The role of monetary policy credibility in explaining the decline in exchange rate pass-through in South Africa

This paper investigates the key factors that explain the documented decline in the exchange rate pass-through in South Africa over the past two decades. The paper finds that this outcome is largely due to improved monetary policy credibility. The South African Reserve Bank has become more credible since the adoption of the inflation target regime through improved communication, transparency, and independence. We show that credibility is enhanced through a gradual disinflation process and reduction of inflation volatility. As result, expectations of agents have become well-anchored at levels that are consistent with its objectives of keeping inflation within the official target range of 3–6 percent even in the presence of external shocks. This in turn reduces the exchange rate pass-through. This finding is important from a monetary policy perspective not only for South Africa but other emerging economies such as Turkey as it shows that improving monetary policy credibility is a key ingredient to reducing exchange rate pass-through.