6% threshold. In addition, the size of the ERPT is nearly three times lower when inflation is within the 3–6 target band compared to when there are no inflation bands imposed in the model. The results indicate that the adoption of the current inflation target band induced a structural change and lowered the size of the ERPT coefficient. The diminished size of the ERPT must be factored into the projection of inflation forecasts and the policy rate path. In addition, the incorporation of the reduced ERPT in the forecasting model will reduce the overprediction of inflationary pressures, thereby improving the credibility of monetary policymaking process.