Taylor Rule spells interest rate trouble

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By Cees Bruggemans, Chief Economist of FNB.

After two years of persistent interest rate cutting, lowering prime from shock levels of 15.5% to balmy territory of 9% (the lowest since the late 1970s) it won’t be easy to welcome interest rate increases back into our midst.

Yet inflation forecasts a year out are flirting with 5% plus (compared to 3.5% now), our inflation and output gaps aren’t going to stand still (at least not indefinitely) and forecast risks are a moving feast.

With Early Bird observers calling for the first interest rate hike in 4Q2011, and with SARB this month making the Delphic utterance that “rates can be stable for some time, provided significant risks don’t intrude” (which can mean anything, right?), just what ARE the realities we should take into account?


The market has already started to roughly price in a 50% chance of a 0.5% rate increase in July, rising roughly to a 100% probability of this first rate hike happening in September. So the market is already saying the first 0.5% rate increase will come sometime in 3Q2011.

The market then discounts by more than 50% that the second 0.5% rate hike will happen by January 2012.

That’s somewhat faster than the relaxed view of only a few weeks ago that the first rate hike wouldn’t happen until 2012. Or SARB’s expressed view last week that rates could remain stable for some time, provided …….

So, What’s Up Doc?


In organs of state, also at central banks, one recognises policy discretion, possibly qualified as ‘bounded discretion’. This allows some human interference at the policy controls as understood, even if the central bank’s response function is recognisably anchored into some kind of inflation targeting framework.

Such limited discretion is technically AND politically always there (‘wriggle room’, Baroness Thatcher might have called it, thinking of George the Elder, who had a way of going ‘wobbly’ on her at exactly the wrong geopolitical moments).

This in contrast to strict policy rules (denying discretion or human interference, letting the cold facts doing the dictating).

One way of testing the ‘responsible or bounded limits’ of discretion is to keep one beady eye on inflation rule mechanisms, none more so than what that old trusted standby (the Taylor Rule) is telling us.

For however simple, Taylor’s concoction does not do a bad job of modeling central bank’s main response function when truly targeting inflation (in which of course an inflation ‘gap’ and an output ‘gap’ need to be resolved simultaneously). Except for that devilish difficult aspect called ‘higher considerations of state’ which doesn’t allow itself to be pigeonholed that easily.


With the Taylor Rule taking into account both the inflation gap and output gap in the economy, and after making simple 12-month forecasts (very much in the middle of the consensus ballpark), after which we can still give a nod to perceived risks, what is the prognosis?

Heads up, people, the prognosis is poor. And that’s without getting overly excited about ‘risks’ (mainly external commodity inflation shocks and the Rand).


There remain five SARB Monetary Policy Committee Meetings this year at which SARB can be expected to seriously consider the adequacy of interest rate levels.

During the January meeting last week, the basic data still looked reasonable, prompting what looked like a durable neutral stance (rates can remain stable for some time, provided …….).

In the case of the prime interest rate the basic real premium of 5.5% is assumed to be standard to every MPC assessment, being a function of our institutional fabric.

The CPI inflation forecast twelve months out (1Q2012) has moved higher towards 5.2%, giving a nominal prime target of 10.7%.

In order to address simultaneously the inflation gap (3.5%-4.5% = -1%) and the output gap (an estimated range of -2% to -3% of GDP) over the coming year, we can deduct -1.5% to -2% from the nominal prime target.

Thus prime could be in the range 8.7%-9.2%. The decision to keep rates unchanged, with the prime interest rate still at 9%, was a good one.

But how may these SARB decisions shape over coming MPC meetings?



One need not be a genius to see the drift of things in these rough estimates.

The first 0.5% rate hike could come earlier rather than later, even by mid-2010 (July) according to the above Taylor estimates, much earlier than most expectations, with the market since last week still pricing in ‘only’ a 50% probability by then.


Just about all analysts are convinced about the rise in CPI inflation from the present level of 3.5% to nearer 5.5%-6% in late 2012.

There’s a lot more argument about defining the size of the output gap. It reminds of what on occasion has been said by learned American judges regarding pornography: he can’t define it but he sure will recognize it when he sees it.

Something like that also applies to output gaps. Models projecting estimated potential GDP compared to likely GDP suggest a gap of -2% to -4% at present.

Everyday data show in some instances far greater distress and greater scope for increases in actual GDP before reaching full potential.

This includes manufacturing capacity utilization (80% compared to 86% max), road and rail capacity (not close to being fully utilized), building and construction tendering competition (cyclically extremely high), office and other space vacancies (cyclically high), and not least the availability for work of formally educated labour (some 1 million on a 9 million employed labour force – extremely high).

Electricity capacity, on the other hand, is fully used (but that’s a simple planning mistake rather than a genuine reflection of the state of the broader economy).

Indeed, the modeling estimates of the output gap still being ‘only’ 2%-3% of GDP feel rather low but the conventional mindset is cautious and inclined not to go too far beyond these model estimates.

Could the risks to the forecasts (actual inflation, inflation gap and output gap) still surprise to the upside or the downside?

Here one would like to know how global oil and food prices will still range (and become reflected here), where the Rand will still move (within a 6-8:$ range?) and how the output gap will move (probably shrinking very slowly as GDP growth may have difficulty over the next two years of outperforming its potential).

On balance those risks may still be neutral, but they could become more negative as the year progresses (thus also arguing modestly for a higher interest rate bias).

One takes notice of sentiment expressed at the MPC release last week that especially administered prices retain a high inflation bias. Political decisions in the public sector setting tariff increases apparently remain a major feature.


So would SARB raise rates by mid-July by 0.5%, prime rising to 9.5%, and another 0.5% hike by November 2011 or January 2012, prime reaching 10%?

The state of the economy (the output gap) in 2H2011 may not warrant such action, not even until deep into 2012 or even 2013.

Also, the government’s deep-felt wish for a weaker Rand, and policy actions of various kinds in recent months taken towards this goal, will not sit well alongside a monetary policy tightening of interest rates (and potentially firming the Rand anew).

If anything, therefore, it might suit to keep interest rates low at present levels (prime 9%) for longer even as market expectations change, hopefully in the process contributing to getting the Rand WEAKER rather than firming it further (even if that also might boost the inflation potential ……).

Yet the state of our forward-looking inflation reality may indeed warrant such Very Early Bird actions.

Raise those rates earlier rather than later, bearing in mind the erosion of real rates so far, and assuming we remain serious about inflation target containment (which I don’t doubt for a second that we do).


Even so, as ECB President Trichet said last week, the really important thing is to look through any commodity-induced inflation spikes to see whether second-round inflation effects (expectations) start to be triggered.

This is a nebulous region. One can potentially wait to see what actually happens with second-round effects (if it suits, to wait with firming rates, given the ‘fragile’ state of the economy). On the other hand, one can wait too long as well, given the nature of inflation expectations.


It is nice cutting rates. Raising them will be another matter altogether, especially if the real economy (output gap) is still not anywhere near potential.

But then the SARB is committed to keep inflation target contained, and interest rates need to be at a certain level to deliver this outcome over time.

It would be nice if we could rely on a little magic here, as apparently does happen from time to time elsewhere in our policy spectrum. Imagine for instance global commodity inflation perhaps somehow bypassing us this year, the Rand remaining a good inflation shield while not hurting our exporters too much (there’s a nice wish), real wage demands remaining deeply subdued (another great wish) and the lingering output gap more noticeably suppressing our inflation revival (plausible but don’t go overboard).

So yes, we could do with the combined might of Peter Pan and Harry Potter. Yet these two fine gentlemen may only remain chimeras (figments of the imagination) and Taylor our only stark reality.

Meanwhile, greater policy objectives (a weaker Rand, more vigorous GDP growth and employment gains) and uncertain inflation features (an externally-induced commodity spike, uncertain short-term second-round manifestations) may keep the policy horses restrained (and prime longer at 9% than what you would expect from these simple Taylor projections).

So the Very Early Bird (July) may get disappointed by the absence of big enough worms. But that somewhere during 2H2010 things could start to change sufficiently to get the policy tightening ball rolling is looking increasingly plausible.

Sad to say, given the still high indebtedness of many households, going by SARB data.

Source: Cees Bruggemans, FNB, January 25, 2011.

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