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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).
- 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 graphic below shows the repurchase rate (REPO rate) as set by the South African Reserve Bank (SARB) and our Taylor's rule calculation.
From the graphic it is clear that the underlying trends are very similar even though the level and magnitude of movements are different. Based on our estimates for Taylor's Rule South Africa's interest rates were way to high at end of 2003 (based on the big differential between the actual REPO rate and Taylor's rule). This differential closed considerably and by the end of 2005 the two lines were pretty close. They remained very close until the first quarter of 2011, when divergence took place again.
- REPO Rate (Blue Line)
- Taylors Rule (Pink Line)
From the graphic it is clear that the underlying trends are very similar even though the level and magnitude of movements are different. Based on our estimates for Taylor's Rule South Africa's interest rates were way to high at end of 2003 (based on the big differential between the actual REPO rate and Taylor's rule). This differential closed considerably and by the end of 2005 the two lines were pretty close. They remained very close until the first quarter of 2011, when divergence took place again.
The divergence in 2011 continued and the two lines only started getting closer by the end of 2014. Perhaps this divergence between Taylor's rule and the actual REPO rate is why the South African Reserve Bank has been talking tough and continued with their interest rate increase cycle, even though inflation is currently driven by external factors (such as the drought in South Africa) and higher crude oil prices which has nothing to do with consumer spending. The average interest rate suggested by Taylor's rule over the period is 6.15% and the average Repo rate for the period is 7.11%, 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 to high, and that SARB MPC should have been cutting rates recently to accommodate the struggling economy.
Based on Taylor's rule, South Africa's REPO rate right now should be at 4.75% yet it is currently sitting at 6.5%, 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.
SARB MPC should clearly distinguish between Cost Push inflation and Demand Pull inflation. Cost push inflation is when inflation rises due to increased input costs in production and manufacturing. Prime example being fuel prices. The rise in fuel prices and the effect that has on inflation has nothing to do with consumers spending more.
Demand Pull inflation is a situation where increased demand for goods and services from consumers pushes up prices, as retailers and businesses look to maximize profits by pushing up prices when the demand for a good increases.
While raising interest rates are effective at deterring Demand Pull inflation, raising interest rates will not lower fuel prices so it will hardly have an effect on inflation caused by Cost Push factors. All it will do is make consumers spend less, which will impact on the levels of inflation of other categories and "hopefully" indirectly reduce inflation.
We believe SARB MPC will not raise interest rates. Why not? Well here's a few of our reasons:
1. Inflation still within the 3% to 6% inflation target
2. Current increases in inflationary trends are not consumer driven (Demand Pull inflation) but driven by external factors such as higher crude oil prices (Cost Push inflation)
3. Slow to now growth in the inflation and seasonally adjusted retail sales shows consumers spending is struggling
4. Strong relief in December 2018 petrol price will provide some inflationary relief in coming months CPI
While we believe SARB wont raise interest rates, and we feel strongly about that fact that they shouldn't raise interest rates. We have this sneaky suspicion that they will do exactly what we want them NOT to do and that is raising interest rates by 25 basis points from 6.5% to 6.75%, putting additional strain on already struggling South African consumers and its very weak economy.
Based on Taylor's rule, South Africa's REPO rate right now should be at 4.75% yet it is currently sitting at 6.5%, 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.
SARB MPC should clearly distinguish between Cost Push inflation and Demand Pull inflation. Cost push inflation is when inflation rises due to increased input costs in production and manufacturing. Prime example being fuel prices. The rise in fuel prices and the effect that has on inflation has nothing to do with consumers spending more.
Demand Pull inflation is a situation where increased demand for goods and services from consumers pushes up prices, as retailers and businesses look to maximize profits by pushing up prices when the demand for a good increases.
While raising interest rates are effective at deterring Demand Pull inflation, raising interest rates will not lower fuel prices so it will hardly have an effect on inflation caused by Cost Push factors. All it will do is make consumers spend less, which will impact on the levels of inflation of other categories and "hopefully" indirectly reduce inflation.
We believe SARB MPC will not raise interest rates. Why not? Well here's a few of our reasons:
1. Inflation still within the 3% to 6% inflation target
2. Current increases in inflationary trends are not consumer driven (Demand Pull inflation) but driven by external factors such as higher crude oil prices (Cost Push inflation)
3. Slow to now growth in the inflation and seasonally adjusted retail sales shows consumers spending is struggling
4. Strong relief in December 2018 petrol price will provide some inflationary relief in coming months CPI
While we believe SARB wont raise interest rates, and we feel strongly about that fact that they shouldn't raise interest rates. We have this sneaky suspicion that they will do exactly what we want them NOT to do and that is raising interest rates by 25 basis points from 6.5% to 6.75%, putting additional strain on already struggling South African consumers and its very weak economy.
So how did we calculate Taylor's rule's estimates? All data was converted into quarterly data since the GPD data is published quarterly.
Statistics South Africa (Stats SA) published the latest inflation numbers at 10:00 this morning and it came in at 5.1% , and the SARB MPC announces it interest rate announcement at 15:00 (22 November 2018)
- Real GDP: 2010 Constant Prices GDP at Market Prices
- Potential Real GDP: We adjusted Real GDP by the percentage of manufacturing under utilisation (see more regarding manufacturing on our manufacturing page), to estimate South Africa's potential GDP if manufacturing was running at full capacity.
- Inflation Target: We used the upper band (6%) of the Reserve Bank's 3% to 6% inflation target.
- Equilibrium Real Interest Rates: We used the average interest rate over the period as the equilibrium interest rate (and adjusted it with inflation to get the Equilibrium Real Interest Rate)
- Ab and Xy: We used 0.5 as suggested by Taylor.
Statistics South Africa (Stats SA) published the latest inflation numbers at 10:00 this morning and it came in at 5.1% , and the SARB MPC announces it interest rate announcement at 15:00 (22 November 2018)