Macroeconomic Effects of Lowering South Africa’s Inflation Target

This paper explores the macroeconomic implications of lowering the inflation target in an Emerging Market such as South Africa using the IMF’s Global Integrated Monetary and Fiscal model (GIMF). Model-based simulations indicate that lowering the inflation target from 4.5 to 3 percent, as recently announced by South Africa’s central bank, may entail moderate near-term output costs (measured by the so-called “sacrifice ratio”), while leading to medium-term output gains and lower borrowing costs. The near-term costs critically depend on the credibility of the central bank, which determines the speed with which agents adjust their inflation expectations. Specifically, output costs are lower when inflation expectations adjust more rapidly following the announcement of the new target by the central bank. Similarly, higher sensitivity of risk premia to the announcement of a lower inflation target can further reduce these costs. Concurrent fiscal consolidation can help support the disinflation process and lower the marginal sacrifice ratio.