Central bankers like rules and one of their most widely used is the so-called “Taylor rule”. Named after economist John Taylor, this formula punches out an optimal short-term interest rate depending on how far inflation and economic output diverge from their “normal levels”. Specifically, it subtracts half the divergence of both numbers from a long-run real interest rate. It then adds expected inflation to get the result. Ben Bernanke is fond of the approach. It has also proved a fairly effective rate predictor. So how much does it suggest that European and UK rates should be cut this week?
Let’s do a dry run on the US first, assuming a long-run real interest rate of 2 per cent and “normal” – ie targeted – inflation of 2 per cent. The Organisation for Economic Co-operation and Development meanwhile provides estimates of the output gap, with core inflation data and consensus inflation forecasts completing the puzzle. Plug in the numbers and the rule suggests that US rates should be 3.5 per cent.
That is way above the Fed funds rate of 1 per cent. However, for most borrowers, the Federal funds rate is not their effective borrowing rate. Instead, it is closer to three-month dollar-Libor, currently at almost 3 per cent. Allow for that and the Taylor rule is close to the mark.
So what about the eurozone? Here the rule suggests rates should be cut by 25 basis points to 3.5 per cent. Again, this does not allow for ballooning credit spreads that have pushed up effective borrowing rates, in this case three-month euro-Libor, to 4.75 per cent. If spreads remain constant, to bring euro-Libor down to the Taylor-made rate, the European Central Bank should cut by 125bps.
However, it is in the UK where the rule suggests that rates need to be cut most – by 75bps to 3.75 per cent. Furthermore, to shrink three-month sterling-Libor to that level, the Bank of England should cut by a full two percentage points.
Every rule, even Taylor’s, has its limits, especially in these turbulent markets. Still, at the very least it shows that eurozone and UK interest rates need to come down – and fast.
For an interactive spreahsheet on the Taylor Rule click here
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