The ideal interest rate for the US economy in current conditions would be minus 5 per cent according to internal analysis prepared for the Federal Reserve’s last policy meeting. The analysis was based on the “Taylor rule” which formulates the appropriate interest level as a function of the “output gap” and the actual versus target level of inflation. [Financial Times].
If the Taylor rule were to be applied to the UK interest rate policy today, the appropriate level for interest rates would be minus 1.5% approximately. This assumes an output gap of 4% (based on Treasury budget data) and a CPI recorded level of 2.9% against a target of rate of 2%.
Since interest rates cannot be negative, the Taylor rule fails and the assumption the economy has to be supported by some other stimulus such as quantative easing or fiscal stimulation arises.
The Taylor rule was always a favourite, developed by the US economist J B Taylor in 1993. But in projecting a negative interest rate, The Taylor rule has failed. It cannot happen. So much for economic rules or laws.
No doubt it will have it’s day in the economics sun again. Unlike, the NAIRU, the J curve and the Law of Comparative Advantage. The latter developed by Ricardo to convince Lisbon merchants to buy English cloth in exchange for vast amounts of reinforced wine. The J curve to explain why devaluation never appeared to be working in the short term or indeed at all.
JKA : Apologies for the Sunday Sport headline. Donkey robs bank, Bus found under Arctic Ice, Bomber found on moon, VAT cuts are working, that sort of thing.
FT Fed study puts ideal interest rate at minus 5%
David Ricardo 1817 Principles of Political Economy and Taxation
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