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Tuesday, May 1, 2007
Taylor’s Rule

Reading between the lines, it is evident that only dire new events (oil or global financial shock) could possibly be capable of diverting the Reserve Bank from its long likely rate plateau of 9% (keeping prime at 12.5%). This is the view of Cees Bruggemans, Chief Economist at FNB.

Once again, last month the Reserve Bank maintained its repo rate. In this light Mr Bruggemans briefly mentions the so-called Taylor’s Rule.
Taylor’s Rule works best in large economies with efficiently operating markets (the US and Europe come to mind). In a small economy such as South Africa’s, structural rigidities and periodic financial market shocks tend to keep interest rates higher than the optimal level indicated by Taylor’s Rule.
However, interest rate levels in South Africa do seem to be in keeping with Taylor’s Rule, suggesting monetary policy is correctly aligned.
Taylor's Rule is a formula developed by Stanford economist John Taylor. It was designed to provide recommendations for how a central bank like the Federal Reserve should set short-term interest rates as economic conditions change to achieve both its short-run goal for stabilising the economy and its long-run goal for inflation.
Specifically, the rule states that the real short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors:
1. where actual inflation is relative to the targeted level that the central bank wishes to achieve;
2. how far economic activity is above or below its ‘full employment’ level; and,
3. what the level of the short-term interest rate is that would be consistent with full employment.

The rule recommends a relatively high interest rate (that is, a tight monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate (easy monetary policy) in the opposite situation.
Sometimes these goals are in conflict: for example, inflation may be above its target when the economy is below full employment. In such situations, the rule provides guidance to policy makers on how to balance these competing considerations in setting an appropriate level for the interest rate.

So, by applying Taylor’s Rule to South Africa Mr Bruggemans comes up with this:


Copyright © Insurance Times and Investments® Vol:20.4 1st May, 2007
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