Stopping Financial Bubbles through Taylor’s Rule

When John Taylor formulated many years ago the very simple and well-known Taylor’s Rule for monetary policy to serve as a guideline for short-term interest rate decisions, he suggested basically that the “real” interest rate should be reviewed whenever there was a major discrepancy between actual inflation and a “target”inflation and also indicated that a similar reasoning should be adopted for the so-called output gap (percentage difference between potential full-employment output and effective real RGP). He suggested different possible weights for the decision taking process, but let us exemplify with 0.5 and 0.5.

The Taylor’s Rule became the very basis for inflation targeting systems all over the world in the last 15 years from New Zealand to Brasil (and possibly the USA in the near future).

Notice that the Taylor’s Rule did not eliminate the basic monetary policy dilemma between inflation and unemployment. The concept is that the Central Banks should be looking at both variables and take their decisions about interest rates. But it is true that since then countries such as Brazil (with a long history of inflation in the last century) decided to become really conservative – some analysts call it the new Bundesbank – and decided to abandon the output gap from the rule, that is, to attribute a zero weight to the real economic activity and look only at what happened to inflation.

In Brazil, only inflation matters as far as our Taylor’s Rule is concerned (see any Central Bank study). No dilemma. A simple rule: raise interest rates whenever inflation goes beyond the target – and vice-versa. Naturally, the whole Brazilian Central model included Phillips Curve, Aggregate Demand, Exchange Rate, etc. along the lines of the original Svensson open economy inflation targeting model, but in practice one should only consider the radical Taylor”s rule Brazilian style.

Naturally, Brazil was very successful in the last 10 years with inflation but there was probably a significant loss of output in the period due to huge output gaps as a consequence of low economic growth, particularly if measured against a potential growth of 5% per year. Moreover, the excessive rigidity with interest rates produced an appreciation of the exchange rate which was even worse for real GDP and for the output gap.

All this is generating discussions in Brazil and everywhere about output gap measurement, exchange rate measurement (basket of currencies versus US$), etc. But additionally and more important, we have had the 2008/2009 financial and real crisis, which came after a huge bubble in the Brazilian stock market when prices in US$ went up more than 10 times in five years (2003-2007).

It is time now to think about avoiding and stopping bubbles. And there is a very simple solution related to Taylor’s Rule – and also valid for other countries. We ought to have an enhanced Taylor’s Rule – including inflation (goods and services), asset inflation and the output gap. The simplest way to measure and think about asset inflation is to consider the monthly variation of a stock price index such as the S&P500 in the USA and the Bovespa in Brazil.

Just as an example, the enhanced Taylor’s Rule would relate short-term interest rates to three variables: a) inflation in relation to target (3%?); b) output gap in relation to target; and c) asset inflation in relation to target (depending on the country: target for real RDP growth or 6% above interest rates, for example).

It is true that there will be dilemmas. Inflation might be rising and “asset inflation” might be falling. Output gap might be going up at the same time that inflation might be going up – the socalled stagflation. But this is after all the role of Central Banks: taking decisions, making choices. As we saw in the last major financial crisis, inflation was not the priority at all. However, if “asset inflation” was included in the enhanced Taylor’s Rule in most countries, we could have avoided very low interest rates in the beginning of the century and eventually avoid the explosion of the bubble in 2008.

In summary, bubbles can and should be avoided – just like inflation. One cannot avoid some real GDP variability, normal business fluctuations, but this has nothing to do with scary bubbles. Our major point being right, it seems that the Federal Reserve should begin to discuss the new dilemmas and eventually raise interest rates up to 1% to avoid inflation and asset inflation. As far as Brazil is concerned, there is still room to bring interest rates down, but not very much. Monetary illusion with 6% nominal interest rates might generate inflation and a new stock market bubble in Brazil.