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What does the Taylor rule suggest for interest rates?

Economics Weekly: Economic Research and Analysis

What does the Taylor rule suggest for interest rates?

Interest rates to diverge?
Interest rates are likely to be on divergent trends in the US, Germany and UK in coming months. Fast growth in the US is leading the Federal Reserve, the US central bank, to raise interest rates from exceptionally low levels two years ago to more ‘normal’ levels now. In the UK, interest rates are poised to be cut, and the financial markets are betting that they will end 2005 at 4% to 4.25% from the current 4.75%. But in Europe, the ECB has repeatedly said that it will not cut interest rates even with Italy in recession and, indeed, it warned that the next move in interest rates may be upward. What is going on? We comment on these trends in this week’s briefing.

Taylor rule helps focus on key issues
One way of analysing interest rates is through the Taylor rule. This uses inflation relative to its target or long run average, short term interest rates relative to its long run average and the amount of capacity in the economy to predict what central bank or official short term interest rates should be for these conditions. The US, UK and EU, the countries we concentrate on in this analysis, have experienced very high and very low interest rates in the last two decades, see charts below. These show that the Taylor rule tracks the actual central bank interest rate very well. And they are currently suggesting some interesting outcomes that perhaps have not been fully taken into account by the financial markets.

US interest rates & the Taylor rule
In the US, it is clear why interest rates are rising; economic growth in the last three years has meant that the economy has no spare capacity left. In our calculations, implicit in chart A, the US has a positive output gap of over 1% of gdp, meaning that the current pace of growth is too fast to be sustainable without generating significant inflation at current interest rates. Although this has not yet led to a rapid rise in average earnings or consumer prices, unit labour costs are rising quickly, implying that price inflation could also quickly build if companies had pricing power. So although price inflation currently remains modest, relative to the 3% long run rate (this was at a 2.5% annual rate in 2005 Q1), the danger is that it will rise in the year ahead if interest rates are not increased rapidly. Our calculation of the Taylor rule is suggesting that a rate of 4.5% would be sufficient to contain price inflation. But since they are only at 3.25% presently, that implies a further 1.25 percentage points of interest rate tightening is required. This is something that financial markets have perhaps not yet factored in fully.

UK interest rates & Taylor rule
For the UK, the current sub trend pace of economic growth implies that the economy has a negative output gap. That means interest rates, according to the Taylor rule, can be cut by a modest ¼%, even with price inflation at the 2% medium term target. However, the range for UK interest rates is very narrow, because if inflation rises further or there is an economic recovery in 2006, then the Taylor rule suggests that interest rates should be raised as with inflation currently at 2%, it could then ratchet higher quite quickly if growth picks up. Of the countries analysed, the UK’s monetary policy stance is the closest to matching the interest rate suggested by the Taylor rule, see chart B.

ECB rates & Taylor rule
In the case of the ECB, the wide gap between the actual interest rate and the Taylor rule rate clearly shows that the ECB may be right to call for higher interest rates as soon as possible. Even though the trend of both series has been sharply downward, a large gap still exists between the actual interest rate and the Taylor rate, see chart C. But that does not mean that it would be the right rate for many of the economies that make up the euro zone. The reason why the Taylor rule suggests that interest rates should rise is that in order for price inflation to meet the ECB’s target of 2% or below, eurozone interest rates have to be kept relatively high in real terms. Hence, the Taylor rule is suggesting that the repo rate should be at 4%. But the euro zone has a negative output gap of 1¼% of gdp, so in practice the ECB will probably not raise interest rates any time soon. However, it is equally unlikely to cut them, unless inflation fell well below 2%, which seems unlikely with oil prices at current levels.

Conclusion
The Taylor rule suggests that monetary policy should be tightened significantly further in the US, cut modestly in the UK and, if the output gap is given priority, kept on hold in the eurozone.

UK economic indicators
The minutes of the MPC meeting in July are important for how they voted to hold rates at 4.75% as a clue to the likely outcome at the August meeting, but the economic data are also key. Retail sales in June may have risen but only modestly, despite the hot weather. As a result, gdp growth for Q2, due Friday, may be only 0.4%, well below the trend of 0.6%. But the monetary data are still likely to show that growth in M4 remains rapid, suggesting that economic growth should soon recover. Slower economic growth is also likely to result in higher government borrowing; public sector data on Wednesday is likely to highlight that this may be occurring.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
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