INFLATION AND MARKET UNCERTAINTY IN SOUTH AFRICA

Comparison of the movements in the VIX index, the rand - dollar exchange rate and South African CPI inflation reveals a striking resemblance between them, raising the question as to whether or not there is an empirical relationship among them. The aim of this paper is to determine whether or not changes in market uncertainty, as reflected in the VIX index, influence South African inflation. Given that the VIX index reflects market uncertainty, its impact on the inflation rate may differ between times of heightened uncertainty and normality, thus suggesting the presence of multiple regimes. To cater for this possibility, the analysis first uses the general-to-specific procedure (including squared and cubed values of dependent and independent variables) with impulse indicator saturation dummies to look for non-linear behaviour in the form of statistically significant squared and cubed variables and clustered periods of outlier dummies that might reflect an alternative regime. Finding such periods, the analysis next uses a Markov-switching model to model this non-linear behaviour explicitly. The results show that market volatility as measured by the VIX indeed explains South African inflation. Moreover, as shown by the second regime of the Markov-switching model, when market volatility is elevated, its influence on inflation also increases.