Interest rates are the hub of our financial system.
Decisions on borrowing, saving and investing are all referenced against prevailing interest rates.
As a rule of thumb…
Rates too high…borrow less; lower asset price appreciation; save more.
Rates to low…borrow more; higher asset prices; save less.
Striking the right balance on interest rates is part science and part feel.
Taylor Rule – Guide To Interest Rate Policy
In 1993, the Taylor Rule was developed as a central bankers’ guide to interest rate policy.
This is from the 14 December 2021 issue of The Gowdie Letter…
‘In an ideal world, central banks would strike a balance in setting interest rates…offering a rate high enough to reward the saver, but not too high as to discourage borrowers from taking on debt for productive purposes.
‘Growth would be slower, but the system in the longer run would have more stability.
‘The formula for balanced rates was developed in 1993, by Stanford University economist John Taylor.
‘This is the formula from the 1993 paper…
Source: Stanford University
‘The formula is known as the Taylor Rule.
‘The rule was designed to provide guidance to the US Federal Reserve and other central banks, on the appropriate setting for short-term interest rates, based on prevailing economic conditions…inflation, economic growth and unemployment.
‘To quote from the March 2019 issue of The Gowdie Letter:
“According to Federal Reserve Bank of San Francisco (one of the 12 districts that make up the US Federal Reserve) (emphasis is mine)…
‘This [Taylor] rule is consistent with a policy regime in which the Fed attempts to control inflation in the long run and to smooth the amplitude of the business cycle in the short run. The arguments in the rule–inflation and the GDP gap–roughly correspond with goals legislated for U.S. monetary policy, namely, stable prices and full employment.’
“As stated on the Federal Reserve Bank of San Francisco’s website, the economic inputs that comprise the Taylor Rule are:
- where actual inflation is compared to the central bank’s targeted level
- how far the level of economic growth is above or below the level of full employment and
- what interest rate would be consistent with fostering full employment.
“With these inputs, the Fed (and other central banks) can roughly estimate what the appropriate short-term (cash) rate is for the economy.
“Is the Taylor Rule any good?
“The following is an extract from a working paper published by the Federal Reserve Bank of Kansas (another of the 12 districts that make up the Federal Reserve Bank).
“The paper is titled ‘The Taylor Rule and the Practice of Central Banking’ (emphasis is mine)…
‘The Taylor rule has revolutionized the way many policymakers at central banks think about monetary policy. It has framed the conduct of policy as a systematic response to incoming information about economic conditions, as opposed to a period-by-period optimization problem. It has emphasized the importance of adjusting policy rates more than one-for-one in response to an increase in inflation. And, various versions of the Taylor rule have been incorporated into macroeconomic models that are used at central banks to understand and forecast the economy.’
“The paper was published in 2010…when up until then the Taylor Rule had framed the conduct of policy as a systematic response.”
‘The original Taylor Rule has been tinkered with since its introduction.
‘This chart shows what the interest rate setting should have been under the Original Taylor Rule (dotted blue line) and the tinkered versions and the Actual Fed Funds Rate (black line).
Source: Atlanta Fed
‘If Greenspan had followed the Taylor Rule in early 2000s, rates would not have gone as low or for as long. Minimising the potential for a nationwide housing boom that led to the Global Financial Crisis.
‘The US GDP growth numbers would not have been as good. But, then again, the 2008/09 recession would probably not been as bad as it was. Yin and Yang.
‘It’s in the post GFC-period where we see the greatest imbalance in the Fed’s approach.
‘Under the Taylor Rule, rates would have started rising from zero in 2010 to over 4% in 2018.
‘Compare that to what the Fed actually did…almost zero for seven years.
‘Had rates been steadily increased — to strike a balance between saver and borrower — there would have been less yield starved investors and less demand for higher yielding junk bonds.
‘This would have reduced the funds available for corporate share buybacks.
‘Which in turn leads to lower EPS (earnings per share) growth and investors applying a more moderate multiple to those earnings.
‘Meaning the US share market would not be at record highs.’
Federal Government Short-Term Stimulus
The Fed’s pursuit of short-term stimulus over long-term stability has seriously upset the equilibrium in the system between the haves and have nots.
There has been no trickle-down wealth effect.
The imbalance between rich and poor has never been greater.
When systems get out of balance, there are always going to be repercussions.
Editor, The Rum Rebellion
Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.