Why Higher Trend Inflation Makes Monetary Policy More Costly in South Africa

Overview

The paper examines how the level of trend (underlying) inflation affects macroeconomic performance in South Africa. It argues that, holding other factors constant, higher trend inflation raises the economic costs associated with price dispersion and nominal rigidities, and therefore lower trend inflation is preferable from the perspective adopted in the model. The analysis is motivated by ongoing deliberations over the inflation target range in South Africa.

Methods and approach

The study employs a fiscal dynamic stochastic general equilibrium (DSGE) model that incorporates nominal rigidities and price-dispersion effects alongside fiscal policy interactions. The model is used to compare economies operating under different assumed rates of trend inflation while holding other structural parameters fixed. Results are obtained through model simulation exercises that trace equilibrium responses and welfare-relevant aggregates across alternative trend-inflation scenarios.

Results

Model simulations indicate that higher trend inflation amplifies distortions associated with price dispersion and nominal stickiness, leading to less favorable macroeconomic outcomes in the framework studied. The simulations support the qualitative conclusion that lower trend inflation reduces these distortions and their aggregate costs, conditional on the model structure and parameterization employed. The paper does not present the analysis as a universal quantification but as evidence within its specified fiscal-DSGE framework.

Implications

Within the model's framework, the findings imply that the choice of trend-inflation objective has material implications for macroeconomic costs through interactions with price dispersion and nominal rigidities. The analysis highlights the importance of accounting for fiscal–monetary interactions when evaluating the welfare trade-offs of target inflation levels, and suggests that deliberations over target design should consider model-consistent assessments of these channels. Policy sequencing and institutional arrangements affecting credibility and fiscal coordination are noted as relevant considerations for translating lower target objectives into practice, but specific procedural prescriptions depend on additional institutional details beyond the model.