Do government debt growth threshold and inflation regimes matter for inflation in SA

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Do government debt growth threshold and inflation regimes mater for inflation in South Africa

By Nombulelo Gumata BA, BComs (Hons); MCom, PhD

Abstract Do government debt growth thresholds matter for inflation expectations? Yes, they do. It is found that inflation expectations increase across the spectrum in response to positive government debt growth shocks. Using the government debt growth thresholds above and below 10 per cent as the demarcation for low and high government debt growth regimes, it is established that low and high government debt growth regimes exert different effects on inflation expectations across the spectrum. All inflation expectations measures increase in the high government debt growth regime compared to the low government debt growth regime. Furthermore, when the 4.5 per cent inflation rate threshold is used to delineate the high and low inflation regimes, evidence shows that the inflation regimes matter for the propagation of positive government debt growth shocks to inflation expectations. Evidence shows that high inflation regimes amplify the responses of inflation expectations to positive government debt growth shocks in the high debt growth regime. In the absence of the high inflation regime channel, inflation expectations across the spectrum increase less, as shown by the counterfactual responses. The low inflation regime channel lowers or dampens the response of inflation expectations to positive government debt growth shocks in the low debt regime. The policy implications of these results are that government debt growth thresholds and inflation regimes matter for the achievement of the price stability mandate. In addition, the results indicate the importance of co-ordination between monetary policy and fiscal policy, as the conduct of these policies interacts and have spill-over effects on each other’s policy objectives.

Introduction Do government debt growth thresholds matter for inflation expectations? If so, what are the implications for the price stability mandate? This paper explores these questions because well-anchored inflation expectations matter for the inflation outlook and the conduct of monetary policy. Why do well-anchored inflation expectations matter for inflation and the conduct of monetary policy? Bernanke (2007) states that the state of inflation expectations greatly influences actual inflation and in turn, the central bank’s ability to achieve price stability. Moreover, Cœuré (2019) asserts that stable inflation expectations at levels consistent with the price stability mandate provide an important nominal anchor for the economy, reduce inflation persistence and curb harmful macroeconomic volatility. As a nominal anchor, well-anchored inflation expectations assist policy makers in dealing with some of the adverse effects of inflation. For instance, it is a well-established fact that inflation (i) injects noise into the price system; (ii) makes long-term financial planning more complex; (iii) introduces a pattern of stop-go monetary policies that are a source of much instability in output and employment; and (iv) interacts in perverse ways with imperfectly indexed tax and accounting rules. Furthermore, high and persistent inflation undermines the public confidence in the economy and the management of economic policy generally (Bernanke, 2007). Friedman (1977) shows that the level of inflation and inflation volatility are strongly and positively correlated and is costly. Higher rates of inflation may cause the reallocation of scarce resources to unproductive activities and thus distort economic efficiency and reduce output growth. In addition, Friedman (1977) argued that inflation may have negative effects on output growth by increasing inflation uncertainty. Ball (1992) showed that the positive correlation also applied to moderate or even low inflation rates and that higher inflation rate increases inflation uncertainty. Georgios (2017) shows that the United States inflation and its volatility have been positively correlated for the period 1800 to 2016 when inflation exceeds 3 per cent. The results of this study indicate a positive relationship between inflation and its volatility when inflation exceeds 3 per cent and a negative correlation when inflation is below this threshold. Pindyck (1991) and Devereux (1989) presented evidence that inflation uncertainty, may lead to real uncertainty which affects output growth and the inflation rate. For emerging market economies, Gillman and Nakov (2004) found that inflation affected growth negatively in Hungary and Poland. Mladenovic (2007) established that in Serbia, high inflation leads to high uncertainty, which in turn, negatively affects the average level of inflation in the long run. Ndou and Gumata (2017) found that in South Africa, periods of elevated exchange rate and inflation volatility are likely to induce more inflation volatility, particularly when inflation is close to the upper band of the inflation target. Furthermore, they establish a negative long-run relationship between economic growth and inflation when using five-year averages for the sample period 1966–2012. The inflation threshold that exerts negative effects in the finance–growth nexus lies within a threshold range of 4–5 per cent. When inflation is above this threshold range, it exerts a negative effect on the finance–growth nexus. What is the link between inflation and fiscal policy? The Keynesian theory suggests that fiscal policy changes have an impact on aggregate demand which results in changes in output and the price level. In turn, the price level can be affected by changes in public wages that can spill over into the private sector wages. In addition, changes in fiscal policy via the tax rates can also affect the marginal costs and consumption expenditure growth. In relation to the adverse effects of headline inflation on inflation expectations, Figure 1 (a and b) shows that inflation and all measures of inflation expectations have been largely within the 3 to 6 per cent inflation target band and trending lower towards the mid-point (4.5 per cent) of the target range post-2009 in South Africa. In addition, Figure 1(c, d and e) show that headline inflation is positively correlated with all the measurements of inflation expectations. On a bilateral basis, the stylised facts show that headline inflation explains more than 50 per cent of the variability in the current and one-year ahead inflation expectations. The correlation is weaker for the two-year ahead inflation expectations. The results of the correlations, therefore, suggests that the immediate inflation outcomes matter more for how agents form inflation expectations. These trends are consistent with extensive literature, such as Sharma and Bicchal (2018), Vargas et al (2009), Mankiw et al (2003) and Fraga et al (2003), which shows that inflation expectations tend to be adaptive and backward-looking. Lastly, the cross correlations in Figure 1(f) show that all inflation expectations measures increase during the first nine quarters, when preceded by high headline inflation.

Figure 1: Headline inflation and inflation expectations in South Africa for the period 2000M1 to 2019M12 Source: South African Reserve Bank and authors’ calculations

The paper contributes to literature on the subject by establishing the link between inflation expectations and the conduct of fiscal policy via the government debt growth channel. In particular, the paper explores the impact of government debt growth regimes on inflation expectations and whether inflation regimes propagate these effects on inflation expectations. Inflation expectations and inflation regimes are important in the conduct of monetary policy and the achievement of the financial stability mandate. The author is unaware of any papers that conduct this kind of research in South Africa, and especially in terms of the use of government debt growth and inflation thresholds to demarcate high and low government debt growth and inflation regimes. Furthermore, no study in South Africa has, to date, explored the interaction of government debt growth regimes and inflation regimes relative to the mid-point (4.5 per cent) of the inflation target range, on inflation expectations. In addition, the paper fills academic, policy research and methodological gaps by using the threshold vector autoregression (VAR) approach to assess the role of asymmetries introduced by different government debt growth and inflation regimes on inflation expectations. The paper also uses the counterfactual VAR approach (Cafiso, 2019; Elbourne, 2008; Giuliodori, 2005; Ludvigson, Steindel & Lettau, 2002) to establish whether the high and low inflation regimes propagate or dampen the effects of high and low government debt growth regimes on inflation expectations. The results, set out in the paper, show that inflation expectations increase across the forecasting horizons or spectrum in response to positive government debt growth shocks. In addition, using the government debt growth thresholds above and below 10 per cent as the demarcation for low and high debt regimes, the results show that low and high government debt growth regimes exert different effects on inflation expectations across the spectrum. All inflation expectations measures increase in the high government debt growth regime compared to the low government debt growth regime. Furthermore, when using the 4.5 per cent inflation rate threshold to delineate high and low inflation regimes, the evidence shows that the inflation regimes matter for the propagation of positive government debt growth shocks to inflation expectations. High inflation regimes amplify the responses of inflation expectations to positive government debt growth shocks in the high debt regime. In the absence of the high inflation regime channel, inflation expectations across the spectrum increase less as shown by the counterfactual responses. The low inflation regime channel lowers the response of inflation expectations to positive government debt growth shocks in the low debt regime. The results imply that government debt growth thresholds and inflation regimes matter for the achievement of the price stability mandate. The paper is structured as follows: section two presents a brief literature review of the link between fiscal policy and inflation. This is followed, in section three, by a summary of the methodology used in the paper and the data. Section four discusses the empirical analysis of how inflation expectations respond to government debt shocks. Section five explores whether the South African government debt growth thresholds matter for inflation expectations and section six assesses whether inflation regimes matter for the propagation of government debt growth thresholds to inflation expectations. Section seven concludes and provides some policy implications of the findings. Theory and literature on the link between inflation and fiscal policy Theory and literature link fiscal policy and inflation mainly through (i) the long-term effects of persistent fiscal deficits and government debt on inflation; (ii) the impact of changes in various components of fiscal policies (fiscal shocks) on inflation; and (iii) the fiscal theory of the price level, which states that fiscal policy plays an important role in price determination, through the budget constraint associated with the debt policy, spending, and taxation (Christiano & Fitzgerald, 2000; Bassetto & Wei, 2017. The fiscal theory of the price level considers the price level as the crucial adjustment variable that ensures the fulfilment of the government’s intertemporal budget constraint (Kocherlakota & Phelan,1999; Buiter, 1999). The government’s intertemporal budget constraint equates the government’s current liabilities to the net present value of government revenues. The theory assumes that under the condition that the Ricardian equivalence (Bernheim, 1987) does not hold, and with a strongly committed and independent central bank, the imbalances in the intertemporal budget constraint need to be adjusted through shifts in the price level. With the assumption of absent Ricardian behaviour, individuals perceive government deficits as increases in wealth and this induces them to raise spending, thus driving up the price level. By contrast, if the Ricardian equivalence is assumed to be present, the wealth effect of the deficits would be neutral and thus leaving the central bank in control of the price level. The Ricardian equivalence states that the fiscal stimulus in the form of an increase in deficit-financed public spending or tax cuts will lead to a crowding out of private consumption, thus decreasing the effectiveness of fiscal policy in boosting economic activity. This is because economic agents’ consumption is determined by the lifetime present value of their after-tax income and they assume that whatever is gained in the present, will be offset by higher taxes due in the future. Thus, whether government choses to increase spending by debt financing or tax financing, the outcome is the same and demand remains unchanged (Hayo & Neumeier, 2017). With the assumption of absent Ricardian behaviour, individuals perceive government deficits as increases in wealth and this induces them to raise spending, thus driving up the price level. By contrast, if the Ricardian equivalence is assumed to be present, the wealth effect of the deficits would be neutral, thus leaving the central bank in control of the price level. Fischer et al (2002) find that fiscal imbalances (fiscal deficits) tend to explain high inflation in a broad country sample. Catao and Terrones (2001) establish a strong and statistically significant long-term relationship between fiscal deficits and inflation for a panel of 23 emerging market countries. Arratibel et al. (2002) find that headline inflation in central and Eastern Europe is impacted by nominal wage growth; lagged inflation due to a relatively large impact of inflation inertia; oil price; and fiscal policy.

Methodology and data

The paper uses a Cholesky vector autoregression (VAR) and a counterfactual VAR approach to estimate the impact of positive government debt growth shocks on inflation expectations and to assess whether inflation regimes matter for the propagation of government debt growth thresholds to inflation expectations. The VAR is defined as given in equation (1), where the N x 1 vector yt denotes the set of variables that is of interest in the analysis. The assumption that yt follows a pth-order VAR means that it can be expressed as shown in equation (1). (See Sims (1980a and 1980b), and Christiano (2012) for further reading).

yt = B0 + b1 yt-1 + … + Bp yt-p + ut, Eutu ‘t = V, (1)

where ut is not correlated with yt-1 ,…, yt-p. It is assumed that p is assigned a large enough value so that ut is not autocorrelated over time. The VAR disturbances, ut ,are assumed to be a linear transformation of the economically fundamentals shock, et :

yt = Cet , CC’ = V (2)

The economic shocks et are assumed to be independent origins, and therefore to be uncorrelated with each other. Many objects in equations (1) and (2) are econometrically identified, meaning that they can be estimated using data without any further (credible or incredible) assumptions. In particular, Bi and V are econometrically identified. To estimate Bi and V, we simply run a series of regressions and compute the variances and covariances among the regression disturbances. However, C is not identified because the symmetric matrix V has only N(N + 1) /2 indepentent elements while C has 𝑁2 > 𝑁 (𝑁 + 1) /2 unknowns. For most forecating purposes, it is enought to have just Bi and V in this case, no identification assumptions are required.

We also use the counterfactual VAR model to assess whether high inflation regimes amplify the responses of inflation expectations to positive government debt growth shocks in the high debt growth regime. The counterfactual VAR model assesses what happens to inflation expectations responses to high government debt growth regimes shocks, in the presence and absence of the high inflation regimes channel given by the gap between the impulse responses as shown in equation (3).

∆Y = (Actual impulse response – counter factual impulse response) (3)

Where, ∆Y is the response of inflation expectations.

The data used in the study are quarterly (Q) and are sourced from the South African Reserve Bank database. The estimations use current inflation expectations, one-year ahead inflation expectations, two-year ahead inflation expectations, government debt and headline consumer price inflation. The growth rates are at an annual rate.

The VAR model in section 4 includes the government debt growth, headline consumer price inflation, current inflation expectations, one-year ahead inflation expectations and two-year ahead inflation expectations as endogenous variables. The recession dummy variable that takes on the values of one during recessions and zero otherwise enters the VAR model as an exogenous variable. The data used in the estimations is on quarterly (Q) basis and start in 2000Q3 to 2019Q4. This is because inflation expectations are only available for this sample period. The growth rates are at an annual rate. The shock is a unit shock to government debt growth. The VAR model is estimated using two lags and 10 000 Monte Carlo draws.

Section 7 of this paper concludes the analysis, by conducting a robustness analysis of the results of the responses of inflation and inflation expectations to fiscal policy variables. For robustness analysis, a VAR model with the same variables as estimated in the sections 4 and 5, namely, current inflation expectations, one-year ahead inflation expectations and two-year ahead inflation expectations is used. Headline inflation is added to assess the robustness of the results to changes in the model size. Also government debt growth is replaced with the budget deficit (budget balance as a ratio of nominal GDP) as the shock of interest to assess whether the results are robust to changes in the definitions of the variables in the model. The model includes the recession dummy as defined in the earlier sections as an exogenous variable. The VAR is estimated using two lags and 10 000 Monte Carlo draws. The shock is a unit to the budget deficit.

How do inflation expectations respond to government debt shocks? This section starts to answer this question by estimating a VAR model as explained in the methodology section.

The results in Figure 2 show that inflation expectations tend to increase across the forecasting horizons or spectrum in response to positive government debt growth shocks. Current inflation expectations increase more than the one-year and two-year ahead inflation expectations at peak response as shown in Figure 2(d and e). In addition, the government debt growth shock explains a higher variation in current inflation expectations compared to the one-year and two-year ahead inflation expectations. The results are robust to the reverse ordering of the variables.

Figure 2: Responses to positive government debt growth shocks Source: Authors’ calculations Note: The grey shaded areas denote the 16th and 84th percentile confidence bands. Govt. in (f) = government.

Do the government debt growth threshold matter for inflation expectations in South Africa?

To answer this question, we use the government debt growth of 10 per cent as a threshold to delineate between the high and low government debt regimes. The government debt growth threshold is taken from Gumata and Ndou (2017).The authors estimate the debt growth thresholds for net debt and gross debt using the sample period 1990Q1 to 2015Q4 based on data obtained from the South African Reserve Bank. They use the Balke (2000) approach in a model that includes gross or net government debt growth, output growth, investment growth, inflation and the ten-year yield on government debt. They established a growth threshold level of 9.62458 per cent for gross debt and 9.50513 per cent for net debt. For ease of reference, the estimated gross government debt growth threshold is presented in Figure 3.

Figure 3: Estimated thresholds for net and gross debt growth Source: South African Reserve Bank and authors’ calculations Note: The shaded area denotes the period 2000Q1 to 2008Q3 when GDP growth averaged 4.1 per cent.

It is also important to note that in Figure 3, during the period 2000Q1 to 2008Q3 when GDP growth averaged 4.2 per cent (the grey shaded area), government debt growth was below 10 per cent. This contrast with the period post-2009 where government debt growth was generally above 10 per cent and GDP growth averaged 1.47 per cent during 2009Q1 to 2019Q4. Investment growth (gross fixed capital formation) averaged 9.2 per cent between 2000Q1 and 2008Q3 compared to 0.25 per cent between 2009Q1 and 2019Q4. We create two dummy variables that capture these regimes: (i) the high government debt growth threshold which takes on all the values of government debt growth above 10 per cent and zero otherwise; and (ii) the low government debt growth threshold which takes on all the values of government debt growth below 10 per cent and zero otherwise. We estimate two VAR models which include the high or low government debt growth regime dummy, headline inflation, current inflation expectations, one-year ahead inflation expectations and two-year ahead inflation expectations as endogenous variables. The recession dummy that takes on the values of one during recessions, and zero otherwise, enters the VAR model as an exogenous variable. The government debt growth regime dummy variables enter the VAR models separately. The shock is a unit shock to the high or low government debt growth regime dummy. The VAR model is estimated using two lags and 10 000 Monte Carlo draws.

Figure 4: Responses to positive government debt growth shocks in the high debt growth regime Source: Authors’ calculations Note: The grey shaded areas denote the 16th and 84th percentile confidence bands

The results in Figures 4 and 5 show that low and high government debt growth regimes exert different effects on inflation expectations across the spectrum. For instance, in Figure 4 the results show that all inflation expectations measures increase in the high government debt growth regime, compared to the low government debt growth regime in Figure 5. It is also evident that the two-year inflation expectations increase with a delay of about three quarters, whereas the current and one-year ahead inflation expectations increase on impact. In the low government debt growth regime, all inflation expectations decline. Thus, we conclude that the government debt growth regimes exert different effects on inflation expectations.

Figure 5: Responses to positive government debt growth shocks in the low debt growth regime Source: Authors’ calculations Note: The grey shaded areas denote the 16th and 84th percentile confidence bands

Do inflation regimes matter for the propagation of government debt growth threshold to inflation expectations?

This section estimates a counterfactual VAR model to assess the role of inflation regimes in the transmission of positive shocks to government debt growth regimes to inflation expectations. We assess the role of high and low inflation regimes in transmitting positive government debt growth shocks in the high and low government debt regimes, as defined in the earlier sections. We define the high (low) inflation regime as that in which inflation is above (below) 4.5 per cent. As such, we create two dummy variables defined as (i) the high inflation regime dummy which takes on all the values of headline consumer price inflation above 4.5 per cent, and zero otherwise; and (ii) the low inflation regime dummy which takes on all the values of headline consumer price inflation below 4.5 per cent, and zero otherwise. The counterfactual VAR model includes the high or low government debt growth dummy variable, current inflation expectations, one-year ahead inflation expectations, two-year ahead inflation expectations and the high or low inflation regime dummy variable. The high or low government debt growth dummy and high or low inflation regime dummy variables enter the models separately. The VAR models are estimated using two lags and 10 000 Monte Carlo draws. The actual responses are those derived from the model when the high or low inflation regime dummy is active in the model. The counterfactual responses are those derived in the model when the high or low inflation regime dummy is inactive in the model. The dampening or amplification effects of the high or low inflation regime dummies is the difference between the actual and the counterfactual responses.

Figure 6: Responses to high government debt growth regimes and amplification by the high inflation regime Source: Authors’ calculations

The results in Figure 6 show that high inflation regimes amplify the responses of inflation expectations to positive government debt growth shocks in the thigh debt regime. In the absence of the high inflation regime channel, inflation expectations across the spectrum increase less, as shown by the counterfactual responses. On the other hand, the results in Figure 7 show that the low inflation regime channel lowers the response of inflation expectations to positive government debt growth shocks in the low debt regime. The actual responses of inflation expectations are lower than the counterfactual responses when the role of the low inflation regime channel is closed in the model. Hence, the low inflation regime dampens the effects of positive government debt growth shocks in the low debt regime.

Figure 7: Responses to low government debt growth regimes and amplification by the low inflation regime Source: Authors’ calculations

Robustness analysis

This section concludes the analysis in this paper by conducting the robustness analysis of the results of the responses of inflation and inflation expectations to fiscal policy variables. The results in Figure 8 show that the results are robust to changes to the model size and parameters or specification. Headline inflation increases in response to positive budget deficit shocks, and this is followed by an increase in inflation across the spectrum. Similar to the results in the previous section, current inflation expectations increase more than the one-year and two-year ahead inflation expectations in Figure 8(d). Inflation and inflation expectations are sensitive to fiscal policy shocks. Thus, it is concluded that the conduct of fiscal policy matters for the price stability mandate

Figure 8: Responses to positive budget deficit shocks Source: Authors’ calculations Note: The grey shaded areas denote the 16th and 84th percentile confidence bands

Conclusions and policy implications

Do government debt growth thresholds matter for inflation expectations in South Africa? We find that inflation expectations increase across the spectrum in response to positive government debt growth shocks. Using the government debt growth above and below 10 per cent as the demarcation for low and high debt growth regimes, we establish that low and high government debt growth regimes exert different effects on inflation expectations across the spectrum. All inflation expectations measures increase in the high government debt growth regime compared to the low government debt growth regime. Furthermore, when we use the 4.5 per cent inflation threshold to delineate high and low inflation regimes, the evidence shows the inflation regimes matter for the propagation of positive government debt growth shocks to inflation expectations. The evidence shows that high inflation regimes amplify the responses of inflation expectations to positive government debt growth shocks in the high debt regime. In the absence of the high inflation regime channel, inflation expectations across the spectrum increase less as shown by the counterfactual responses. However, the low inflation regime channel lowers the response of inflation expectations to positive government debt growth shocks in the low debt regime. The implication is that government debt growth thresholds and inflation regimes matter for the achievement of the price stability mandate. In addition, the results indicate the importance of co-ordination between monetary policy and fiscal policy, as the conduct of these policies interacts and has spill-over effects on each other’s policy objectives.

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