Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

The Taylor Rule and interest rates in India

Given the correlation between interest rate and inflation gap, India could possibly revise its policy rate stance

In the run up to 30 July monetary policy review by the Reserve Bank of India (RBI), opinions regarding the stance of the central bank have tended to focus on benchmarks based on the Taylor Rule—an interest rate feedback rule of how central banks should set short-term interest rates as economic conditions change to meet the goals of economic stability together with desired inflation rate.

The rule states that short-term interest rates should be determined by two factors—inflation and output gaps. It is argued that with India’s policy rates lower than the recommended levels, the Taylor Rule leaves no ambiguity regarding the 30 July monetary policy stance—monetary tightening. The question, however, is: can one discern a global monetary policy trend vis-à-vis the Taylor Rule rate such that Indian policy rates, being lower than the Taylor Rule, are simply mirroring global trends? What could be the reason for such global deviations from the Taylor Rule? Two economists, Boris Hofmann and Bilyana Bogdanova, using quarterly data for 11 advanced economies and 17 emerging market economies over 1995 to 2012 to compute a range of Taylor Rule implied policy rates globally as well as advanced and emerging market economies. (Taylor Rules and Monetary Policy: A Great Global Deviation?, BIS Quarterly Review, September 2012). In doing so, they use all possible combinations of different inflation measures and the output gap to avert any bias.

The results show that global policy rates since 2003 have been systematically lower than those prescribed by the Taylor Rule. Policy rates for both advanced economies and emerging market economies are below Taylor Rule rates, though the deviation is more pronounced in the latter case. It appears then, that from the Taylor Rule perspective, monetary policy has been systematically accommodative globally since the early 2000s. Indian policy rates simply mirror global monetary policy trends vis-à-vis the Taylor Rule.

One of the reasons behind such deviations could be that of core advanced economy central banks’ concern about financial stability. Concerned with the macroeconomic tail risks associated with financial instability, these banks exhibited an asymmetric monetary policy response during the financial cycle in the last decade, with policy rates falling rapidly and strongly during the two financial busts since 2000 and rising only slowly or not at all during the following recovery.

The second explanation offered is in terms of global behavioural monetary policy spill-over effects. Specifically, low policy rates in core advanced economies may have influenced the policy rates of emerging markets and other advanced economies downwards. Low policy rates adhered by these central banks could have been prompted by their desire to avoid unwelcome capital flows and the resultant exchange rate movements due to large and volatile interest rate differentials.

Both these channels may have driven down global policy rates below the level suggested by the Taylor Rule. Other analysts have also found that US interest rates have been an important argument in estimated policy rules of both advanced economies and emerging markets.

Thus, it appears that factors other than inflation and output dynamics, as suggested by the Taylor Rule, may be at work in the global deviation of policy rates below prescribed levels. As such, the Taylor Rule may not capture adequately factors relevant for macroeconomic stability and, hence, monetary policy.

An important limitation of the standard Taylor Rule is the implicit equal weightages it assigns to both the growth and inflation objectives. However, central banks, especially those of developing countries such as India, may have asymmetric preferences for interest smoothing based on their monetary policy stance.

Notwithstanding this criticism, what is the significance of all this for policy prescriptions?

A study by RBI based on quarterly estimates for the period 2000-01 to 2012-13 found that the proxy policy rate—average overnight call money rate—shows greater divergence from the standard Taylor Rule interest rate in the post-crisis period (after the third quarter of 2007-08) than the pre-crisis period. In fact, the policy rate remained above the Taylor Rule rate for much of the pre-crisis period. Also, the gap has narrowed in 2012-13. Another significant finding is that the higher the deviation of the policy rate from that implied by the standard Taylor Rule (interest rate gap), the higher is the deviation of the inflation from its desired level (inflation gap).

It is likely that the Indian policy rates in the post-crisis period were following the global and advanced economy monetary policy trends. If such tagging behaviour continues, then it gives us a pointer to the likely direction that monetary policy will take on 30 July.

Given the observed correlation between the interest rate gap and the inflation gap in India, as also with the US policy rates tightening, Indian monetary authorities may going forward well reverse their lower policy rate stance.

Tulsi Jayakumar is a professor at the SP Jain Institute of Management and Research, Mumbai.