South African interest rates: Guided by the Taylor Rule

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By Cees Bruggemans, Chief Economist of FNB.

When should interest rates be raised, if at all, and by how much?

As on past occasions, a simple Taylor Rule estimation can provide some guidance, taking into account the need for a real interest rate, both current and expected inflation a year out, a view of the output gap, and possibly a hint of risk bias.

Nearly all these data estimates are debatable. As former SARB Governor Tito Mboweni used to say, these forecasts are merely based on models and need not always be taken too seriously.

Yet these data estimates roughly reflect consensus thinking and market discounting, and presumably can be used as reference point for the likely reaction function of a forward-looking central bank.

But here we run into an interesting question. The Fed likes to use core inflation as it reference (for very good reasons) while the ECB is more inclined to use headline inflation.

The main reason for this difference is the likely behaviour of second-round effects in response to inflation shocks.

Using either estimate makes for some policy discretion, something that could well mark our next few months to a considerable degree.

As such I have done Taylor Rule estimations for both headline CPI inflation (which tends to be high this coming year), and did another exercise using core CPI inflation (which still tends to lag this coming year).

Both estimations are shown separately as Comment articles on the website today.

The difference in outcome is quite startling.

When using headline CPI, it turns out that even with a still large output gap the prime interest rate should already be at over 10%. Only if the risk bias for inflation had been benign would prime at present levels still be advisable.

In recent months SARB officials have indicated that risk bias for inflation is unfavourable, so that argument does not apply.

Therefore according to these estimates, interest rates are behind the curve and should be raised in stages shortly.

In contrast, when using core CPI inflation estimates there is still scope to leave interest rates unchanged at the present juncture.

It may well be that at its Monetary Policy Committee meeting SARB will refer to core CPI inflation as well as the still large output gap as reasons for keeping rates on hold this week.

If we move to future Monetary Policy Meetings, however, the picture changes steadily in the remainder of this year and into next.

When using headline CPI as reference, the Taylor estimates suggest target prime interest rates rising from over 10% in July 2011 to over 11% in July 2012.

It gives an indication of how much prime may have to rise over the coming 18 months from a level of 9% today.

In contrast, when using core CPI inflation, the target prime interest rate reaches 8.9% in July 2011, 9.4% in September 2011, 9.7% in November 2011, 9.9% in January 2012, 10.1% in March 2012 and 10.4% in July 2012.

These estimates suggest prime could be kept unchanged at 9% in July 2011, but be increased to 9.5% in September 2011, be increased further to 10% in January 2012 and be increased to 10.5% in July 2012.

Depending therefore on how SARB sees second-round inflation effects materializing and driving core and headline CPI inflation higher in coming quarters, it may decide on a strategy to tighten interest rates during various MPC meetings through mid-2012, using a variety of arguments that fall within these two ranges.

Either way, interest rates are going to rise. The only things in doubt is by how much and when.

The markets are discounting a 50% chance of the first 0.5% increase for this September (prime rising to 9.5%) and fully discounting prime 9.5% only by November’s meeting.

Thereafter follow more interest rate increases next year, prime reaching at least 11%.

Much of course will depend on events between now and every MPC meeting thereafter at which these decisions are made.

Source: Cees Bruggemans, FNB, May 11, 2011.

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