Second-round effects on inflation, and underlying inflation

Ruch, Franz Ulrich (2016-12)

Thesis (PhD)--Stellenbosch University, 2016.


ENGLISH SUMMARY : Supply shocks, especially food and energy price shocks, play a significant role in the evolution and dynamics of headline consumer price inflation in South Africa. Although headline inflation is the price index officially targeted by the South African Reserve Bank, monetary policy can neither control the relative price movements, nor would it be desirable for the central bank to do so. It is only when these relative price shocks affect the underlying trend rate of inflation – core inflation – through second-round effects that monetary policy has a critical role to play. The presence of second-round effects change how a central bank needs to respond to relative price shocks. Generally, a central bank can look through shocks to food and energy prices, in the absence of second-round effects, communicating clearly the reason for its inaction. However, when second-round effects are present, the central bank has to respond appropriately to ensure that inflation expectations remain anchored around the target. Second-round effects emanate from the ability of price-setting firms and wage-setting labour to increase prices (whether through mark-ups or higher marginal costs) and wages, and therefore general prices of goods and services, in response to relative price shocks. In order for monetary policy to adequately respond to second-round effects, these effects need to be identified and quantified. Such identification depends on the definition of core inflation, the underlying trend in overall inflation, and the consequent measurement of this core inflation. This PhD dissertation contributes to the academic literature and policy discussion of second-round effects and underlying, or core, inflation in South Africa. First, the impact of second-round effects on inflation following supply shocks will be quantified using a Structural Bayesian vector autoregressive model, with sensible zero and sign restrictions. This identification relies on a conventional exclusion-based measure of core inflation – headline CPI less food and energy – that is often used in policy discussions and decisionmaking. The results of this model confirm the impact of wage-setters in South Africa, that changes in the prices of food, petrol and energy are accommodated and lead to strong secondround effects. Second, monetary policy in South Africa is forward-looking and requires forecasts of inflation to set policy. To ensure the best possible estimates of core inflation are available to the central bank, we look at a host of possible models that existing literature shows to have some success in forecasting, and that cover a wide variety of new techniques. These include models that take account of large datasets of information, that address possible breaks in the inflation series as monetary policy regimes change, that address the changing relationship between variables and inflation or the structure of the economy, and that provide mechanisms to look at the importance of volatility. The myriad of forecasting techniques reveal that accounting for changing relationships improve forecasts of core inflation, while exploiting more economic information does not necessarily produce better forecasts compared with smaller models. Last, it may be that a conventional definition of core inflation currently used by central banks – headline CPI less food, non-alcoholic beverages and energy, the exclusion-based measure most quoted by the South African Reserve Bank – is not the most appropriate, or theoretically consistent, to ensure best policy outcomes. To address this, a novel approach to the definition and calculation of core inflation will be followed using micro-price-level data. We study the underlying dynamics of 5;200;466 individual price quotes of goods to determine the frequency of price changes at a product level. This is used to construct a sticky-price goods inflation measure. Sticky-price goods inflation is more persistent, less volatile and correlates well with future goods inflation. The advantage of sticky-price inflation is that it grounds the concept of underlying inflation into the theoretical framework currently used by central banks to make policy decisions, and what is considered optimal policy by monetary theorists, making it an ideal core inflation candidate for the central bank.

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