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In today's blog we take a look at what "Taylor's Rule" says about South Africa's current interest rates and where it is supposed to be sitting at. While the South African Reserve Ban (SARB) might not pay a lot of attention to Taylor, it is a useful indicator of whether South Africa's interest rates are in line with expectations and whether it is to high or low.
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So what exactly is Taylor's Rule?
Taylor's rule was developed and refined by economist John Taylor in 1993. It is used as a guide to show what nominal interest rates of a country should be based an various variables that include:
The actual formula being used:
Interest Rates= CPI + Equilibrium Real Interest Rates+ab*(CPI-CPItarget)+xy*(RealGDP-PotentialRealGDP). Where ab and xy are ratios (0.5 for both as recommended by Taylor). The line chart below shows South Africa's actual interest rates compared to what Taylor's rule suggests South Africa's interest rates should be.
- Inflation Target
- Actual Inflation
- Real GDP
- Potential GDP
- Equilibrium Real Interest Rates
The actual formula being used:
Interest Rates= CPI + Equilibrium Real Interest Rates+ab*(CPI-CPItarget)+xy*(RealGDP-PotentialRealGDP). Where ab and xy are ratios (0.5 for both as recommended by Taylor). The line chart below shows South Africa's actual interest rates compared to what Taylor's rule suggests South Africa's interest rates should be.
The average interest rate suggested by Taylor's rule over the period is 7.14% and the average Repo rate for the period is 7.17%, showing that the two series over the time span is very close, even though the magnitudes at different points in time differ significantly. Based on the graphic above South Africa's current interest rates are too low ( and they have been since the first quarter of 2011).
Based on Taylor's rule, South Africa's Repo rate should be at 6.7% , yet it is currently sitting at 7%, indicating that the South Africa is behind the so called "8 ball" when it comes to interest rate setting policy. Further proof of this can be seen by the fact that the Repo rate was slow to come down in 2003 when Taylor's rule's estimate was showing that interest rates should have been a lot lower than they actually were. And with South Africa's slowing inflation rate, and terrible economic growth, SARB will find it very hard to justify why it is not cutting interest rates. They are very quick to raise rates when it looks like inflation is heading towards the upper end of their target rate, yet in the past have been extremely slow in cutting rates when it has been well within the target of 3% to 6% for prolonged periods of time.
The biggest positive difference between Taylor's predicted interest rate and the actual Repo rate was 3.9%, when the Repo rate averaged 8.7% for the quarter (Fourth quarter of 2013), yet Taylor's rule suggested it be 4.8%, and the biggest negative difference was 2.5% when the Repo rate average 5% for the quarter (Third quarter 2013) yet Taylor's rule suggested it be 7.5%.
Based on Taylor's rule, South Africa's Repo rate should be at 6.7% , yet it is currently sitting at 7%, indicating that the South Africa is behind the so called "8 ball" when it comes to interest rate setting policy. Further proof of this can be seen by the fact that the Repo rate was slow to come down in 2003 when Taylor's rule's estimate was showing that interest rates should have been a lot lower than they actually were. And with South Africa's slowing inflation rate, and terrible economic growth, SARB will find it very hard to justify why it is not cutting interest rates. They are very quick to raise rates when it looks like inflation is heading towards the upper end of their target rate, yet in the past have been extremely slow in cutting rates when it has been well within the target of 3% to 6% for prolonged periods of time.
The biggest positive difference between Taylor's predicted interest rate and the actual Repo rate was 3.9%, when the Repo rate averaged 8.7% for the quarter (Fourth quarter of 2013), yet Taylor's rule suggested it be 4.8%, and the biggest negative difference was 2.5% when the Repo rate average 5% for the quarter (Third quarter 2013) yet Taylor's rule suggested it be 7.5%.
So what is Taylor's rule telling us about the future movements of the Repo rate? Based on the current graphic the South African Reserve Bank is behind where they should be in terms of interest rate setting targets. We think a interest rate cut will be on the cards very very soon. If not at today's MPC meeting, odds are on for one at the next MPC meeting as the arguments for cutting rates are far outweighing the ones for keeping it constant or increasing rates.
Sadly we suspect SARB will continue to adopt a "wait and see" position before deciding to cut interest rates. South African consumers are under significant pressure and debt levels are continuing to rise as consumers are starting to take on debt to fund monthly expenses. And as consumers are a major driving force behind South Africa's economy, a slow down in their spending would naturally filter through to the economy that would slow down as a result too. So if SARB was bold, they would be giving South Africa's economy a massive shot in the arm with a interest rate cut tomorrow. But we suspect they will be conservative and continue the "wait and see" approach they have been adopting for the last few meetings.