So great is the popularity of American pop artist Taylor Swift, that when she performs a concert anywhere, it influences the level of inflation in that country. And while Canadian rapper Drake is almost as popular, he hasn't been able to influence the inflation of countries like Taylor thus far. This blog, however, is not about either of them. Don't worry, it is about inflation, and it is about a Taylor and a Drake.
Drake equation
Let's start with Drake. In 1961, physicist Frank Drake devised a formula for determining how many alien societies could possibly exist in our galaxy. At first glance, this Drake equation seems like an incredible tool. However, the outcome of the formula depends so much on the assumptions you put into it that it becomes almost a circular reasoning. For example, an important assumption in the Drake equation is the probability that life will arise on a planet that is in the ‘habitable zone’ (not too far or close) of a star. It's hard to make a strong statement about that probability, as we only have one example of a planet like that: the Earth. Take an optimistic estimate of that probability (along with an optimistic estimate of the likelihood that intelligence will emerge if life emerges), and the Drake equation says that there should be nearly 16 million planets with intelligent life in our galaxy (according to the Wikipedia page on the Drake equation). With a pessimistic estimate, however, you arrive at almost zero (9*10-13), which implies that we are a lucky shot. In other words, if you think intelligent life is easily created on planets, then Drake's formula says there are planets with intelligent life. If you don't think so, then the formula will also make you right.
Taylor rule
Drake's equation is reminiscent of another, that of the economist John Taylor. In 1993, Taylor proposed a simple equation to predict central bank interest rate policy. He was referring to the US, but the model is also used to predict the policy rates of other central banks. This so-called ‘Taylor rule’ states that a central bank’s policy rate should be equal to the neutral real rate plus a weighted average of (i) the deviations from inflation with the inflation target of central banks and (i) the deviation from economic growth from its long-term trend[1].
ECB policy rate
That sounds pretty straightforward. Nevertheless, there are some problems with the ‘Taylor rule’. The main problem is that the assumption for the neutral real interest rate is quite decisive for the outcome. The neutral interest rate is the rate that neither stimulates nor inhibits an economy which is operating at full-capacity. It’s a theoretical interest rate, which cannot be directly observed and must therefore be estimated on the basis of a model. Estimates for the neutral real interest rate in the eurozone range from -1.2% (Oxford Economics) to +0.3% (the New York Fed, the HLW model version) and +1.5% (Bank of International Settlements, HT model version)[2]. According to the ‘Taylor rule’, this implies a policy rate ranging between 1.2% and 3.9%[3].
Which is quite a difference: we can expect the ECB to either cut its policy rate substantially or to raise it somewhat in the near future. Admittedly, these are the minimums and maximums of the estimates. For financial markets, though, it matters a great deal whether the ECB will (i) sharply, (ii) slightly or (iii) not lower its policy rate[4]. The first scenario will be significantly more positive for both equities and bonds than the third scenario. It must be said here that it matters to what extent a rate cut or increase is driven by a deep economic recession or better-than-expected economic growth.
Expectations of financial markets
For financial markets, the monetary policy of the ECB and the Fed plays a crucial role. The ECB and the Bank of Canada seem to have kicked off interest rate cuts, but whether that kick-off is a one-off or the start of a series is still uncertain. Based on the pricing of Overnight Index Swaps, financial markets expect another rate cut of 0.25% for the ECB in September and one of the same size for the Fed in December.
Garbage in, garbage out
In any case, many analysts, economists, and investors in the coming months will try to make predictions on how far the ECB and the Fed will go with their rate cuts and when they will take place. They will no doubt use 'Taylor rule'-like models for this. Take these models to heart, but bear in mind the following. Whether it concerns models for extraterrestrial life or for monetary policy, GIGO applies to both: “Garbage in, garbage out".
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[1] The original Taylor equation is: Policy rate = current neutral real rate + 0.5 (expected inflation – 2%) + 0.5 (expected economic growth – long-term economic growth) + expected inflation. Just so you know, there is no consensus on the period over which expected or historical growth and inflation are measured, nor on the weights for the deviation from the trend.
[2] HLW and HT stand for econometric models to estimate the neutral real interest rate, based on the work of Holston, Laubach and Williams (2023) and Hördahl and Tristani (2019), respectively.
[3] Suppose we assume long-term economic growth in the eurozone of 1.2% (the 20-year average), an expected economic growth and inflation in 2024 of 0.7% and 2.4%, respectively (economists’ current forecast from Bloomberg), and a weighting of 0.5 for both economic growth and inflation. In that case, the ‘Taylor rule’ gives a policy rate of 1.2% at a neutral real interest rate of -1.2% [-1.2% + 0.5* (0.7% - 1.2%) + 0.5 * (2.4% - 2%) + 2.4% = 1.2%]. At a neutral real interest rate of 1.5%, the ‘Taylor rule’ gives a policy rate of 3.9% [1.5% + 0.5* (0.7% - 1.2%) + 0.5 * (2.4% - 2%) + 2.4% = 3.9%].
[4] For the US, this is less pronounced because the assumptions for neutral real interest rates are less divergent there. However, the estimates for economic growth and inflation also vary, so there too is a similar problem, albeit to a lesser extent than in the eurozone.
