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The Taylor Rule

Many news reports over the first two months of 2007 noted some surprise at the behaviour of the Bank of England in its interest rate decision. The quarter point rise in the Bank's Base Rate in January caught some analysts by surprise: they had anticipated a rate rise in the first quarter of the year, but not quite as soon as January.

The reason for the rate rise was simple: inflation in the UK, as measured by the Consumer Price Index (CPI), was rising and in the last quarter of 2006, the Governor of the Bank of England, Mervyn King, had made it very clear that the Bank expected inflation to reach at least 3.0%, 1% over the Treasury set target of 2.0%. If inflation is rising then the Bank will look to increase the cost of borrowing, which aims to put the brakes on consumer spending and slow down the economy. In so doing, the hope is that inflationary pressures will ease and inflation will begin to rise at a slower rate.

The Bank of England: the Central Bank for the UK. The Monetary Policy Committee meets here every month to decide on the interest rate at which the Bank will lend to the rest of the banking system. This, in effect, sets the structure for interest rates across the whole banking system. Do the MPC work to some sort of rule when making such decisions or do they exercise far more discretion in their decision making? Copyright: A.Ashwin.

How far should rates rise?

Interest rate rises are a clear signal to the economy that inflation will not be tolerated. In theory, it is very straightforward: raise rates when you want to slow down price rises, and reduce them when the pressure on prices is off. In reality, the problem is how far interest rates need to be changed to bring about the desired effect. Is a quarter point rise sufficient enough warning to reduce inflationary pressure or will rates need to be increased further? If so, by how much - another quarter point, half a point, 1%, 2%? Will the rises be needed in stages or should it be made in one big hit?

This dilemma has faced decision-makers in central banks and governments, which still have control of monetary policy. In 1993, John Taylor, an economist at Stanford University in the United States, spent some time observing the behaviour of the Federal Reserve Bank of America's Federal Open Market Committee (FOMC), the equivalent of the UK's Monetary Policy Committee (MPC) at the Bank of England. Taylor's observations led him to put forward what has become known as the Taylor Rule. The Taylor Rule has been an influential idea since it was published. For many economists, the interest has been centred on the extent to which the rule is followed in interest rate decision-making around the world, if at all.

Is it possible to apply a rule to monetary policy decision-making? Copyright: Sparky, from stock.xchng.

What is the Rule?

There are a few terms that we need to make clear at the outset when looking at the Taylor Rule.

1. Nominal as opposed to real short term interest rates
2. Nominal as opposed to real gross domestic product (GDP)
3. Trend GDP or potential output

Short-term interest rates

Short-term interest rates refer to the rate of interest relating to debt that typically has less than 1 year to maturity. Examples of this type of debt include treasury bills and bank certificates of deposit. These types of financial instruments are the means by which financial institutions raise funds to help ease liquidity problems.

In the UK, the Bank of England has responsibility for setting interest rates. It does not set every interest rate but its decisions dictate their structure. The Base Rate, which it sets each month, is effectively the rate at which the Bank will lend to the rest of the banking system, which determines to a large extent the structure of interest rates in the economy as a whole.

• The nominal interest rate refers to the prevailing interest rate that exists at the time.
• The real interest rate differs in that it takes account of the level of inflation.

An example may best serve to illustrate this important point.

• The real interest rate reflects this change in the prices of goods and services.
• The real interest rate = nominal interest rate - inflation.

In our example, the real interest rate would be 5% - inflation (2%) = 3%.

Nominal as opposed to real GDP growth:

The concept here is similar to that above. Nominal GDP growth refers to the rate of change of the value of output of goods and services over a specified time period. This is expressed in what are called current prices. For example, the value of output of goods and services is the amount produced times the price of the good or service.

Assume that the only thing the economy produces are apples. In year 1, the output of apples was 1,000 and the price of each apple was 50p. GDP would be £500. In year 2, the number of apples produced increases by 100 but the price of apples also rises to £1. GDP in year 2 is now £1,100. The percentage increase in GDP is 120%.

Part of the reason for the large rise in nominal GDP is the fact that apples have doubled in price. In reality, there are only 100 extra apples produced, so the rate of growth of GDP is distorted by the fact that we have not taken into account price changes. We could amend this by expressing the GDP information in either the prices that existed at the beginning of year 1 or those that existed in year 2. If we express year 2's GDP in year 1's prices, we get a GDP of 1,100 x 50p = £550. The percentage growth in GDP now is 10%.

Real GDP therefore takes into account changes in prices when calculating GDP growth.

Potential Growth:

Potential growth and actual, or real, growth can differ. Potential growth is the trend growth in the productive capacity of the economy. In simple terms, potential growth can be estimated by looking at the drivers of output on the supply side of the economy. This is basically measured by the inputs of factors of production, labour and capital. The labour input will be dependent on the number of hours worked. The capital element is determined by the build up of physical capital that contributes to production. We can estimate potential output in simple terms by using a production function:

q = f (l + k)

This simply states that output (q) is dependent upon (f) the amount of labour and capital in the economy (l + k). This simplification does not tell the whole story, however. We have to consider the relative productivity of both capital and labour. To calculate potential output, we can use existing historical figures substituted into our production function and then extrapolate the result into the future.

Labour and capital - the essential drivers of economic growth. Copyright: A.Ashwin.

Real output is a measure of the level of GDP adjusted for inflation. Any difference between real and trend output tells policy-makers something about the extent of inflationary pressures in the economy. If real GDP is higher than trend output, it may indicate the existence of inflationary pressures (the economy will be overheating) and if lower than trend output, there will be downward pressures on prices.

This is referred to the 'output gap'. If the output gap is negative, it implies that actual output is less than potential output; if positive, it implies that actual output is above potential output and thus there are inflationary pressures in the economy. Estimates of the output gap in the UK vary but the well respected ITEM Club (Independent Treasury Economic Model), sponsored by Ernst & Young, estimate that the current output gap in the UK is negative at 1%.

A Brief Résumé of Monetary Policy

Over the last 50 years, policy-makers have had to face the problems that inflation has brought on most major western economies. Keeping inflation under some degree of control has been something that many governments have identified as a key aim of economic policy.

Monetary policy has been seen as one way in which this could be achieved but the problem is in knowing what sort of levers to adjust to achieve the desired outcome. In the late 1970s and early 1980s, the UK government tried to use targets of some definition of the money supply as the basis for operating monetary policy. This was accompanied by deregulation of financial markets and the explosion in the variety of and ease of obtaining credit. Whatever definition of the money supply was being used simply did not work as a measure.

In the latter part of the 1980s, the Conservative Government used the exchange rate as their anchor in the fight against inflation but that ended with the debacle with the pound exiting the Exchange Rate Mechanism (ERM) in 1992. Since that time, the UK government has placed more of a primary role of the interest rate in monetary policy.

Still the problems exist, however, in terms of just how far to adjust interest rates in response to the threat of inflationary pressure. The Bank of England and other central banks make no secret of the fact that they do not fully understand the precise effects that any change in interest rates is going to have on the economy. They will also be some uncertainty about the time lags involved between changes in interest rates and the effect on the economy. This is what the Bank of England has to say on the subject:

Source: How Monetary Policy Works - The Bank of England

The idea of 'leaning into the wind' with interest rates implies a more aggressive response in setting interest rates to maintain stability in inflation. Copyright: Rurik Tullio, from stock.xchng.

The Taylor Rule

John Taylor was observing the US economy and the work of the FOMC. Inflation in the US had come under a far greater degree of control in the 1980s when the FOMC was headed by Paul Volcker. Part of Taylor's conclusion was that the FOMC had reacted more aggressively to inflation than had occurred before 1979. His observations led to the notion of the interest rate-setting body 'leaning into the wind' when it comes to inflation. By this he meant being willing to raise rates more significantly in response to an inflation threat than had been the case prior to 1979.

Taylor suggested that the pattern of FOMC behaviour with regard to interest rates during the period 1979-1992 could be expressed as a formula which came to be known as the Taylor Rule. This formula is given below - it has been simplified a little but in essence captures the main flavour of his original work.

r = p + 0.5y + 0.5 (p - 2) + 2 (after Tobin, 1998)

In this formula, the following variables are expressed:

• r = the short term interest rate in percentage terms per annum.
• p = the rate of inflation over the previous four quarters. (Taylor used a measure known as the GDP deflator)
• y = the difference between real GDP from potential output.

Taylor made a number of assumptions about the US economy in this formula. He assumed that there was a target level of inflation, which he put at 2%. He also made an assumption that the equilibrium real interest rate was also 2%.

The formula offers a rule or guide to policy-makers about what the level of interest rates should be if there is a target for inflation of 2%. In effect, interest rates can be set in response to the deviation of inflation from the target and the deviation of real output from potential output. It suggests that the response to inflation or output being off-target should be met with a more aggressive response to monetary policy - this is the so-called 'leaning into the wind'.

How Accurate is the Taylor Rule?

Studies have shown that a number of countries seem to have patterns of interest rates that follow the Taylor Rule relatively closely. In reality, Taylor and other researchers appreciated that decision makers could not stick rigidly to such a rule because sometimes circumstances might dictate the need to apply discretion. Such circumstances might be when the World Trade Centre was attacked in 2001, the intervention in Iraq or a possible stock market collapse.

Taylor argued that whilst a rule gave a guideline to policy-makers, it also implied that any deviation from the rule had to be explained through a coherent and well-argued case and that such a discipline was helpful to overall monetary policy decisions. The Taylor Rule has provided researchers with a great deal of impetus to look at the whole way in which monetary policy decisions are arrived at. It also gives the financial markets the opportunity to be able to second guess the decision making of central banks and factor this into their thinking. As was seen in January 2007, however, central banks do not always behave in quite the way that analysts might expect!

References

• Tobin, J. (1998) Monetary Policy: Recent Theory and Practice. In Current Issues in Monetary Economics, Cowles Foundation, Yale University.
• Finding Our Potential - The ITEM Club Special Report, September 2006 [PDF, 512KB] (http://www.ey.com/Global/download.nsf/UK/Economic_Outlook_for_Business_-_report_09_06_-_Finding_our_potential/$file/EY_ITEM_Finding_Potential_Report_Sept_2006.pdf)
• The UK economy can go faster - E & Y press release (http://www.ey.com/global/content.nsf/UK/Media_-_06_09_29_DC_-_UK_economy_can_go_faster)