Evaluating the monetary conditions index with time-varying weights: insights for policy across different repo rate regimes in South Africa

Conventional Monetary Conditions Index (MCI) frameworks assign fixed weights to interest rate and exchange rate components to approximate the discretionary stance of the monetary authority and assess the overall tightness or looseness of monetary policy. This limiting their ability to reflect changing economic conditions and guide monetary policy effectively. This study explores the benefits of allowing MCI weights to vary over time, providing a more dynamic measure of monetary conditions. Using quarterly data from Q1 2000 to Q3 2024, we apply a rolling vector error correction model (RECM) and a Markov-switching VAR (MS-VAR) to capture both gradual shifts and regime-dependent policy effects. Results show that fixed weights offer stability but may miss evolving trends, whereas time-varying weights make the MCI more responsive to real-time economic changes. Specifically, in Regime 1, a 1% increase in the fixed MCI raises the repo rate by 0.10%, while the time-varying MCI lowers the rate by 0.003% in Regime 2, highlighting potential easing under restrictive conditions. The study demonstrates that, the time-varying MCI reduces the repo rate under restrictive conditions, suggesting potential easing when needed. These findings imply that central banks, such as the SARB, can improve policy effectiveness by adopting a time-varying MCI, enhancing the responsiveness of interest rate decisions to current economic developments.