Should the South African Reserve Bank respond to exchange rate fluctuations? Evidence from the cosine-squared cepstrum

Abstract

Empirical evidence on the whether the inflation targeting South African Reserve Bank (SARB) should also consider responding to exchange rate fluctuations are contradictory. We revisit the issue by questioning if inflation rate is more volatile than it would have been had South Africa not moved to a flexible exchange rate regime in 1995, using the cosine squared cepstrum. We find that CPI inflation in South Africa has become more volatile since the second quarter of 1995, post a flexible exchange rate regime, than it would have been had the country continued to pursue a fixed exchange rate policy. Based on this result, we can conclude that the SARB should perhaps respond to exchange rate fluctuations, however, we also warn against the cost of increased volatility in output that is likely to result from targeting exchange rate variability.