Taylor’s Rule: too high, too low – where should interest rates go?

Taylor’s Rule is an interest rate forecasting model invented by John Taylor in the early 90s. And according to Investopedia “it’s a proposed guideline for how central banks should alter interest rates in response to changes in economic conditions.” In South Africa, the Reserve Bank’s mandate is very topical at present, which in turn sets up a discussion around interest rates. SARB’s current mandate is tailored around a targeted inflation band of 3-6%, with the repo rate currently at 6.75%. The analysis below uses Taylor’s Rule, to determine that the rate is too high, and should be lowered more than an expected 0.25%. But lower interest rates in theory lead to an outflow of funds and a weaker currency, which in turn creates upside to inflation. Hence SARB’s decision. The contrasting view is that the economy needs a boost, 3.2% contraction in the first quarter, so lowering rates would solve part of that problem. The expected outcome there is that a lower rate will in effect give people more money in their hands, and by spending more would fuel a recovery. Either way you look at it, it’s a fascinating debate that has no simple answer. The below assessment is by a team of analysts who work under the pseudonym of John Maynard. – Stuart Lowman

Are interest rates too high in South Africa, and does the South African Reserve Bank (SARB) mandate have anything to do with this?

By John Maynard*

With all the controversy surrounding the ruling party’s apparent decision to expand the mandate of the South African Reserve Bank (SARB) to include growth and employment as part of their mandate, we take a look at South Africa’s current interest rates as set by the SARB monetary policy committee (MPC) after the disasterous GDP numbers for South Africa released yesterday and find our interest rates are far above suggest levels.

The question is whether this is due to SARB’s current mandate or a misinterpretation of SARB’s mandate by the MPC itself?

So what exactly is the mandate of the South African Reserve Bank?

Below is the official mandate of the South African Reserve Bank as found on their website:

Mandate

The Reserve Bank is required to achieve and maintain price stability in the interest of balanced and sustainable economic growth in South Africa.

The achievement of price stability is quantified by the setting of an inflation target by Government that serves as a yardstick against which price stability is measured. The achievement of price stability is underpinned by the stability of the financial system and financial markets. For this reason, the Bank is obliged to actively promote financial stability as one of the important determinants of financial system stability.

At present, sections 223 to 225 of the Constitution of the Republic of South Africa, 1996, the South African Reserve Bank Act, 1989 as amended and the regulations framed in terms of this Act, provide the enabling framework for the Bank’s operations. The Bank has a considerable degree of autonomy in the execution of its duties.

In terms of section 224 of the Constitution, 1996, “the South African Reserve Bank, in pursuit of its primary object, must perform its functions independently and without fear, favour or prejudice, but there must be regular consultation between the Bank and the Cabinet member responsible for national financial matters.” The independence and autonomy of the Bank are therefore entrenched in the Constitution.

The Bank has been entrusted with the overarching monetary policy goal of containing inflation. The Bank can use any instruments of monetary policy at its disposal to achieve this monetary policy goal. This implies that the Bank has instrument independence in monetary policy implementation but not goal independence in the selection of a monetary policy goal.

The Governor of the Bank holds regular discussions with the Minister of Finance and meets periodically with members of the Parliamentary Portfolio and Select Committees on Finance. In terms of section 32 of the South African Reserve Bank Act, 1989, the Bank publishes a monthly statement of its assets and liabilities and submits its Annual Report to Parliament. The Bank is therefore ultimately accountable to Parliament.

Is there scope for changing the South African Reserve Bank’s mandate?

Absolutely. A large number of central banks across the world has more than one focus area when it comes to monetary policy. The US Federal Reserve being one. The US Congress established three key objectives for monetary policy in the Federal Reserve Act: maximising employment, stabilising prices, and moderating long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve’s dual mandate.

The mandate of the Reserve Bank of New Zealand was recently amended. Below more details about the recently adjusted mandate of the Reserve Bank of New Zealand.

“On 1 April 2019, amendments to New Zealand’s monetary policy framework came into effect. The amendments to the Reserve Bank of New Zealand (RBNZ) Act 1989 (“the Act”) added an employment objective to the RBNZ’s long-standing price stability objective, and created a formal Monetary Policy Committee (MPC) with members internal and external to the RBNZ. The amendments also articulated the Act’s overarching purpose, which is to promote the prosperity and well-being of New Zealanders, and contribute to a sustainable and productive economy. ” – This was obtained from the new Monetary Policy Handbook as found on the RBNZ’s website.

But some local economists and market commentators might even say that there is no need to amend SARB’s mandate, as the current mandate already allows for a broader interpretation especially the reference made to balanced and sustainable growth. However the SARB MPC is purely focused on price stability that SARB implements via inflation targeting. And a big problem with this is their inflation expectations (which is partly informed by sending inflation questionnaires to labour unions, businesses etc). The fact that unions are surveyed has to be questioned as they tend to push for well above inflation increases, which skews the inflation expectations of SARB upwards. So with unions pushing up inflation expectations and the fact that the SARB’s inflation forecasting model has proved relatively poor in terms of forecasting longer term inflation, one has to wonder about the inputs into SARB’s quarterly projection model (QPM) and the impact that this has on the final monetary policy implemented by the MPC.

According to SARB’s own projects they expect a interest rate cut in late 2020 or early 2021. See the repo fan chart forecast below.

While many South African’s would be relieved about a potential interest rate cut of 25 basis points coming (repo being cut from 6.75% to 6.5%) towards the end of 2020, based on our calculations and estimates of Taylor’s rule, our interest rates should be cut far more than just 25 basis points expected by the MPC. So what is Taylor’s rule and what does it say about South Africa’s interest rates?

Applying Taylor’s rule for South Africa

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:

  • 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).

So how did we calculate Taylor’s rule’s estimates? All data was converted into quarterly data since the GPD data is published quarterly.

  • 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.

The line chart below shows our actual interest rate (REPO rate) per quarter as well as the interest rate suggested by Taylor’s rule. And it is clear that based on Taylor’s rule interest rates are far higher than they should be in South Africa.

The view of interest rates being far to high is not one just held by us. On 27 August 2018, Dr Roelof Botha, economist at Optimum-group wrote in Beeld that SARB is 150 basis points above where it should be. On RSG radio he said after the release of South Africa’s latest GDP figures, which showed the economy contracted by -3.2% in the first quarter of 2019 when compared to fourth quarter of 2018 that interest rates should be 200 basis points lower than the current rate

The latest GDP number which we will discuss in more detail below should be of serious concern to President Cyril Ramaphosa and government. Without growth, rising unemployment and increased poverty levels will not be addressed. Perhaps it’s time to stop with the policy drift and start pushing and implementing pro-growth policies, otherwise South Africa’s economy will continue to stumble along aimlessly. The image below shows the quarter on quarter seasonally adjusted and annualised growth rates for various sectors of the South African economy.

So 7 out of the 10 main sectors in the South African economy recorded declines in economic activity in quarter one of 2019, when compared to quarter four of 2018. A big part of why South Africa’s economy is struggling is due to struggling consumers. And why are consumers struggling? High levels of debt, high interest rates, increased tax burden on consumers with government continuously raising taxes (think sin taxes, fuel levy, road accident fund levy, VAT that pushed up a few years ago) and adding new taxes such as the carbon tax added to the latest fuel prices, rising unemployment to name but a few reasons. There is just no excess money in consumers pockets that they can spend that will increase demand in the economy and starts creating a bit of growth.

Now if interest rates were 225 basis points lower, at say 4.5% as suggested by Taylor instead of the 6.75% it is sitting at now South African consumers will have a lot more money available to spend and start stimulating economic growth in South Africa. And this is part of the reason the ruling party, unions, economists and others are starting to take a long hard look at SARB’s mandate and whether it should be expanded in order to ensure monetary policy actually assists in facilitating growth in the economy, and not kill it with excessively high interest rates. We have shown before that if South Africa’s monetary and fiscal policy is coordinated growth achieved is higher than when they not coordinated and working against one another.

So before running for the hills and worrying about SARB’s independence, ask whether SARB is currently interpreting and enforcing their mandate correctly, and if not, should it be amended (as New Zealand’s was) in order to ensure that monetary policy takes into account more than just inflation targeting.

  • John Maynard is the nom de plume of an independent economist who is obsessed with official statistics – and uses these facts to blast through misleading narrative and propaganda. For more of his unique insights click here.