Chart of the day: Emerging markets and the Taylor Rule

According to Wikipedia, the Taylor rule is a “monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions.” It is named after Stanford economist John B. Taylor.

According to the Taylor rule, for each 1% increase in inflation, a central bank should raise the nominal interest rate by more than 1%. While the Federal Reserve never operated according to a strict Taylor rule, many thought of it as a guideline which did influence Fed thinking. But in the wake of the financial crisis, no one is paying any attention to the Taylor Rule. To wit, emerging markets – where a crisis seems to be brewing. The World Bank had this to say in January about monetary policy in the emerging markets:

The “imported” easing of monetary conditions through large capital inflows in recent years has contributed to rapid credit expansion, widening current account deficits, and increasing banking sector vulnerabilities in some cases.

The surge of capital flows in the post-crisis period has contributed to lenient domestic credit conditions, directly through cross-border intermediation channels and indirectly through exchange rate and monetary policy spillovers. Regarding the latter, a simple Taylor Rule predicting the monetary policy stance of central banks in developing countries on the basis of domestic conditions (deviation of consumer price inflation from the policy target and the level of slack in the economy) suggests that policy rates were kept lower than normally suggested during periods of large capital inflows (figure B3.7.1 and He & McCauley (2013))

Figure B3.7.1 quoted above is this one below:

This Taylor Rule chart from World Bank shows how grotesquely loose many EMs were for years, yet they blamed the Fed pic.twitter.com/KHAHRgzyqe

— A Evans-Pritchard (@AmbroseEP) January 29, 2014

But of course, it’s not just emerging markets where the Taylor Rule is out the window. In the US, it is as well.

Taylor rule “would call for interest rates to start rising in mid-2014 and reach nearly 3% by the end of 2015” https://t.co/QmwqjJ52oX

— Edward Harrison (@edwardnh) January 9, 2014

What are the consequences of ultra-easy monetary policy? When the credit cycle turns down, we usually find out. EM may be a harbinger of what is to come elsewhere.