Where Should Interest Rates Really Be? Applying the Taylor Rule to the World’s Central Banks.

The Taylor Rule is a formula widely used by central banks to determine how interest rates should change based on inflation, output, economic conditions and other factors. Since the start of the Great Financial Crisis in 2008, the world’s “G4” central banks – U.S., Japan, UK, and Europe have injected over $5 trillion of liquidity into the global economy. The U.S. Federal Reserve began “tapering” in December 2013, starting the process of exiting its quantitative easing program designed to keep rates low, stimulate borrowing and promote investing. Amidst signs that the global economic recovery is broadening and becoming more sustainable, market attention has begun to shift to whether less overall monetary accommodation is needed.

We applied the Taylor Rule to test the monetary policy stance of the G-4 central banks – testing each of them individually and making the results available below and conclude that policy for all but the Eurozone is too accommodative and that central bankers may have to respond more swiftly than many expect.

Taylor Rule 1.jpg

John Taylor devised the Taylor Rule in 1992 from the U.S. experience of the late 1980s and early 1990s. Interested readers can read its history and implementation in The Taylor Rule and the Practice of Central Banking, a Kansas City Federal Reserve research paper. (The equation and its explanation are at the bottom of this blog.)

This research paper says “the Taylor Rule can be seen as part of a broader movement in which commitment (and therefore credibility), transparency, and independence, replaced a culture of discretion, ‘mystique’ and occasional political influence.” It concludes by saying the Taylor Rule advanced the practice of central banking. Perhaps giving greater importance to it in the Fed’s monetary policy, Fed Chairman Janet Yellen has repeatedly pointed to the Taylor Rule as guiding her views on the proper stance of monetary policy.

To calculate our own Taylor Rule analysis for the G4 economies we collected inflation data, output gap estimates from the Organization for Economic Co-operation and Development (OECD), and central bank effective nominal interest rates. Here are our findings.

Taylor Rule 2.jpg

Taylor Rule Applied: U.S.

Pioneer has a constructive view of the U.S. economy for 2014. If our view on growth materializes, it could force the Fed to tighten policy ahead of what is currently priced into the market.

  • We believe the economy will pick up momentum in 2014 and grow above trend at approximately 3.0%, versus a consensus forecast of 2.7%. The Congressional Budget Office estimates U.S. potential GDP at 1.6%
  • We expect the economic recovery will broaden and be led by consumption, fixed investment, and exports.
  • We anticipate the effects from the fiscal drag of the government’s finances to dissipate from 1.8% in 2013 to between 0.5% – 0.8% this year.

Taylor Rule 3One can see in the chart above that underlying U.S. economic growth momentum is strong, as the economy, ex-government consumption, grew 5% in Q3 the strongest growth rate in nearly 30 years, while government’s consumption growth rate has fallen.

The Taylor Rule for the U.S. suggests monetary policy is too accommodative. Calculations indicate that given the cur-rent economic and inflation backdrop and steady, persistent diminishing of the output gap, the Fed should tighten monetary policy to 1.9% compared to the current Fed funds target rate of 0 to 0.25%. Currently, markets are pricing in the 1st rate hike in August 2015.

Taylor Rule Applied: EU

The EU has emerged from its second and most protracted recession since 2008.

  • We project the EU economy to grow 1.3% in 2014, slightly above consensus.
  • The ECB continues to warn that risks to growth re-mains to the downside taking some enthusiasm from the tenuous recovery.
  • The ECB remains deeply concerned over the prospects of deflation with inflation currently at a lowly 0.5% and forecasts inflation to remain below its 2% target for at least the next two years.

The Taylor Rule indicates ECB monetary policy needs to be more stimulative with rates at 0.1% compared with the cur-rent benchmark interest rate of 0.25%. While some would argue that monetary policy is appropriate, we would argue otherwise. The above backdrop will continue to put pressure on the ECB to implement conventional or unconventional monetary policy. We expect the ECB to cut the repo and deposit rate in the coming 2 quarters.

Taylor Rule Applied: Japan

Bank of Japan monetary policy is well known to be too accommodative. Despite this, we expect the BoJ to continue with ZIRP (zero interest rate policy) and aggressive QE over the next two years.

  • Of the G4 economies, Japan is the only one where growth is expected to be weaker in 2014 compared to last year. GDP will slow from 1.5% in 2013 to 1.4% in 2014.
  • The growth setback is due to the expected hit to private consumption from the April 1 consumption tax.
  • Despite the slowdown, growth will still be trend-like.

The Taylor Rule reveals that the BoJ benchmark interest rate should be at 2.5% rather than 0%. A rising inflation trend and a narrowing output gap are the factors behind the surprising hawkish number. We do not believe policy should be tightened, as the risks for reverting back to deflation still remain high. Nonetheless, this analysis does suggest the BoJ may need to be more nimble to reverse course if need be.

Taylor Rule Applied: UK

Similar to the U.S., our analysis of the Taylor Rule sug-gests UK monetary policy is too accommodative.

  • The UK economy is forecasted to grow 2.7% in 2014.
  • We expect the BoE to begin to tweak its forward guid-ance in anticipation of the transition from QE similar to what is happening in the U.S.

The Taylor Rule suggests the BoE benchmark interest rate should be at 2.7% rather than the current level of 0.50%.

The Investment Implications of Current Central Bank Policies

The economic recovery has begun to deepen in almost all countries with the exception of the Eurozone, which is still in early recovery mode. Except for the Eurozone, G4 central banks have kept monetary policy excessively loose for several years, inevitably increasing the risks of inflation, asset price bubbles, or imbalanced economic activity.

Our Taylor Rule analyses indicate that monetary policies remain too loose in three of the G4 nations. It is becoming increasingly clear that central bank policy makers will have to start the process of exiting overly accommodative monetary policies. Given current economic fundamentals, we believe the Fed and the BoE should be on the fore-front of removing excess stimulus, while Japan deserves a reprieve as it looks to escape from years of deflation.

We believe investors should not be complacent over re-cent stability in U.S. 10-year yields. Inevitably, financial markets will pivot to the next big theme on the horizon, the question of when monetary policy will tighten. As a result, we remain bearish on U.S. Treasury yields and warn investors about the risks of duration. Eurozone and Japanese sovereign bonds yields could decouple, as Japan’s monetary policy remains accommodative. Finally, we be-lieve a rising U.S. Treasury yield environment will also create a defensive environment for most emerging market assets, especially fixed income.


The Taylor Rule, which was based on the U.S. experience in the late 1980s and early 1990s, suggested that the federal funds rate (r) should normatively (with qualifications) be set, and could positively be explained, by a simple equation:
r = p + 1/2y + 1/2(p-2) + 2,
Where y represents the percent deviation of real GDP from trend and p represents the rate of inflation over the previous four quarters. With inflation on its assumed target of 2 percent and real GDP growing on its trend path of roughly 2 percent per year (so that y=0), the real ex post interest rate (r-p) would also equal 2.

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About Paresh Upadhyaya

Paresh Upadhyaya is Senior Vice President, Director of Currency Strategy, U.S. at Pioneer Investments. He joined Pioneer in 2011.
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