Equity prices and inflation in South Africa: An empirical analysis

This paper attempts to assess the indirect relationship between equity prices and inflation in South Africa in order to infer the possible reaction of the monetary authority in the face of excessive changes in equity price or bubble. To this end, use is made of a system equation, rather than a single equation, in the context of cointegrating VAR with over-identifying restrictions. The paper decomposes actual inflation into expected and unexpected components and shows that the two components react differently to the changes in equity prices. Nonetheless, given a weak reaction of expected inflation to the change in equity prices and the fact that monetary authority behaviour is forward-looking in South Africa, the paper concludes that equity prices should not form part of the monetary authority reaction function in South Africa.