Policy rules and risks to current market pricing of interest rates

Policy rules based on the latest outlooks for inflation and unemployment point to the Fed and ECB cutting rates around the middle of this year, a little later than market pricing, with a higher neutral rate underpinning a shallower rate cut cycle in the US. 

Policy rules indicate that the RBA actually has not done enough on rates in the near term and will be a little slower than its peers to cut rates. That said, the RBA might decide to follow the large banks and cut sooner if it rejects higher estimates of the neutral rate and/or decides that inflation at the top of the target band is good enough.  

The Taylor rule is commonly used by central banks as a guide to setting monetary policy, where the policy interest rate is determined by the real neutral policy rate, the gap between inflation and the central bank’s target, and the amount of spare capacity in the economy.

CCI has used a version of the Taylor rule to gauge the risks around current market pricing of the policy rate in the US, euro area and Australia.

This exercise used the rule to back out profiles for the cash rate over the next few years based on estimates of the neutral policy rate, the latest consensus forecasts for inflation and unemployment, and estimates of the NAIRU (spare capacity in the economy was proxied by the unemployment rate less the NAIRU).

Central bankers are typically cautious – recent history shows them holding rates steady for long periods to avoid the stop-start interest rate cycles of earlier decades and only gradually adjusting interest rates as needed – and we allowed for this by incorporating a degree of inertia in the policy rule.

In the analysis, the neutral policy rate anchors the rule’s estimates over the longer run when economic forecasts are either back at or near central bank targets and estimated NAIRUs.

• In the US, the nominal neutral rate is assumed to average around 3½%, consistent with the average of Fed model estimates and market pricing. This is above the FOMC’s long-run estimate of 2½ and surveyed economist estimates of around 2¾%, but not far from the FOMC’s short-run estimate of 3%.
• In the euro area, the nominal neutral rate was assumed to be about 2%, in line with market pricing. This is below the median of surveyed economist estimates of 2½% and above the NY Fed’s model estimate of 1¼%.
• In Australia, the nominal neutral rate was assumed to be around 3¾%, which was the RBA’s estimate as at earlier last year. The RBA estimate is calculated as the average of several different measures, including market pricing, where the latter currently puts the neutral rate at around 4%.

The NAIRU was held steady at its latest average value in the analysis.

• The US NAIRU averaged around 4% at the end of last year for both FOMC and economist estimates. The CBO puts the NAIRU at almost 4½%, while the Fed FRB model is lower at just over 3½%.
• The euro area economist estimate is 6½% early this year, while the dated (and unused) OECD estimate was much higher at 7¾%.
• In Australia, the average of RBA estimates was just under 4% as at the middle of last year.

Based on these assumptions for the Taylor rule, the latest market outlooks for inflation and unemployment – which are a little more timely than recent central bank forecasts – pointed to:

• The Fed cutting rates by around the middle of the year, a little later than current market pricing, with the funds rate settling at around 3½% over the next few years, higher than the market estimate of about 3%.
• The ECB also cutting rates by around the middle of the year, again a little later than current market pricing, albeit with the main refinancing rate settling at around 2% over the next few years, below the latest market estimate of about 2½%.
• The RBA cutting rates from a slightly higher cash rate of about 4½-4¾%, suggesting that the RBA has not done enough in raising rates in the near term, lowering them slightly later this year. The rule provides quite different results for Australia because unemployment is forecast to rise to only the estimated NAIRU of 4½%, while improving inflation is above the 2½% midpoint of the RBA’s target range over the entire forecast horizon.

In terms of risks to the Taylor rule results, history shows that the central banks – and the market for that matter – find it very hard to forecast inflation and unemployment over the 1-2 year horizon relevant for policy, even in the pre-pandemic years.

Also, the neutral rate looks to be higher than pre-COVID estimates in the US and Australia, while the NAIRU also varies over time.

In Australia’s case, there is some risk that the RBA diverges sharply from the Taylor rule estimates, deciding to follow the large central banks and cut rates from around the middle of this year onwards.

This could happen if either Governor Bullock follows her predecessor in rejecting estimates of a higher neutral rate and/or the board decides that inflation reaching the top of the 2-3% target band is good enough, ignoring the RBA review’s recommendation to focus on the 2½% midpoint.