1. Price Setting and Monetary Policy in South Africa PhD Research Proposal by Kenneth Creamer Supervisor Dr Greg Farrell School of Economic and Business Sciences, University of Witwatersrand, 31 October 2006

2. Overview of Presentation 1.Abstract and Outline of Research 2.Background and Overview 3.Literature Review 4.Details of survey of price setting conduct 5.Details of micro-data analysis of CPI data 6.Modeling implications of pricing for monetary policy 7.Conclusion

3. Abstract This research proposal, firstly, seeks to test the hypothesis that there are significant price rigidities in the South African economy, and, secondly, seeks formally to model how the prevalence of such price rigidities would impact on the optimal conduct of monetary policy. To test for price rigidities, use will be made both of a survey of the pricing conduct of South African firms and of a micro-data analysis of South Africa’s official consumer price dataset. In testing for price rigidities, Blinder et al’s (1998) finding for the US economy that 78 percent of the GDP is priced quarterly or less frequently, and the finding of the European Central Bank’s Inflation Persistence Network (Altissimo et al 2006) that the average duration of consumer prices is 4 to 5 quarters, will be treated as benchmarks in assessing the comparative significance of the degree of price rigidity in the South African economy. Furthermore, a number of important descriptive features of price setting conduct in the South Africa economy will be revealed through the survey and the data study, including inter alia the degree of upward and downward symmetry in price setting, inter-sectoral comparisons of the frequency, degree and seasonality of price adjustments, and the rating of the applicability of various microeconomic theories of price setting conduct. To model the implications of the findings on price rigidities for the optimal conduct of monetary policy, a framework including a New Keynesian Phillips curve will be developed for South Africa. This will enable a micro-founded macroeconomic analysis of the co-movement of real and nominal variables, including a study of the optimal conduct of monetary policy in the presence of cost push shocks, and will indicate the implication of interest rate setting for output and inflation and the nominal and real policy rates. JEL Classifications: E31, E52

4. Outline of Proposal 1.Introduction –a.Overview –b.Macroeconomic context –c.Literature Review 2.Survey of the price setting conduct of South African firms –a.Overview –b.Sample selection –c.Substance of the Survey –d.Survey Findings 3.A micro-data analysis of price setting in the South African economy –a.Overview –b.Analysis of frequency of price changes –c.Analysis of size of price changes 4.Modeling the implications of pricing conduct for monetary policy in South Africa –a.Overview –b.Modeling the implications of pricing behaviour –c.Conclusion 5.Bibliography

5. 2.Background and Overview In the disciplines of macroeconomics and monetary economics a significant emphasis has begun to be placed on the micro-founding of macroeconomic models. In this context a number of important recent studies have been conducted aimed at gaining a better understanding of price setting behaviour in a wide range of economies These studies have used two basic methodologies in order to better understand price setting behaviour: –Surveys of individuals responsible for price setting – aimed at assessing the frequency, direction and size of price changes for the economy as a whole and across various economic sectors, but also in order to gain insight into the factors that motivate and shape price setting decisions –Micro data analysis of CPI and PPI data – aimed at quantitatively ascertaining the frequency, direction and size of price changes for the economy as a whole and across various economic sectors

6. Why study price setting behaviour? The research will throw up a rich new data set which will provide a deepened understanding of price setting behaviour in the South African economy, including findings, such as: How frequently are prices changed in South Africa Is pricing asymmetrical or are prices as likely to be decreased as increased? Which theories of price setting behaviour best explain price stickiness in South Africa? The findings of the study will have implications for the conduct of economic policy: A model will be develop to show that in situations of relatively high price stickiness, monetary policy should be less aggressive in responding to cost shocks, such as, an oil price increase or a sharp currency depreciation

7. 3. Literature Review The research would begin to fill a significant gap in South Africa’s economic literature as studies on price setting, inflation, monetary economics and monetary policy in South Africa have generally pursued a different set of questions from those under discussion in this research proposal. Aron and Muellbauer (2005) - reviewed monetary policy in South Africa over the past decade, suggesting that wage setters in South Africa are backward looking as they indexing wages to past inflation plus a “safety margin”, and that a ‘cost channel’ effect exists whereby higher interest rates lead to a higher cost of capital and wage pressures, which leads to price setting firms increasing prices Fedderke and Schaling (2005) - in their modeling of inflation in South Africa found evidence of mark-up pricing Nell (2000a) - shows that inflation is largely due to higher imported prices and wage rates (cost push inflation) in the period from 1984 to 1998, as compared to demand pull factors in the 1973-1983 period Roberts and Malikane (2005) - critique the narrow focus of inflation targeting, which is premised on the prevalence of demand pull causes of inflation, when in fact inflationary pressures may be due to cost push factors and highlight the negative welfare effects of high inflation on goods purchased by low income households such as health care, education and food Bhorat and Oosthuizen (2006) - studied the differential impact of inflation on rich and poor South African households, showing the effects of distinctive ‘democratic’ and ‘plutocratic’ weightings of the Consumer Price Index. Bhundia (2002) - shows that with regard to the impact of exchange rate shocks on inflation in South Africa, that inflation is more responsive to nominal shocks, when the currency depreciation was associated with loosening of monetary policy, than to real shocks when the currency appreciated in response to tighter than expected fiscal policy and a slow down in growth in the global economy

8. Comparable International Studies North America: –Blinder et al, “Asking about prices: A new approach to understanding price stickiness”, 1998 –Amirault et al. “Survey of price setting behaviour of Canadian Companies”, 2006 European Union: –Since the year 2000 a number of recent survey and micro data studies have been conducted under the auspices of the European Central Bank’s Inflation Persistence Network, including for Spain, France, Portugal, Germany, Austria, Belgium, Holland and Italy, including Loupias et al, 2004 and Alvarez and Hernando 2005, Baudry et al, 2004, Dias et al, 2005 Other: –Hall et al, “How do UK companies set prices?”, Bank of England Quarterly Bulletin, 1996 –Baharad and Eden, “Price Rigidity and Price Dispersion: Evidence from Micro-data”, Israel, 2003 –Kovanen, “Why do prices in Sierra Leone Change so often? A case study using micro-level price data?”, IMF Working Paper, 2006

9. 4. Details of Survey of Price Setting Conduct Overview It is envisaged that the survey would include face-to-face interviews with 100 business decision makers drawn from a representative sample of the targeted component of the GDP. There will be a pilot survey of 10 interviews. The objective of the survey would be better to understand price setting behaviour in South Africa, both: –of how frequently prices are changed and how quickly prices respond to cost shocks and demand shocks, and –an assessment of the validity of various economic theories of price setting behaviour from the angle of price setters themselves. Positive aspect of interview method - assist in assessing otherwise non- observable issues such as the existence of implied contracts and the impact of such implied contracts on pricing Limitations of the interview methodology - results can be sensitive to the wording of questions, as in this case where theories of price setting are to be de-jargonised and written in plain language.

10. Survey Sample Selection The targeted survey sample will be the private, for-profit, un-(price)- regulated, nonfarm component of the GDP, which in the US amounted to about 71% of total GDP and in South Africa would amount to about 67% of the GDP broken down as follows: –Manufacturing - 28% –Construction - 4% –Wholesale and Retail trade, catering and accommodation - 22% –Transport Storage and Communication - 15% –Finance Insurance and Real Estate - 31% Following Blinder et al (1998) the exclusions are explained as follows: –focus is on the private sector as theories of price setting are used to explain behaviour of profit maximizing firms, –the price-regulated sector is excluded as in this sector price rigidity is either trivial to explain (as flexibility is illegal) or requires a complex theory of government regulatory behaviour, and –farms excluded as farm prices are not perceived to be sticky.

12. Substance of Survey -Firstly, price setters would be asked a number of descriptive questions to ascertain their pricing practices, including the frequency of price reviews and how responsive price setters are to changes in costs and changes in demand. -Secondly, price-setters would be asked to score, from 1 to 4, the importance of a limited number of theories of price setting behaviour in explaining their firms price setting, with a score of: -1 the theory is rated “totally unimportant”, -2 the theory rated “of minor importance”, -3 the theory rated “moderately important”, and -4 the theory rated “very important”.

13. Theories to be tested Some of the theories to be tested will be drawn from those used in Blinder et al’s 1998 study and other’s will be selected due their a priori relevance to South Africa’s economic conditions. From Blinder’s study, the top rated theories of pricing behaviour were: – coordination failure (where firms hold back on price changes, waiting form other firms to go first), –cost-based pricing (where price rises are delayed until costs rise), –nonprice competition (where firms vary nonprice elements such as delivery lags, service or quality) and –implicit contracts (where firms tacitly agree to stabilize prices, perhaps out of “fairness” to customers). Moderately rated theories of price setting were: -nominal contracts (where prices are fixed by contracts), -costly price adjustment (where firms incur costs of changing prices), -procyclical elasticity (where demand curves become less elastic as they shift), and -pricing points (where certain prices - like R99,99 - have special psychological significance). Poorly rated pricing setting theories were: -constant marginal costs (where marginal cost is flat and markups are constant), -inventories (where firms vary inventory stocks instead of prices), -hierarchy (where hierarchical delays slow down decisions) and -judging quality by price (where firms fear customers will mistake price cuts for reductions in quality).

14. South African specifics Given South Africa’s economic conditions, other approaches to price setting to be considered for incorporation into the survey would include the following: - whether pricing decisions are aligned to the stated inflation target - whether pricing decisions take into account future inflation - whether price adjustments are more likely when inflation is high and that there is likely to be no adjustment when inflation is low - whether changes in interest rates impact on price setting conduct - the manner in which wage setting impacts on price setting conduct - the extent of backward lookingness or indexation prevalent in price setting - whether prices are raised in order to reach revenue targets in the context of decreased demand, - on the impact of exchange rate volatility on price setting conduct, and - possible questions on the impact of import parity pricing and the impact of trade liberalisation.

15. Survey Results The survey will reveal two sets of findings: descriptive findings and theory-evaluation findings. Descriptive findings for South Africa will include an estimation of how frequently prices are adjusted in the South African economy, and an estimation of how long are the lags in price adjustment following a cost or demand shock. Blinder et al’s 1998 descriptive findings for the frequency of price changes the US economy is that there is significant price stickiness as about 78% of the relevant sample of the GDP is repriced quarterly or less often, as per Table 2 on the next slide. Also how how long it takes for prices to adjust after a demand or cost shock, as per Table 3 The survey will also include an open ended question about why prices are not changed more frequently, which leads to difficult characterization problems, but has the advantage that “it gives respondents a chance to choose their favourite explanation for price stickiness before their minds are contaminated by hearing any other suggestions”.

17. Survey results Theory-evaluation findings will include an evaluation of the applicability of competing theories of price setting behaviour in the South African context. Such findings will be presented on an aggregate basis as well as on a by industry basis. Analysis of survey data would include an ordered probit analysis of the survey results to assess how the observable attributes of various firms assist in explaining the importance which price-setters attach to each theory of price stickiness. For example, Blinder et al (1998), found that firms in the construction and mining sector are unlikely to regard adjustment costs (or menu costs) as an important reason for price stickiness, as follows: The Importance of Menu Costs (Theory B8) = – 1,84 CON – 1,46 RETAIL – 0,57 WHOLESALE + 0,46 FLATMC – 0,35 CYCLICAL + 0,008 CONSUMER – 0,15 WRITTEN – 0,48 LOYAL Perhaps because construction firms work to order. In addition firms with written contracts are less likely to perceive adjustment costs as an important source of price rigidity.

18. 5. Details of micro-data analysis South Africa’s CPI data An empirical analysis of the large sample unit level or micro-data set of the Consumer Price Index (CPI) is proposed, which will allow findings to be made on the following issues: –the frequency of price changes (and the related duration of price setting) in the South African economy, and –the size and direction of price changes in the South African economy. (Broadly the methodology adopted by Alvarez and Hernando, 2004 is to be followed.)

19. Frequency of price changes This study will for the first time produce a set of results for South Africa comparable to Table 4’s results for Spain (from Alvarez and Hernando, 2004) This shows findings as to the frequency of price changes (measured in terms of the average proportion of prices changing each month over the most recent 45 month period for which data is available from Statistics South Africa). For example, in Table 4, 50% of unprocessed food prices change each month, with 26% of unprocessed food prices rising each month and 23% of unprocessed food prices declining each month. The study will also enable findings as to whether price setting is asymmetrical or symmetrical upwards and downwards. A finding will also be made as to whether the frequency of price setting is homogenous or non-homogenous across product categories. An analysis of factors influencing the frequency of price setting is also proposed, including such factors as seasonality, the prevailing rate of inflation, preference for round prices, changes in excise duties, exchange rate developments (not included in Alvarez study), and interest rate developments (not included in Alvarez study, but which could assist in analyzing the cost channel aspect of South Africa’s transmission mechanism).

21. Size of Price changes Findings for the first time for South Africa will include, both for the CPI as a whole and the main components of CPI: –the average percentage change in prices for all items, –average price increases, and –the average price decreases (assuming a maximum of one price change per period). (See comparable results for Spain in Alvarez et al’s Table 5) An analysis of factors influencing the size of price changes is also proposed, including such factors as seasonality, the prevailing rate of inflation, preference for round prices, changes in excise duties, exchange rate developments (not included in Alvarez study), interest rate developments (not included in Alvarez study).

23. 6. Modeling implications of price setting behaviour for optimal conduct of monetary policy An important objective of the research is formally to show the implications of the finding on price setting behaviour in South Africa for the optimal conduct of the country’s monetary policy. A model such as that developed by Altissimo et al (2006) can be used to show that in comparing situations of high and low degrees of price rigidity, monetary policy should be less aggressive in the face of cost push shocks in order to achieve optimal output, interest rate and inflation outcomes. In this regard, the minimization of a loss function is used to assess the optimal conduct of monetary policy. For example, the following loss function penalizes deviations from employment, inflation and output growth targets: L = a 1 (U-U*) 2 + a 2 (P- P*) 2 +a 3 (Y-Y*) 2 where a 1, a 2, a 3 >0. Altissimo’s model (2006) uses a variation of this loss function, as it places a dominant weight on inflation stabilization (0,85) and smaller weights on the stabilisation of the output gap (0,075) and the interest rate changes (0,075).

24. Modeling policy implications The Altissimo et al model is based on a Phillips Curve, IS curve and Taylor rule, as follows: Phillips curve: IS Curve: Taylor Rule: Where: Π = inflation, y = the output gap, E = expectations operator, u = a cost push shock, ε = a demand shock, r = the policy rate, κ = the degree of response of inflation to output, σ = variance of cost push shocks, λ = extent of interest rate smoothing by authorities, and γ = proportion of backward looking or price-indexing firms

25. The workings of the model The model responds to a cost-push shock u (typically a single standard deviation increase in prices) as follows: -an increase in prices (due to u) leads to an increase in inflation  (Phillips Curve relation) -the increase in  lead to an increase in the policy interest rate r (Taylor rule) -this leads to a restraining of output growth y (IS curve) -which ultimately leads to reduced pricing and containment of inflation (Phillips curve).

26. The effect of price stickiness and backward indexing of prices The degree of price stickiness affects the response of inflation to output variations, κ. With stickier prices being associated with smaller κ values. As indicated by the following Diagram, the model has different outcomes depending on whether the degree of price stickiness in the economy is low (prices set for two quarters), medium (prices set for three quarters) or high (prices set for four quarters) (associated with smaller κ values). The diagram indicates the impact of the degree of price stickiness on the response of output, inflation and the nominal and real policy rates. The model also provides for analysis of the optimal conduct of monetary policy in the context of varying degrees of intrinsic inflation persistence (indicated by γ in the model). Intrinsic inflation persistence increases with the increase in the degree of backward-looking indexation with reference to previous inflation in price setting (associated with rising γ in the model).

28. Why do price rigidities matter? There are two key reasons why a higher degree of price stickiness implies a less aggressive monetary policy reaction. –Firstly, due to price stickiness a given increase in the nominal interest rate will have a larger effect on the real rate and on output. –Secondly, with higher price stickiness credible monetary authorities have a greater incentive to smooth out their policy response (to avoid the sacrifice ratio without risking inflation), resulting in smaller initial output gap response, but one which is prolonged and cumulatively significant.

29. 7. Conclusion Findings concerning price setting behaviour in the South African economy will be used to calibrate a model appropriate to South African conditions. This will enable a detailed discussion on how price setting behaviour can be shown to impact upon the optimal conduct of monetary policy in South Africa, particularly in the context of cost-push shocks. The research will conclude with an integration of the theoretical and empirical results into a discussion about the optimal conduct of monetary policy in South Africa.