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Blog: 25 January 2017 (Taylors rule revisited)
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After the interest rate announcement by the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) to keep interest rates unchanged we have decided to relook one of the most popular topics on our website. Taylor's rule. A brief background on Taylor's Rule and it's aim follows:
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). |
So what is Taylor's rule saying about South Africa's interest rates and where it should be considering all of South Africa's economic variables and the environment it finds itself in now.
Based on available economic variables and making the assumption that the economy will grow at the same pace in Q4:2016 as it did in Q3:2016 we estimated a value for interest rates for Taylor's Rule up to Q4:2016. Essentially what Taylor's Rule is saying is that South Africa's current interest rates should be sitting at 7.7% and not at 7% as currently held by SARB. Therefore if Taylor's Rule was to be followed SARB would have hiked interest rates in their meeting that took place (23-24 January 2017).
Taylor should not be seen as a strict estimator of where interest rates should be, but should be used as a guide by analysts (both within and outside of SARB) in order to identify when there are large divergences between actual interest rates and Taylor's suggested interest rates. As large divergences tends to level out over time, largely due to sharp interest rate movements (both to the up and down side). In early 2009 for example Taylor signalled that interest rates should be a lot lower than the level it was at and within a few quarters there were signifcant declines in interest rates, bringing interest rates in line with Taylor's estimate.
By early 2012 Taylor indicated that interest rates should be at around 7.5% while they were sitting at levels around 5.5%. Sharp interest rate increases by middle 2015 to middle 2016 saw interest rates be in line with Taylor's estimate again.
However over the last few quarters there seems to be a growing divergence between Taylor and actual rates again, but due to the weak economic growth figures and subdued demand, we cannot see SARB raising rates in the near future, and we expect them to keep rates constant for a while still, during which SARB and the analysts would secretly be hoping that economic circumstances change and that Taylor's estimated level for interest rates drops signicantly and allows SARB to buy some more time, and hopefully allow enough room to allow for a interest rate cut or two middle to end 2017 to stimulate demand in South Africa's lacklustre economy.
However over the last few quarters there seems to be a growing divergence between Taylor and actual rates again, but due to the weak economic growth figures and subdued demand, we cannot see SARB raising rates in the near future, and we expect them to keep rates constant for a while still, during which SARB and the analysts would secretly be hoping that economic circumstances change and that Taylor's estimated level for interest rates drops signicantly and allows SARB to buy some more time, and hopefully allow enough room to allow for a interest rate cut or two middle to end 2017 to stimulate demand in South Africa's lacklustre economy.
