In the last few months, Central Banks across the developing world, especially China followed by India, are raising their short term policy interest rates in response to the emergent inflation which has resulted as a result of the rise in commodity prices. It would be interesting to see how much further and how fast the Central Banks need to increase interest rates.
In this regard, Taylor Rule gives us a handy guidance. We will attempt to apply the Taylor rule to current situation in India and China.
The rule states that the short-term nominal interest rate is an addition of:
- Rate of inflation
- Real interest rate desired
- Some proportion of the difference between actual and desired inflation
- Some proportion of the difference between actual and desired GDP growth
Now, let us try to apply the Taylor Rule to India -
- Inflation, as measured by RBI’s favorite WPI measure, is around 8.25%. Let us take 8% as the inflation.
- There is no officially pronounced inflation target, but the media and the government starts getting worked up when inflation goes beyond 5%. So, let us take 5% as the target inflation for India. We concede that this target is very high, even by standards of other fast growing countries such as China, but, for arguments sake, assume that India is different, and is willing to tolerate high inflation, as compared to the global standards. This gives the gap between the actual and targeted inflation at 3%.
- Let’s say that policy makers should be happy with a real interest rate of 1% or above. A real interest rate of below 1% can fuel an asset price bubble in a fast growing economy.
- India’s government has said on many occasions that it wants to achieve a real GDP growth rate of 10%, so our target GDP growth rate is 10%. The projected growth rate for India for the next twelve months is 9%. So, the gap between the projected and target GDP growth rate is minus 1%
- Let us say that India wants to give high importance to GDP growth rate, hence we will give 150% weight to the gap in GDP.
- Let us say that India will tolerate high inflation for the sake of growth, hence we will give 50% weight to the gap in inflation.
Based on the above assumptions, the implementation of Taylor Rule gives short term policy interest rate of 9% for India worked out as.
The current median of RBI policy rate corridor is 6%. This gives us reason to believe that RBI is significantly behind the curve when it comes to raising interest rates.
Now, for China -
- The current inflation is about 5% as measured by CPI
- The authorities started taking action on inflation when the inflation threatened to cross 4% rapidly. Hence, we are taking 4% as target inflation. This gives a gap of 1% for inflation.
- The target medium term GDP growth rate is 7% pa (recently announced for the 12th plan), while the 2011 estimate for GDP is 10%. This gives a gap of 3% for GDP growth rate.
- Given the social situation in China, the Chinese authorities will like a gradual reduction in GDP growth rate; hence we will give 50% weight to the gap in GDP growth rate. We will assign similar weight for the gap in inflation rate.
- We assume that a real rate target of 1% is appropriate at the current juncture.
- Based on the above assumptions, the implementation of Taylor Rule gives short term policy interest rate of 8% for China worked out as.
Thus, if we assume that the Chinese are serious about slowing their economy to 7%, then the short term interest rate should rise to 8% in next few years. If there are doubts over their seriousness on slowing the economy, then, the actual PBOC rate of 6.06% is within 50 to 100 basis point range of the target rate.
We understand that the implementation of Taylor rule is a subjective exercise, and the above analysis, like any other projection is subject to inputs to the model. However, we believe that the analysis presented here gives a very useful framework for our readers to fashion their own judgement.