Does the South African Reserve Bank follow a nonlinear interest rate reaction function?

- We explore the descriptive power of the Taylor rule.
- We use linear augmented and nonlinear versions of the Taylor rule.
- We evaluate the behaviour of monetary authorities in South Africa.
- The nonlinear approach rule leads to the reduction of the measurement errors by 150 basis points.
- Evidence of asymmetries in the reaction function of the South African Reserve Bank

This paper analyses the descriptive power of the different extensions of the Taylor rule. It also investigates whether monetary policy in South Africa can indeed be described by a linear Taylor rule or, instead, by a nonlinear rule. In particular, we extend the linear Taylor rule to a regime-switching framework, where the transition from one regime to another occurs in a smooth way, using a logistic smooth transition regression (LSTR) approach. The purpose of this paper is to evaluate the behaviour of monetary authorities in emerging countries, particularly in South Africa, in response to changes in macroeconomic variables over time based on LSTR model. In this sense, we empirically analyse Taylor-type equations for short-term interest rate in South Africa using quarterly data covering the period 1995:Q3-2011:Q4. Our results show that the nonlinear approach leads to the reduction of the measurement errors by 150 basis points in 1998 and 40 basis points in 2009. Moreover, the South Africa's monetary policy exhibits nonlinear patterns that better capture special events and unexpected contingencies and may contain relevant information rendering it applicable only to unusual conditions i.e., recession. Additionally, the presence of asymmetries in the reaction function of the South African Reserve Bank (SARB) requires disconnection from its automatic pilot rule and use of judgement to make decisions.