By Dr Ray Choy, Head of Economics & Research
- The Taylor’s rule in setting interest rates are empirically supported by the key determinants of interest rates are GDP growth, the inflation rate and unemployment rate.
- These key variables suggest Malaysia has the policy flexibility to cut rates further.
- Empirically, other macroeconomic variables and considerations such as FX contribute far less although they may remain important talking points.
Keeping it simple
Interest rates are determined by a whole range of factors, so much so that it is difficult to distinguish and prioritize the key issues leading to interest rate optimization. Furthermore, monetary policy has advanced substantially to modern variants that include quantitative easing, while a central bank’s role has expanded beyond the primarily concern of interest rate optimization to other issues such as rhetoric management, reserves management and debating the extent of coordination between fiscal and monetary policy goals. Therefore, apart from the multitude of economic variables to be considered, the purposes, objectives and priorities of central banks today has expanded far beyond textbook representations.
Multiple considerations do not necessarily add to optimal decision-making and may in fact deprioritize important goals or confuse the policy setting process. The philosophy of Occam’s razor should be applied in this case. Occam’s razor suggests the simplest explanation is usually the best one, and one does not need the enlightenment of a medieval theologian, since parsimony in statistical analysis is common practice where only variables of statistical significance are included in predictive analytics.
Which variables are important?
Empirical research has shown that modified versions of the Taylor’s rule has been effective in providing the trend, if not the precise level, required to guide optimal interest rates. Mathematical equations aside, principles of the Taylor rule can be deemed effective given its adherence to parsimony and its ability to provide empirical proof that interest rates are primarily influenced by variables pertaining to the inflation rate, unemployment rate and GDP (Gross Domestic Product).
Assuming this to be the case, the mysteries surrounding the determinants of interest rates can be distilled from other influential variables which are believed to have a bearing on the interest rate decision, such as: (i) exchange rates and international portfolio flows; (ii) proxies of growth apart from GDP such as the PMI (Purchasing Manager’s Index); (iii) IPI (Industrial Production Index); and (iv) measures of trade performance.
To explain further, a cut in interest rates or a rise is expected to have a negative or positive effect on exchange rates as it either reduces or increases capital flows to a country owing to the change in the investment yield of a country’s financial markets. The PMI is often monitored since it is a lead indicator of GDP growth and provides higher frequency (monthly) data as compared to GDP (which arises quarterly). Trade, especially for export-oriented emerging economies, is often thought of as important to the interest rate decision since it affects both exchange rate performance as well as national income growth, since trade influences the level of foreign exchange reserves and is an important engine of economic growth. Apart from these, there are several other macroeconomic variables which can proxy domestic growth, trade performance, and international portfolio flows.
Fortunately, Taylor’s rule helps focus on the key variables of unemployment, GDP growth and inflation otherwise one would lose the forest for the trees. The essence of Taylor’s rule is not merely nominal, but regressions suggest the empirical correlationship between the interest rate, unemployment, GDP growth and inflation is decidedly stronger than the correlationship between other variables in the popular narrative of interest rate determinants. For example, in Malaysia’s case, the exchange rate for example, has a weak correlationship with the OPR (Overnight Policy Rate). This empirical result is not entirely surprising, if we are reminded that exchange rates are essentially driven by interest rate differentials between Malaysia and the major currencies, rather than endogenous interest rates. Other variables such as trade related variables are also poorly correlated with interest rates since the focus of interest rate policy is inclined towards domestic economic management.
Performance of the Taylor’s Rule over time in predicting the direction of interest rates
Historically, the Taylor’s rule is unable to give a precise estimate of the policy rate for several reasons. This is due to a couple of factors. Firstly, the frequency and form of variables used in assessing the strength of the labour market is one such example. The unemployment rate is not the only possible measure and can be frustrating for analysts especially when there is a lack of higher frequency indicators beyond the quarter. Secondly, empirical research has shown the original Taylor’s rule systematically prices the policy rate above the actual policy rate, that implies central banks are generally too accommodative. Given this discrepancy, the Taylor’s rule can be modified to narrow the gap between the result of the model-predicted and actual interest rates, for example, by adding in a factor for policy inertia or changing the weights and sensitivities of each component in the equation. Technicalities aside, the Taylor’s rule, whether modified or not, has at least been effective in guiding the trend of expected interest rates over time, if not the precise level.
In Malaysia’s case, similar to the global experience, the actual policy rate was generally lower than the “optimal” interest rate predicted by the Taylor’s rule. However, in recent years, there has been a greater convergence between the policy rate and the Taylor’s rule implied rate. This could mean either one of the following: the policy rate today is more closely reflective of a systematic approach to interest rate policy parameters, or, interest rates today (while still accommodative), are less accommodative than they were in the past. Adopting the more critical viewpoint of the latter, this suggests that there is room for a further interest rate cut, and secondly, on an optimistic note, many central banks including Malaysia’s, retains the policy flexibility required to aid the economy, especially at a time when government debt is high.
Central banks today may be less willing to cut interest rates too generously since loan moratoriums imply that easy monetary policy had been implemented through other means, even if not in the specific form of lowering interest rates. Furthermore, global fiscal policy had been accused of being quite profligate in the wake of the pandemic, rendering supply risks to the bond market which adds upward pressure to the cost of capital. This is especially true for developed economies which are expected to maintain expansionary fiscal policy in 2022, although emerging markets may tend towards fiscal consolidation since continued debt expansion for emerging markets is a sensitive issue during a time when global leverage and high yield debt issuance is at record high levels.
There is also the issue where excessively accommodative monetary policy will lead to the problems of moral hazard and misaligned incentives where increasingly indebted borrowers maintain dependence on debt for cash flow needs or uneconomic projects and zombie businesses are funded simply because borrowing is cheap. In particular, banks are indisposed towards lower interest rates since it will compress interest margins at a time when credit costs to unworthy borrowers are rising. Further to that, banks are by no means an insignificant lobby group and their voices will be heard. Last but not least, due to the scrutiny from de facto global monitors such international rating agencies and index providers, there is an ongoing aversion to policy actions which can lead to the creation of asset bubbles, financial repression and excessive indebtedness that would lead to capital outflows.
Taylor’s rule purists would likely maintain the focus on unemployment, inflation, and GDP growth as key variables in guiding the potential policy rate. However, as we have discussed, the expansion of central banks’ toolkits such as macroprudential policy, international monitoring, and other variable proxies for inflation, national income and the labor markets suggests that the path to interest rate optimization is not an easy one. While the range of considerations certainly adds to uncertainty, it is in this uncertainty that central banks retain the ultimate prize of policy flexibility. In this regard, it is worth reminiscing Alan Greenspan, former Federal Reserve Chairman who once said: “If I seem unduly clear to you, you must have misunderstood what I said”.
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