Isolating a Measure of Inflation Expectations for the South African Financial Market Using Forward Interest Rates

Abstract

The inflation expectations channel of the transmission mechanism has generally become recognised as crucial for the implementation of modern monetary policy. This paper briefly reviews the practices commonly employed for measuring inflation expectations in South Africa and others a market-based alternative with advantages over existing measures. It is widely recognised that the yield curve contains some information about the future inflation expected by the markets. The availability of inflation-indexed bonds in South Africa for the past few years has provided an opportunity to use more recently developed techniques for isolating a measure of inflation expectations using the difference between nominal and real forward interest rates (inflation compensation). In this paper, the methodologies of Nelson and Siegel (1987) and Svensson (1994) are applied in order to determine a series of implied nominal and real forward interest rates. The difference between the nominal and real forward rates on a particular day are then determined, and this is used as a measure of the inflation expectations of the markets. This measure of inflation expectations should not be viewed as a substitute for other measures of inflation expectations, but should rather supplement these in order to offer an additional insight.