Labour Market Conditions, Positive Inflation Shocks and Policy Rate Responses
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This chapter extends the analysis of labour market indicators on inflation and repo rate adjustments by estimating various labour market conditions indices. Evidence shows that labour market conditions play an important role in the transmission and propagation of inflationary pressures and inflation expectations. The propagation role of labour market conditions is potent when labour market conditions are loose and inflation is above 6 per cent. As a result the policy rate is tightened aggressively when inflation is above 6 per cent and when labour market conditions are loose. In contrast, the policy rate adjustments are less aggressive when the labour market conditions are tight.
Evidence in the paper suggests that labour market conditions benefit from price stability and vice versa. Tight labour market conditions shocks lower inflationary pressures, and more so when inflation exceeds 6 per cent. In turn, the pace of the repo rate adjustments to inflationary shocks is slower and muted. This is consistent with the mandate of flexible inflation targeting.
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