The Taylor Rule and the Reserve Bank of Australia

[Note: This is an old post I originally wrote in January 2012.]

The Taylor rule is an equation that relates the nominal interest rate to inflation and output (Gross Domestic Product, or GDP). A forward-looking version of the rule could be expressed as follows:

Nominal interest rate = (Underlying) Inflation + Real neutral interest rate + a * (Expected (underlying) inflation - Target inflation) + b * Expected Output Gap

Now that the Reserve Bank of Australia has been publishing its output and inflation forecasts in its quarterly “Statement on Monetary Policy” since early-2008 I thought it would be an interesting nerdly exercise to see if you could relate the RBA’s setting of the cash rate to its output and inflation forecasts using the Taylor rule formula.

First, some assumptions

OK, there’s a lot of assumptions we have to make before we can put the rule into effect. First, we need to assume a value for the real neutral interest rate. The real neutral interest rate is, in theory, the value of the cash rate adjusted for inflation that means that monetary policy is neither expansionary nor contractionary. For those monetary policy newbies, a real interest rate below the neutral rate should tend to heat up the economy and raise output and inflation, while a real interest rate above the neutral rate should tend to slow things down. Understandably, the RBA has been reluctant to say what it thinks the value of the neutral rate is, but we can take an educated guess. A value of 3 per cent or more seems too high, given that the real cash rate has been lower than that for the majority of the “inflation targeting” era. In May 2011, when the cash rate was 4.75 per cent and underlying inflation was 2½ per cent, giving a real rate of 2¼ per cent, the RBA said that “this represents a mildly restrictive stance of monetary policy”. Then in November 2011, when the cash rate was reduced to 4.5 per cent and underlying inflation was 2½ per cent, giving a real rate of 2 per cent, the RBA said that “a more neutral stance of monetary policy was now appropriate”. Based on this, a real neutral interest rate of 2 per cent is good enough for me.

Next, how far in the future should we measure expected inflation and expected output? Gruen, Romalis and Chandra (1997) found that there was an average lag of about five or six quarters in monetary policy’s impact on output growth. So I’m going to assume that the RBA are looking at inflation and output five or six quarters out. Since they publish forecasts at six-monthly intervals, I’ll use the forecasts for five quarters out when those are available, and the forecasts for six quarters out when those are available.

Third, we need to calculate the expected output gap. The output gap is equal to real GDP less the level of real potential output (all divided by real potential output). Real potential output is the highest level of real GDP that can be sustained based on the supply of workers and capital and how productive they are; if real GDP is higher than real potential output than inflation tends to increase. Basically, if you can accurately work out what potential output is you’re an uber-nerd. I’m going to assume that potential output is growing at 3 per cent per year, and that it was less than real GDP back in early-2008 and about the same as real GDP in late-2011. This means that real GDP was expected to be well below potential output (i.e. the output gap was negative) during late-2008 and 2009 due to the effects of the global financial crisis and the resulting downturn in the world economy.

Fourth, I’m going to set target inflation at 2.5 per cent, the mid-point of the RBA's target band for inflation over the medium-term.

As mentioned above, I’m using underlying inflation figures rather than changes in the Consumer Price Index. Underlying inflation strips out the most volatile prices, and is therefore less affected by short-term movements (such as temporary rises or falls in petrol or food prices).

Finally, I’m setting a = 0.5 and b = 0.5, as John Taylor originally did.

So, the results ...

The graph below compares the actual cash rate from the March quarter 2008 to the November quarter 2011 with the cash rate as implied by my Taylor rule and my mangling of the RBA’s forecasts.

I don’t know - it doesn’t look too bad a fit to me ... I could probably make it fit a bit better by fiddling around with the potential output series, but I think you could characterise the RBA’s policy-setting as “Tayloresque”. There’s a bit of a difference around the global financial crisis era, but you could understand if the RBA wanted to be aggressive in cutting rates around that time.

It’s all a bit rough - I don’t imagine any major banks would be staking their millions on using this to accurately predict the RBA’s next move, but in a world of baffling economic models it’s always nice when you can use something simple to explain behaviour.



The Case of The “Racist” T-Shirt

Sitting on the second floor of a bar in Khao San Road, I spotted the only one of the multitudes of cheap t-shirts in Bangkok that I had to have. From the second floor, it looked something like this:

 

When I got downstairs, I bought the shirt, after what I recall was an expert piece of bargaining (the trick is to be wasted on blue daiquiris and not care too much if you get the item in question). I also recall my wife rolling her eyes at the shirt (or maybe at my reaction to the shirt) somewhere in the process. Nevertheless, I felt quite pleased with my purchase as we headed back to the hotel.

However, the next morning I looked a bit closer at the shirt, and saw that the word balloon actually said this:

 



 

To my tolerant white person self, this rang a few alarm bells. ‘Ching chong’ – had I inadvertently bought a t-shirt that was offensive? How did I not realise the implications of the phrase the night before? Well, it was probably because I was loaded up on blue daiquiris … I thought it was just a cool t-shirt with gangsters playing Rock Paper Scissors. My smugness in relation to my well-bargained purchase started to fade a little.

Since then, whenever I have seen the t-shirt in my wardrobe it has bothered me a little. Could I wear this t-shirt in public? I thought perhaps I could wear it around the house at least, but that seemed a waste (of less than $10, but still … ). So on Monday, I resolved to find out what the phrase ‘ching chong chai’ actually meant. I typed the phrase in Google and came up with this:   





 

Seeing those second and third results didn’t exactly do a lot to ease my fears. The first result looked more promising – perhaps this would uncover the English translation of the phrase. If I knew the translation, then whenever people looked at my t-shirt and then at me skeptically I could say ‘I know what you’re thinking, but that phrase is actually Chinese for … [insert English translation here] So, uh, yeah … ’ However, the link offered no translation at all, and suggested that the phrase was just nonsense faux Chinese. This didn’t reassure me either.

Nevertheless, I decided to back my choice - I wore the t-shirt down to basketball that night, although on the way down I pondered whether I could get my handy wife to sew a patch over the offending word balloon for future outings. At basketball, I felt another pang of worry as I saw that the team that we were playing possibly had some members of Chinese descent.  And yes, the fact that I couldn’t tell if they were of Chinese descent or not didn’t make me feel any better.

P.S. That night, I mentioned my worries to my wife, who told me that ‘Ching Chong Chai’ was what you say before you choose rock, paper or scissors.

Ahhhhh…..

That made me feel better – it was an accepted phrase then. People (or some people at least) would know what it meant. Now I could wear the t-shirt without undue worry … (That is, as long as I conveniently ignored that the phrase still probably had a derogatory origin.)





BEER!! [3] – Mountain Goat Rare Breed Before The Dawn Black IPA

Name: Before The Dawn

Brewery: Mountain Goat

Place Of Origin: Richmond, Victoria, Australia

Type: Black IPA

Alcohol Content: 7.4%. And at 640ml a bottle it can get you fairly toasty.

Why I Bought It: Because Mountain Goat have worked out that if you call your product ‘Rare Breed’ beer snobs like me will grab one before they run out.

Also there’s the fantastic quote on the label:

“There’s a black that’s blacker than its own shadow. As black as the dark side of the moon. So black even the white bits are black. Darker and more impenetrable than Keyser Soze’s heart. It’s as black as a midnight eclipse, the bottom of the Black Sea, or the inside of the Black Knight’s helmet. This is two shades lighter than that.”

Taste: Quite rich, but still recognizably an IPA. I really liked it - I ended up naming it my favourite beer of 2012.

What I did while drinking it: Since it’s a longneck, I thought about my next glass, and the glass after that, and the glass after that.

What I did after drinking it: Admired that fantastic quote on the bottle some more.



The Finger Points Outwards - No. 52

 

Image: Wikipedia

 

CULTURE: How to tell a geek from a nerd. (I think I have traits of both, but probably fit more on the geek side.)

 

ECONOMICS: A conversation on how much a good boss really matters to productivity. I wonder if a ‘good boss’ just means ‘not a raving lunatic’.

FILM: The lowest grossing movie of 2012 is revealed. However, it still made more than this one.

POLITICS: Bloomberg on the new noble families in China.

ECONOMICS (again): The income premium for being beautiful.



 

 



VIDEO GAMES: The 10 hardest NES games. Apparently there’s a phrase that’s been coined to capture the difficulty of NES games: Nintendo Hard. And here I thought it was just because I was eight years old and bad at video games – I feel like I have to re-evaluate my life now. Best of all, I’m glad I’m not the only one who never passed the third level of ‘Battletoads’.    

Australians Chasing Small Totals

When it looked like the Australian cricket team would be chasing between 100 and 200 runs to win in the fourth innings against Sri Lanka last week, commentators continuously pumped up the Lankans’ chances, and Aussie cricket fans chewed their fingernails. The reason was the well-known belief that “Australians have trouble chasing small totals”. I always thought this was a bit overblown: if you’re a successful team like Australia that often chases small totals, you’re bound to stuff up a chase every now and then.

As it turns out, this belief is not just overblown, it’s almost completely wrong! Since 2003, in the 15 Tests where Australia has had to chase between 50 and 200 runs in the fourth innings to win, it’s only lost once, in the ‘dead rubber’ against India in 2004. Even if you count the loss against New Zealand in Hobart when it was chasing a bit more than 200, there’s really very little to support the view that the modern Australian team has trouble chasing a small total down.     

2013: v SL – won chasing 141

2012: v WI – won chasing 192

2010: v NZL – won chasing 106

2006 v ENG – won chasing 168

2006 v SA – won chasing 95

2005 v WI – won chasing 78

2005 v WI – won chasing 182

2005 v NZL – won chasing 164

2005 v NZL – won chasing 133

2005 v PAK – won chasing 62

2004 v PAK – won chasing 126

2004 v IND – lost chasing 107

2003 v IND – won chasing 95

2003 v ZIM – won chasing 172

2003 v WI – won chasing 147

So where does this belief spring from then? It’s probably mainly due to the twin disasters against the West Indies and South Africa in 1993 and 1994, and of course the famous loss against England at Headingley in 1981. But the Windies and SA matches are now a couple of generations ago, and almost all of the current team were not even born when Ian Botham conjured up that unlikely victory at Headingley. So relax Aussies, your team can chase down small totals just fine.

How Do Minimum Wages Affect The Gender Pay Gap?

Yes, back in July last year I said I would not be posting anything about economics for a while. But circumstances have changed, and as my wife would say, now I can pontificate about economics to my heart’s content.

Back in its 2009-10 annual wage review decision, the Minimum Wage Panel  of Fair Work Australia (now the Fair Work Commission) said that an increase in minimum (award) wages is likely to assist in promoting pay equity given the relatively high proportion of women among the award-reliant (para. 318). Actually, it turns out this isn’t likely to be true, and with a little bit of thought you can work out why. The ‘proof’ was presented in the final chapter of a 136-page(!!!) report that I got dragged into. But really the whole argument could have fitted onto a single sheet of paper*, as I’ll demonstrate below.

Assume that award wages are increased and nothing else changes.** Then the change in the overall gender pay gap will be close to the percentage of women that are award-reliant less the percentage of men that are award-reliant multiplied by the percentage increase in award rates of pay. In 2010, 17.5 per cent of adult women in Australia employed in non-managerial positions were award-reliant, compared to 12.2 per cent of men. So for a 1 percentage point increase in award rates of pay, the reduction in the difference in earnings between men and women is only about 0.04 percentage points. The overall gap in hourly earnings between men and women is over 10 per cent. So even an increase in award wages of 5-10 per cent is unlikely to make any significant dent in the gap in earnings between men and women. Now if, say, 90 per cent of women were reliant on awards, and only 10 per cent of men were, that would be a different story!

Note that this is a very different topic from whether Fair Work Australia/Fair Work Commission should adjust the pay rates of specific award-reliant employees so that award-reliant employees in female-dominated industries and award-reliant employees in male-dominated industries all receive equal pay for work of equal value. That’s an area where Fair Work Australia certainly does have an effect in removing pay disparities, because it controls the award rates. (See the equal remuneration order for the Social and Community Services award.)

*Not the Panel’s fault that it wasn’t, since it just picks the research topics, not how they’re carried through. In my view, many of the Minimum Wages Branch's research reports were way too long. 

**Of course, other things will change, but it seems unlikely that any of them will change by enough to affect the general result. I’m also assuming here that the Minimum Wage Panel wouldn’t just change award wages for one gender!

The Wooden Finger Five: January 2013

Summer is the season for listening to girls singing sweet, summery tunes. These are five of the songs currently soundtracking my days in the sun.
 
1. Origins - Tennis 
 

To date, wife-and-husband duo Tennis have fit more in the category of bands that I would want to like. But this song is a gem; reminiscent of The Sundays’ similarly excellent hit ‘Summertime’. It’s part-‘60s pop tune, part substitute Captain Planet theme music (‘Have you confused your power with mine?’)   

 2. All Your Gold – Bat For Lashes

Natasha Khan’s ‘Laura’ is getting more plaudits, and while it’s a good song it’s a bit bare for my tastes. ‘All Your Gold’ recaptures the bells and whistles of Natasha’s ‘Two Suns’ album, but with somewhat of a spookier overtone.  

3.  Forever – Haim

Does this song remind anybody else of that Donna Lewis hit from the mid-90s ‘I Love You Always Forever’? Perhaps Ms Lewis would now be considered as cool as these three sisters if she too looked like she stepped off the set of ‘Portlandia’. The video to this song has made it on to my YouTube favourites list (just above the similarly cool and summery Friends track ‘I’m His Girl’).

4. Serpents – Sharon Van Etten

This is one of those songs that gradually builds and builds, but not really in the conventional U2 kind of way. The sounds kind of spiral around before they reach their full force, and without announcing it the song becomes a very different beast to how it started off.    

5. Shiver – Lucy Rose

I first heard of Lucy Rose in an NME article that was trying to convince people that this pixie-like folk singer is actually something of a hellraiser. Don’t expect to hear that in her music however; her album ‘Like I Used To’ is as every bit as soft and melodic as you think. This is the best track from that record.

BEER!! [2] - Genesis Dry Hopped Session Ale

Name: Genesis Dry Hopped Session Ale

Brewery: Shmaltz

Place Of Origin: Saratoga Springs, New York, US

Type: Session Ale. What is a Session Ale you ask? This article from Beeradvocate tries to explain it.

Alcohol Content: ? (But according to the article above, it must be less than 5%.)

Why I Bought It: If you think it’s for any other reason than the upside-down label, you’re underestimating how superficial I am. (Apparently the upside-down label is a mistake. Maybe I shouldn’t have recycled the bottle – it’s a collector’s item!)

Taste: Just an ordinary, lightish ale really; that’s not meant to sound like a bad thing.

What I did while drinking it: Watched the penultimate episode of Season 1 of ‘Girls’. What a great show, even if nobody drinks that much in it.

What I did after drinking it: Watched the final episode and dreamt of New York.