Optimal monetary policy reaction function in a model with target zones and asymmetric preferences for South Africa

Abstract

In this paper we provide an in-sample assessment of how the South African Reserve Bank (SARB) sets policy rate in the context of both linear and nonlinear Taylor type rule models of monetary policy. Given the controversial debate on whether central banks should target asset prices for economic stability, we investigate whether the SARB policy-makers pay close attention to asset and financial markets in its policy decisions. The main findings are that the nonlinear Taylor rule improves its performance with the advent of the financial crisis, providing the best description of in-sample SARB interest rate setting behaviour. The SARB policy-makers pay close attention to the financial conditions index when setting interest rate. The SARB’s response of monetary policy to inflation is greater during business cycle recessions with not much weight on output and seems to place high importance on inflationary pressures of output during boom periods. The 2007-2009 financial crisis witnesses an overall decreased reaction to inflation, output and financial conditions amidst increased economic uncertainty, with a shift from an asymmetric response to financial conditions over recessions to a more symmetric response irrespectively of the state of the economy.