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How Appropriate is the Taylor Rule?

The Taylor Rule, established by economist John Taylor in 1992, tries to target a level for short term interest rates that will stabilise the economy whilst maintaining long term growth based on three factors:

Actual inflation levels

Full employment vs. actual level of employment

Short term interest rates consistent with full employment

This means the rule will recommend raising rates when inflation is high or employment exceeds the perceived level of full employment and vice versa. Like all economic models, it is only as good as the data input, in this case assumptions about the long run neutral rate and the cyclical position of inflation. Historically, however, the Taylor rule has proved a useful guide to the appropriateness of monetary policy.

The change in central bank rhetoric would indicate that we have reached an inflection point where historically accommodative monetary policy will start to be reversed through the tapering of quantitative easing measures then the raising of interest rates.

                                                                                                                                                                     Baseline Taylor Rule Estimate for United States

The US taylor Rule

                                                                                                                                                               Source: Bloomberg

At the peak of the financial crisis in mid-2009 the Taylor rule suggested that US interest rates should target a rate of -2%, but the Federal Reserve unsure of the effects of negative interest rates instead embarked upon a quantitative easing project designed to reduce the overall cost of credit by employing its own balance sheet. By 2013 the rule was advocating rates be raised to approx. +1% encouraging Chairman Bernanke to embark upon the first tapering of QE that caused the summer tantrum in the US Treasury market.

Today the Taylor rule suggests that rates should be nearer 3.75% in the US which is probably the largest disconnect between the theoretical normalisation of rates and actual interest rate policy sparking debate about where the peak in this hiking cycle will ultimately prove to be. For many the current neutral rate is believed to be around 2%, much lower than the historical average of nearer 4%, but probably explains the Fed’s new commitment to tighter policy despite the absence of wage inflation in the system. In any event it seems clear that fundamental models such as the Taylor Rule are pointing towards higher rates and the phasing out of QE.

The Fed is expected to announce balance sheet reductions in September leading to another hike in rates in December; The ECB to move to a reduction in QE during Q4 17, the Bank of Japan’s balance sheet growth is reducing; and the BOE surprised many with its more hawkish rhetoric of late leading the Gilt market to adjust its rate hike expectations in the UK. The causes of the higher levels of inflation in the UK are creating a greater divergence between actual and theoretical rates which may explain the difference of opinion in the future path of interest rates.

From the bond markets perspective the adjustment to higher rates will generate capital losses as yields move higher and if handled badly by policy makers negative sentiment could spread to other areas of the economy. Expect central banks to offer high levels of forward guidance and move forward very cautiously as they remove support from the financial markets.

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