... how high, how soon?
Despite the RBA Governor’s recent frankness on a ‘normal’ level of interest rates, there is still conjecture about the extent and timing of the coming rate rises. Applying a ‘forward-looking Taylor Rule’ that takes account of targets and current expectations for inflation and unemployment strongly suggests that cash rates will rise by a further 1.5% to 6.25% and that we should expect cash rates at that level within 9 months.
The RBA Governor has warned that the cash rate is likely to rise from current low levels to more normal levels. A more normal level in the Governor’s eyes is defined by the Fischer theorem: a neutral or “equilibrium” real interest rate plus the expected rate of inflation. There is some ambiguity in these terms, but not much.
A neutral real interest rate in practice is likely to be a smoothed yield on indexed government bonds, currently around 3.5%. The rate of inflation might be the current rate or the expected rate [should be the latter, we believe], but by coincidence both are around 3%. So a normal interest rate might seems to be around 6.5%.
John Taylor is an ex-US Fed official now working in the US Treasury Department. Some see him as the likely next Chairman of the Fed. Ambition has led him to downplay his earlier work but he was in fact a pioneer in developing operational guides for central bank monetary policy decisions. His ‘Taylor Rule’ justifies varying the cash rate from normal levels according to the strength of the desire of a central bank to achieve particular targets instead of the current (or forecast) outcomes.
In the US, where the Fed has no stipulated inflation target, the presumption has always been that the pace of economic growth and the rate of inflation are equally important targets and outcomes. An alternative to economic growth is the unemployment rate.
For Australia, we have developed a forward-looking Taylor Rule that seems to accord reasonably [visually] with what has occurred quarter-by-quarter since 1997. It is: The cash rate = the inflation rate + the real interest rate + 0.5*(target unemployment – forecast unemployment) + 0.5*(target inflation – forecast inflation)
While we have playfully suggested we could replace the Governor and his Board with such an equation, in reality we need someone or some body to make the forecasts and apply a bit of judgement. For instance, despite the RBA being committed to inflation targeting, it has judiciously not pursued its target for inflation at the expense of growth or unemployment (except perhaps by accident in the early 1990s).
Fortunately for those of us not privileged to attend Reserve Bank Board meetings, the RBA quarterly monetary policy statements provide forecasts for unemployment and inflation, in words and direction if not in numbers, and it takes only a little interpretation to put numbers into the formula.
Though Australia does not specify an unemployment rate target, we reckon that it was 6% until mid-2001, but is now 5%. What comes out? The equation predicts that the cash rate will be 6.25% by December 2002 (This assumes targets of 5% for unemployment and 2.5% for inflation, versus forecasts of 6% (but declining) for unemployment and initially 3% for inflation.)
The use of optimistic unemployment projections will most likely be tempered by caution. In the tightening and loosening episode in 2000 and 2001 the RBA lagged our Taylor Rule indications by a quarter.
The current moves to tighten have coincided with a signal from the rule to tighten, implying a brisker response this time around (for which “well done” is the appropriate accolade, if it were continued).
On this logic – or is it evidence – we predict that the cash rate will be moved up to 6.25% in 6 separate 0.25% moves (anything bigger, like 0.5%, would be ‘unusual’), spread over the next 9 months. The faster the pace of increase, the sooner forecasts for the CPI will fall from the top of the target range, and the sooner rates can subsequently be reduced from their peak.
The risks appear to be on the upside. The current spate of good domestic economic news may reduce forecasts of unemployment and increase forecasts of inflation, implying a greater amplitude to the tightening cycle. But this risk is not unlimited: bigger interest rate increases would raise the exchange rate by more than is already likely (eg US$0.62 by December, which is what we expect given the differential between economic performance in Australia and the US in the remaining months of 2002), and would dampen inflation as well as keep unemployment up. (As such, the exchange rate complication is almost self regulating.) Against this upside risk, we expect the RBA Board to be cautious until a strong and sustained recovery in the US is evident.
Originally published under the nom de plume of Henry Thornton in The Australian.