Does the Inflation Threshold Lead to Asymmetric Effects of the Rand Per US Dollar Exchange Rate Changes on Inflation?

Abstract

Are there differential effects exerted by appreciations and depreciations, particularly during prolonged periods of either exchange rate depreciations or appreciations? First, we establish that mean inflation is around 5.64 percent during depreciation episodes compared to 4.59 percent during appreciation episodes. This means that depreciations are associated with inflation close to the upper band of the inflation target. Furthermore, inflation is four times more sensitive to depreciations than to appreciations. For instance, a 10 percent depreciation in the exchange rate is likely to add 0.4 percentage points to inflation, relative to just 0.1 percentage points from appreciations. Thus, exchange rate depreciation episodes are likely to be inflationary. On the other hand, appreciations episodes do bring about marginal disinflation. Second, the findings suggest that inflation responds asymmetrically to different magnitudes and directions of the exchange rate shocks subject to the inflation threshold. The inflation rate increases by big magnitudes due to the Rand per US dollar depreciation compared to the appreciation in the high and the low inflation regimes. The observed non-linearity is consistent with the menu costs theory of price adjustment. This suggests that the policymakers’ caution that exchange rate deprecations are a threat to inflation is a binding constraint. This is because the mean inflation is high such that any depreciation pushes inflation outside the band. This is irrespective of whether the exchange rate pass-through has declined or not. Thus a gradual policy response to the inflationary is ideal.