Does lowering and narrowing the inflation target band enhance the effectiveness of monetary policy transmission? Evidence from South Africa

The South African Reserve Bank has indicated since 2024 the urgency to lower the current inflation target (IT) band from 3-6% to a lower target point. This paper estimates the impact of various IT bands on the interest rate pass-through and the mark-up of repo rate changes to weighted lending rates in South Africa. It examines whether the interest rate pass-through to lending rates differs when inflation is within three ranges: (i) 0-3%, (ii) 3-6%, or (iii) above 6%. The findings suggest that the pass-through is higher and the mark-up is lower when inflation is between 0-3% compared to within the 3-6% band. Additionally, the paper explores the effects of narrowing the target band from 3-6% to 2-4%. Evidence indicates that narrowing the target band from 3-6% to 2-4% results in a higher interest rate pass-through to lending rates. These findings imply that the transmission of monetary policy is more effective when inflation is within the 2-4% range. Consequently, the SARB's adoption of a lower inflation target will enhance the transmission of policy rate changes to lending rates and reduce the mark-up.