Taylor Rule keeps signaling prime 10%-11%

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By Cees Bruggemans

The Taylor Rule is a simple device suggesting appropriate current short-term interest rates, given a long-term real interest rate and premiums or discounts reflecting the presence of any inflation gaps and/or output gaps.

Though policy does not have to follow Taylor Rule advice precisely, there is nonetheless a lot of shadowing going on, for a simple reason. Central banks are trying to eliminate (simultaneously solve) both shaping inflation gaps and output gaps (whether positive or negative) while maintaining real interest rate benchmarks.

On this score the present moment still shows high CPI inflation of 8.6%, but already a much reduced forecast of 5% CPI inflation by 2Q2010, even as the present recession is tracing out a sizeable output gap (the difference between where GDP actually is and where it could have been, given resource capacity).

It gives the following Taylor Rule:


But even when we think six months out, and take into account the then ruling expected CPI inflation rate of 5.5%, a slightly upped CPI forecast of 5.5% by 4Q2010 and a similar output gap, the results are not startlingly different. Much, though, depends on inflation still coming off by up to 3% in the interim. Without this gain, Taylor would advice higher interest rates now.

Taylor by September 2009, given current assumptions:


Thus our financial markets are currently quite right in not accepting the current prime interest rate of 13% as our final end destination, provided the expectation of further falls in our inflation rate proves correct.

As to how the SARB wants to achieve this lower level of interest rates, there are seven MPC meetings left this year, suggesting we will hit a cyclical trough in interest rates by 3Q2009, even as the economy is still in recession and only gradually preparing its likely exit from about 4Q2009.

Though GDP should be gaining again by 4Q2009 on present projections, it will be doing so with the actual level of GDP considerably below the level of potential GDP, and likely to remain so throughout 2010 even as the economy gathers pace.

It is the combination of expected further reductions in CPI inflation and a lingering output gap that will make low double-digit prime interest rates through 2010 most likely.

In turn, this should not only encourage economic recovery and recovering corporate earnings at low inflation, but it should also provide renewed encouragement to asset prices (housing, equities).

However, change the projected inflation through 2010, and so will Taylor’s advise.

The SARB will keenly follow the actual inflation outcome and the actual condition of the economy, but also the changing CPI projections over time in order to decide an appropriate interest rate level.

If the past is any guide, SARB may to choose to lag conservatively any outcomes, possibly just to be sure, and preventing too exuberant a spending and asset price adjustment to both lower inflation and interest rates.

By Cees Bruggemans, First National Bank, March 30, 2009.


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