Predictability of monetary policy by the financial market in South Africa under the inflation targeting framework

M. Com. (Financial Economics)The success of a monetary policy framework depends mostly on whether economic agents, especially the financial market participants, understand monetary policy decisions and are able to predict them in advance. Academics and practitioners agree that a successful Central Bank should be “boring” such that surprises about monetary policy should not arise in the announcements and the actions of the Bank, but rather in the macroeconomic developments. Thus policies that enhance clarity, transparency and communication between a Central Bank and the market can contribute to strengthening monetary policy predictability and improve the effectiveness of monetary policy itself. This dissertation assesses the predictability of the South African Reserve Bank’s (SARB) interest rate decisions since the adoption of the inflation targeting monetary policy framework in February 2000. Firstly, in order to evaluate predictability, money market forward rates are used to test whether the financial market is able to forecast the future level of policy rates, using the unbiased forward rate hypothesis. Then, using an event study methodology, changes in the money market forward rates following a monetary policy announcement are used to test whether the financial market participants were surprised by the SARB’s monetary policy decisions. The results of the unbiased forward rate hypothesis (UFRH) and the event study analysis indicate that, at least in the short term, specifically on a one-month-forward period, financial market participants have been able to predict the SARB’s monetary policy decisions with a high degree of accuracy. Moreover, the results of the event study analysis show that the South African financial market is at least semi-strong efficient, in the sense that monetary policy decisions are quickly incorporated in the market interest rates following the announcements. The event study analysis also provided some evidence that volatility in financial markets at the time of interest rate decisions has been declining over time