Sovereign Spreads and Non-linear Responses of Inflation to the R/US$ Exchange Rate Depreciation Shocks

Abstract

This chapter investigates the role of sovereign credit spreads on the ERPT by estimating a threshold at which the sovereign credit spreads exert non-linear effects on the ERPT. Evidence suggests that inflation increases more due to persistent rand-US dollar depreciation shocks in the high sovereign spread regime. This means that sovereign spreads play a role in the ERPT to inflation. This evidence implies that the simultaneous occurrence of persistent exchange rate shocks and heighted sovereign spreads requires different monetary policy response relative to the low spread regime. Monetary policy is tightened more in the high sovereign spread regime relative to the small tightening in the low spread regime in order to dampen inflationary pressures from the exchange rate depreciation shocks.