Developing Trends - Central Banks - The Good the Bad and the Ugly
1. Surjit S. Bhalla | surjit.bhalla@oxusinvestments.com
Ankur Choudhary | ankurc@oxusinvestments.com
Nikhil Mohan | nikhil@oxusinvestments.com
Developing Trends
Volume 1, Issues 3 & 4Developing Trends | November 2011
Oxus Research Report
Central Banks: The Good, The Bad
and the Ugly
To a large degree, central banks are both inflation targetters and output maximisers.
The US is the best performing central bank amongst the Developed Economies, while the central bank of
Israel is the best among the Emerging Markets for the period 2002 - 2011.
Countries with lower than Taylor Rule dictated interest rates have incurred almost no inflation cost in subse-
quent periods but have posted smarter growth.
Inflation was a major concern in early to mid 2011; growth, rather the lack of it, will be a major concern in
Emerging Markets Oct 2011 onwards. Look for interest rate cuts in Emerging Markets.
2. Developing Trends | November 2011
Page 2
Introduction
The crisis of 2008 has brought about a seismic shift in the
composition of the bold, the powerful and the influential.
Unlike the late 1990s when Clinton adviser James
Carville opined that he would want to come back as a
bond trader, the dream of every policy wonk, wannabe
and otherwise, is to come back as a Central Banker,
preferably as the head. Globalization has meant that this
dream is shared by all, developing and developed
countries alike. Move over Finance Ministers and Prime
Ministers – here comes the Guv‘nor.
This is the third, and special double issue of Developing
Trends, a Research Report quarterly brought out by Oxus
Research and Advisory Services. Given the importance
of central banks, this issue is dedicated to exploring their
performance. For the first time, we believe, there is a
systematic and rigorous attempt to define, and estimate,
performance of central banks. Since these bankers
provide checks and balances on the economy, it is only
fair that there should be some checks and balances, and
evaluation, on their own behaviour. So read on, find out,
and give us feedback – and oh, subscribe!
Assessment and Ranking of Central
Banks
Monetary policy is at the centre of attention in this difficult
recovery year for the global economy. Growth has
considerably slowed down worldwide, and median
inflation has risen by about 1.5 percentage points in the
developed world and by 2.5 percentage points in the
emerging market economies. This inflation increase may
have been partly caused by the rise in commodity prices
in the first half of 2011.
Inflation appears in broadly two forms – cost push and
demand pull. An assumption made by many is that
monetary policy is relatively ineffective and inappropriate
against cost push inflation, but very effective and most
appropriate against demand-pull inflation. A rough
estimate of cost-push inflation is when output is below
trend and inflation above the trend/normal/target level of
inflation. Demand pull is easily identified as the
occurrence of both output and inflation above trend.
While these are the easy identifiers, there are many grey
areas in between. And a lot is only known, well, ex-post.
The job of a central banker has never been an easy one,
especially not now in these extraordinarily difficult circum-
stances for the world economy.
Central Bankers are constantly being criticized for being
―behind the curve‖. The origins of this phrase pertain to
the normal bell shaped curve; the left half of the curve is
―behind‖ the median, and that is a ―bad‖; the right side is
ahead of the pack, or certainly ahead of the rest, and
therefore is ―good‖. Fast forwarding to monetary policy,
the prevailing assumption is that if policy interest rates
are lower than what they should be, then the Central
Bank is behind the curve. Try as we might, we haven‘t
been able to find the opposite symmetric inference – a
central bank is also behind the curve when interest rates
are higher than they should be. The ―should‖ part is
discussed in some detail below.
Monetary policy cannot be assessed in isolation. If the
world is accurately described as a ―no place to hide‖
location, then the construction of curve models cannot
assume a closed economy framework. In the old closed
economy hiding world, one looked at domestic money
supply growth to draw almost any inference about
monetary policy. There was a level of such growth that
was assumed to be ―right‖ and departures above it had to
be reined in, and departures below meant more money
needed to be supplied. Of course, as Keynes rightly
pointed out, this strict and ancient monetarist model had
a deep flaw – it assumed the velocity of money to be
constant and insensitive to the level, and changes, in
interest rates. That world has long passed.
Today, there are open economies and open economy
models. One such was provided by John Taylor.
According to the Taylor model, the assessment of
whether central bank set interest rates are appropriate is
dependent on a combination of the following two gaps –
the output gap as represented by the deviation of output
from its trend (or potential), and analogously with
inflation. The inflation gap is sometimes with reference to
a ―targeted‖ rate of inflation.
In this Research Report we go a step beyond the
application of the Taylor rule to our 26 country sample.
As regular readers know, this Oxus sample is
representative of both developed and emerging market
economies. With these countries as a basis, the central
banks are ranked for performance for the period 2002
and beyond. The ranks are based on ―goodness‖ of
policy. Read on to find out the good, the bad, and the
ugly among the central banks.
“ A Central Bank is also behind the curve
when interest rates are higher than they
should be.”
3. Developing Trends | November 2011
Page 3
Long Term Trends in Inflation and
Economic Growth
Before developing the framework for analysis of
monetary policy, a quick recap about recent trends.
What the repo or overnight interest rate should be is
essentially based on two major considerations – nature
of economic growth and inflation. For each, there are
several indicators. GDP growth, employment and/or
industrial production could be used to proxy for eco-
nomic growth. Inflation can be represented by two indi-
cators – the GDP deflator (the more implicit measure of
inflation), or the consumer price index, CPI.
Inflation in Emerging Market Economies (EMEs) has in
general trended downwards since the mid 1990s (Figure
1). This trend is evident with both the CPI and the GDP
Deflator (almost mirroring each other). The year 2009
marked the post-crisis recovery period where inflation
dipped to its lowest (CPI, 2.8%, and Deflator, 2.4%).
However, 2009 can be considered as a one-off (blip)
year, along, perhaps with 2011. In general, both
indicators of inflation have tended to trend downwards. A
stable inflation rate in EMEs is around 5 percent.
In the developed world inflation has remained between
1.5% and 2.5% for the last 16 odd years. Stable
inflation is around 2 percent.
Economic growth (Figure 2) has been on an uptrend
since the mid 1990s. The results remain unchanged
regardless of the measures (Industrial Production or
GDP growth) used to proxy for economic growth. For the
developed world, barring the recessionary/recovery
period of 2009, growth has seen periods of stability
(2001-2003) and substantial increases (2004-2007).
In general the EMEs and the Developed Economies
have maintained a steady state of economic growth
since the mid 1990s. There is a gap, though; a gap
reflective of catch-up by the EMEs. A reasonable
conclusion is that GDP growth in EME‘s, at an average
5 to 6 percent per annum, is about 3 to 4 percentage
points higher than the developed world.
So much for a historic review. What about now? High
commodity prices have posed tough challenges for
central banks, especially in the Emerging Economies, in
the form of higher than normal inflation. The initial
response of the Emerging Market Central Banks to
rising inflation was to raise, and raise, short term policy
rates. However, the globalized nature of inflation, and
the quantitative easing in the developed world, has
meant that traditional policy response (raise the repo
rate) may have run its course.
Therefore, the dilemma central banks face is the extent
to which rates can be raised without compromising on
growth. At what point does traditional monetary policy
become, well, redundant? Brazil, Indonesia, Israel and
Turkey have already started lowering their short term
rates and further decreases are expected in the coming
months. In striking and somewhat bewildering contrast,
India has raised rates 13 times since March 2010 and
the repo rate now stands at 8.5 per cent. Has Indian
policy been appropriate? Is the decline in interest rates
in Israel warranted by the ground reality? Which is a
―better‖ central bank? For these and other intriguing
questions, read on...
“Given the globalised nature of inflation,
traditional monetary policy response (raise
the repo rate) may have run its course.”
-10
-5
0
5
10
15
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
EMEsDeflator EMEsCPI
DCsDeflator DCsCPI
Figure 1: Long TermInflation Trends (% changes YoY)
Sources:EconomistIntelligenceUnitand Oxus Research
-4
-2
0
2
4
6
8
10
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
EME's Real GDP Developed Real GDP
Figure 2: Long Term Growth Trends (% changes YoY)
Sources:EconomistIntelligence Unitand Oxus Research
4. Developing Trends | November 2011
Page 4
The Taylor Rule & Our Methodology
The Taylor Rule gained favour in the late nineties with
central banks in search of a rule. Money supply growth
ceased to give relevant signals about inflation, or
demand, some time back, and the Taylor rule filled the
gap. While not many countries explicitly follow the Taylor
rule, many do so implicitly, or behind the (smoke)
screens.
The Taylor rule essentially stipulates how much a central
bank should change the nominal interest rate as
inflation, output and other economic conditions change.
In essence, the rule demands that monetary policy
become tighter when inflation is higher than
―targeted‖ (hence its application to target rules); and
looser when inflation is less than targeted. However, in
an increasingly globalised world, economies are rocked
by other developments e.g. exchange rate movements.
Therefore, the setting of short term policy rates,
especially in Emerging Economies, cannot be solely
dependent on output and inflation.
For the purpose of analysis, GDP growth and Industrial
Production growth are used as proxies for economic
growth; CPI and GDP Deflator to proxy for inflation and
the Real Effective Exchange Rates, REER, for exchange
rate deviations. Lastly, for interest rates, the major policy
rate of the central bank is chosen e.g. the Fed Funds
rate in the US, the Repo Rate in India, the 1-year rate in
China and ―market-determined‖ rates in Hong Kong and
Singapore.
Quarterly data since 2002 are used for the analysis of
short term rates. The countries chosen are the nineteen
countries in G20 and important emerging market
economies like Chile, Singapore, Hong Kong, Taiwan,
Israel, Thailand and Philippines. This gives us a
composite of 26 countries.
The Generalised Taylor Model
A generalised Rule for short term interest rate setting
can be formulated as follows:
Short term rate = β1*(Inflation Gap)-1 +β2*(Output Gap)-1
+ β3(REER)-1 +β4(D1) + β5(D2)
where D1 and D2 are dummy variables2
meant to
capture the unusually ―rough‖ developments in the last
four years. Output and inflation data (and the derived
gaps) are based on quarterly data, and converted into
seasonally adjusted annualized rates (SAAR). The one-
period lag is essentially a lagged two-quarter average
of the independent variables.
The Taylor Equation states that short term rates are a
function of the lagged inflation gap, the lagged level of
the output gap and the lagged change in the Real
Effective Exchange Rate. The gaps have been
computed as the difference between the actual and
predicted level, and the predicted level is obtained via
the Hodrick-Prescott filter. The output gap is the
deviation of an economy‘s output from its long term
trend (potential level); the inflation gap is the deviation
of inflation from its ―trend‖. An appreciation of the real
effective exchange rate is a growth dampener
(appreciation leads to a loss of competitiveness) and
increases can be considered to have the same effect as
increases in interest rates. How large, and statistically
important, the effect is remains to be econometrically
determined.
If the coefficient on inflation were to be 1, that would
mean that a 1 percentage point increase in inflation
would need to be met with a 1 percentage point
increase in the short term interest rates – essentially a
direct one-for-one pass-through relationship. These
coefficients are expected to vary, and do vary, across
countries. For a country like India, where much of the
inflation is supply side determined, the output gap may
be more significant than inflation. For South-East Asian
economies, which rely heavily on exports for growth, the
exchange rate may prove to be the more significant
variable.
The model is tested with, firstly, the GDP as the
measure for output gap and GDP deflator as the
measure for inflation and secondly, with Industrial
Production (IP) as a measure for the output gap and
CPI as a measure for inflation. Note that IP and CPI
data are released monthly while GDP and GDP defla-
tor data are available only on a quarterly basis. How-
ever, the frequency with which the data are released
will not make much difference since one-period lags of
the independent variables are used for the purpose of
analysis. Lags are used because that reflects the
standard practice among policy-makers/central bankers,
i.e., basing decisions on at least 3 to 6 months data.
1
The output gap is the difference between the actual level of output and the potential level of output. To derive the potential level of
output we apply an econometric filter known as the Hodrick-Prescott filter to IP or GDP growth. The filter removes the cyclical components
from the original data to produce a data series that is free of any cyclical variations and what we have is the potential level of growth/output.
2
D1 is a dummy variable for the period 2008Q4 – 2009Q3 – the beginning and end points of the US recession. D2 is the dummy variable for
the period 2009Q4 – 2011Q3 – the recovery period. Introduction of these time dummies allows one to better capture the magnitude and
statistical significance of the structural parameters - β1, β2 and β3 - in the model.
“The Taylor Rule—Evaluation of central
bank performance based on inflation and
output fundamentals.”
5. Developing Trends | November 2011
Page 5
Results and Revelations
While the Taylor model is tested with the IP-CPI data and GDP-GDP Deflator data for each individual country,
the model with the best fit, R2
(of the two), is chosen for the purpose of reporting results. Table 3 reports these
results for the Taylor model for each of the 26 countries.
3
The Eurozone in this report consists of France, Germany and Italy. In order to construct the output gap and inflation gap for the Eurozone,
output and inflation were pooled together for the three countries with Germany having the maximum weightage of 42%, followed by France,
31% and Italy, 27%.
Table 3: Taylor Model Coefficients for Each Country and Region, 2002Q1 - 2011Q3
Countries/ Region Model
Coefficients
R2
Inflation Gap Output Gap REER
Emerging Markets
Argentina GDP -0.18 -0.87 -0.19 0.82
Brazil IP 0.8 -0.06 -0.05 0.72
Chile IP 0.35 0.14 0.01 0.56
China GDP 0.09 0.14 0.04 0.49
Hong Kong* GDP 0.2 0.05 0.08 0.72
India IP 0.09 0.19 -0.04 0.61
Indonesia IP 0.18 -0.2 0.05 0.42
Israel IP 0.22 0.04 -0.07 0.63
Korea GDP -0.14 0.16 -0.05 0.47
Malaysia IP 0.06 0 0.02 0.67
Mexico GDP -0.12 0.13 0.02 0.65
Philippines IP 0.29 0 -0.04 0.57
Russia GDP -0.07 -0.4 -0.01 0.46
Singapore* IP -0.22 0.02 0.14 0.5
South Africa IP 0.43 -0.02 -0.01 0.71
Taiwan IP 0.05 0.01 0 0.27
Thailand GDP 0.12 -0.02 0.07 0.45
Turkey GDP 1.52 0.44 0.24 0.58
Developed Markets
Australia IP 0.26 0.16 0 0.65
Canada IP 0.12 0.06 0 0.76
3
Eurozone** GDP 0.99 0.41 0.05 0.77
- France GDP 0.86 0.19 0.06 0.82
- Germany GDP 0.35 0.32 0.03 0.65
- Italy GDP 0.36 0.43 0.06 0.63
Japan GDP 0.12 0.02 0 0.34
United Kingdom IP 0.15 0.08 0.01 0.92
United States GDP 0.9 0.17 0.02 0.57
Note: Bold and Underlined coefficients indicate statistical significance at 1%, Bold coefficients at 5% and Underlined coefficients at 10%;
Coefficients with no formatting indicate statistical insignificance and are therefore not reported; * Countries that follow a pegged/
managed exchange rate regime. For these two economies short term rates are market determined and are not policy instruments by
themselves. ** is an overall joint regression for the three Eurozone countries—France, Germany and Italy.
Source: Oxus Research Database
6. Developing Trends | November 2011
Page 6
Central Bank response to Inflation
The inflation gap is an important indicator for monetary
policy. However, outside of Latin America, the response
coefficient in Asian economies is a bit muted. For both
China and India, the elasticity of response is a
surprisingly low 0.09. This means that when inflation is 5
percentage points above target, the central banks in
these economies have, on average, raised the repo rate
(1 year rate in the case of China) by only 0.5 percentage
points. The highest inflation coefficient in emerging
economies is, not surprisingly, for Brazil; the 0.8
magnitude suggests that in this formerly high inflation
economy, there is almost one for one pass through of
inflation to the repo rate.
The highest pass through of inflation in the developed
world is in the Eurozone followed by the US! Response
coefficients of 0.99 and 0.9, respectively. Which means
that as inflation rises, the ECB and the FED are very
likely to raise rates. Equally likely, at least for the US, is
that when inflation is below trend, the FED would be
aggressive about cutting rates. Recall that there are 2
dummy variables in the regression – for the recession
period 2008-9, and the slow inflation and recovery period
afterwards. So this overall coefficient is not being af-
fected by the recent low interest rate period.
Central Bank response to Growth
Barring India, China, Korea and Mexico, the output gap is
not important for the other Emerging Economies. The
small response coefficient for India, 0.19 is in fact the
largest among all other Emerging Economies, followed
by Korea, 0.16 and China, 0.14. This means that when
the actual output is 3 percentage points above the
potential level (a likely event); the central bank in these
economies have raised repo rates by about half a
percentage point.
Amongst the Developed Economies, the output gap is
most important for the Eurozone and Italy, the response
coefficients being 0.41 and 0.43, respectively. Japan and
the US are the only two countries in the group for whom
the output gap has apparently little bearing on short term
rates.
Unlike Emerging Economies, where inflation was the
more dominant variable, there seems to be a balance
between the output gap and inflation gap for the De-
veloped Economies. No one variable dominates the
other. In other words, the developed economies are not
subscribing to just inflation targeting – all of them seem to
be practicing a dual mandate of looking at both growth
and inflation, an official policy position of the US.
Central Bank response to Exchange Rate
In general, most countries seem to have a weak
relationship with REER. However, note that Hong Kong
and Singapore have the largest and most significant…
...coefficients for REER (amongst EMEs) - 0.08 and
0.14, respectively. This is primarily because, monetary
policy is a function of some form of Exchange Rate
Management. The Hong Kong Monetary Authority
pegs its currency to the US dollar (HK$1 = US$7.8)
and engages in open market operations of buying or
selling the US$ or HK$ to contain Nominal Effective
Exchange Rate movements. The Singaporean
Monetary Authority manages its exchange rate
vis-à-vis a trade-weighted basket of currencies within
an undisclosed band. Hence, for these economies, the
exchange rate is the monetary policy instrument.
These results allow us to estimate central bank
performance. The predicted value of the repo rate tells
us where the central bank should be; the actual repo
rate informs us as to where the central bank is. The repo
gap (difference between actual and predicted) contains
information about whether the central bank is “behind
the curve”, a negative gap, or “ahead of the curve”, a
positive gap. A priori, it is not clear whether a positive
gap is good, and a negative gap, ugly. This is tested and
reported in the latter part of this report.
Panels 1 (a) - (d) show the actual short term interest
rates (―market-determined‖ rates for Hong Kong and
Singapore) and the predicted rates for each of the 26
countries under consideration. For instance, Panel 1(a)
shows that India‘s repo rates are currently at 8% (the
three-month average for the quarter, not the latest). If
the RBI were to follow the Taylor rule as predicted for
India, the average repo rate in the July-September
quarter should have been closer to 6 percent.
Information on growth and inflation in the first 2 calendar
quarters is used to generate the deviation from ―normal‖
of the repo rate for the 3rd
quarter.
Argentina, Russia, Brazil, Indonesia and Turkey are left
out of this discussion as they are categorised as high
inflation countries. Panel 1(a) for Developed
Economies and Panels 1(b), (c) and (d) for Emerging
Market Economies show that almost all countries
(including India) decreased their short term interest rates
as per the Taylor rule during the financial crisis in
2008-Q3. Similarly, with the exception of Hong Kong,
Singapore, Mexico and South Africa, all other Emerging
Economies have increased their short term policy rates
since 2010-Q4. For most of these countries, 2010-Q4
and 2011-Q1 were ‗bumper‘ quarters in terms of growth.
The countries that raised their rates did so in the belief
that high growth will continue and inflation would follow.
“Emerging Markets - Inflation the more
Dominant factor. Developed markets - A Dual
Mandate of Output and Inflation”
11. Developing Trends | November 2011
Page 11
Almost all countries stuck to the Taylor Rule during the
crisis period, not necessarily because they were
following the Rule, but because of the crisis. During all
other times, all countries (including India) seem to err
substantially on either side of the predicted path of the
Taylor Rule. The remainder of this report discusses cen-
tral bank performance based on how well central banks
have followed the Taylor Rule, whether it is beneficial to
be below or above the predicted path and if above, how
much is too much and if below, how much is too little.
Ranking Central Banks
Ranking poses the following problem. If one country has
a repo rate that is a Δ amount (difference between the
actual and predicted rate) higher than what it should be,
and another a Δ amount lower, then which country
should be ranked as having ―better governance‖?
We make the assumption that a lower repo rate is
better than a higher repo rate. We test for whether
such a policy leads to higher inflation (it does not)
and/or higher growth (it does!). Each country is ranked
according to the Residual for each quarter and a
quarter-wise performance ranking obtained (highest
negative residual to the highest positive residual).
Developed and developing economies have been
ranked separately and five high inflation countries
(Argentina, Brazil, Indonesia, Russia and Turkey) have
been left out of the ranking analyses.
Quarterly ranks can now be summed up and a rank of
ranks (also called a Borda rank) computed for any
desired set of quarters of years. We have divided the
quarters from the beginning of 2002 till 2011 Q3 into
four periods viz. Period I - 2002-05(initial expansion in
world growth); Period II - 2006-07 (high growth); Period
III, 2008 Q1- 2009 Q2 (global financial crisis as
represented by the beginning and end points of US
recession), and period IV: 2009 Q3 – 2011 Q3 (global
recovery). The rankings in each period and the overall
rankings are presented in Table 6.
“Almost all countries decreased their short term
interest rates as per the Taylor Rule
prescription during the financial crisis period.”
Table 6: Country Rankings for each period and the entire period
Developed Markets
Rankings
Period 1 Period 2 Period 3 Period 4 Overall
USA 1 8 1 2 1
Eurozone** 5 1 6 1 2
- Italy 3 2 7 1 2
- Germany 4 1 7 3 3
- France 7 4 4 5 5
Canada 2 7 2 6 4
UK 6 6 5 3 5
Japan 8 2 3 8 7
Australia 5 5 6 7 8
Emerging Markets
Hong Kong* 1 13 1 5 *
Singapore* 6 10 4 1 *
Israel 7 4 5 6 1
Thailand 5 9 7 3 2
South Africa 10 3 10 3 3
Mexico 11 2 13 1 4
Malaysia 12 1 6 8 4
Chile 2 11 8 7 6
Philippines 13 5 2 8 6
Taiwan 4 8 11 8 8
India 9 6 3 13 8
Korea 3 11 8 11 10
China 7 7 11 11 11
Notes: Period 1 = 2002 - 2005, Period 2 = 2006 - 2007, Period 3 = 2008 - 2009Q2, Period 4 = 2009Q3 -2011Q3; * Countries that follow
a pegged/managed exchange rate regime and are therefore not ranked. For these economies short term interest rates are “market
determined”. ** The joint overall rank for the three Eurozone countries - Italy, Germany and France - is number 2.
Source: Oxus Research Database
12. Developing Trends | November 2011
Page 12
A Discussion of the Rankings
Emerging Market Economies
Hong Kong and Singapore have the smallest Taylor rule
residuals, but they are not ranked because short-term
rates in these economies are determined by the market,
rather than by policy. The best emerging market economy
central bank: Israel. Philippines is an important also ran –
very good performance after the first period, 2002-2005,
when it was ranked last! Between China and India it is a
close race to the bottom, and China noses ahead of India.
Developed Economies
Somewhat surprisingly (at least to us at Oxus!) the US
FED emerges as the best developed country central
bank. Reassuringly for our model, and therefore our
rankings, the US was the worst performing central bank in
the growth boom period, 2006 and 2007. The FED has
been severely criticized for keeping interest rates too low
during the go-go years, thereby helping generate the
Great Crisis of 2008/9.
The cross currents in the world economy make for a lot of
volatility in the rankings of the two major central banks -
the FED and the ECB. In the boom period the FED was
ranked last, and the ECB first. In the period since
2009Q3, ECB is again first. But it would premature for the
ECB to celebrate. For the three quarters of 2011, the
ECB is very close to being the worst central bank in the
developed world. It has kept rates too high for too long.
It is reassuring for our model, and our rankings, to note
that days into his new job, ECB president Mario Draghi
cut short term interest rate (refinancing rate) by 25 basis
points.
What about 2011? India - The Worst Central Bank
Rankings are also computed for the three quarters in
2011 (see table 7). The worst central bank - India. A little
detail about its actions explains why this is a very plausi-
ble and credible result. Indeed, this result is a “smell
test” of the overall efficacy of our rankings.
The RBI, on 26th
of October 2011, raised the repo rates
by another 25 basis points, to a near record level of 8.5
percent. It is very likely that growth will show moderation
from the already slow GDP growth experienced in
2011:Q2.
Oxus‘s estimate is that the SAAR of GDP growth for this
quarter was close to 5 percent. If this estimate is even
half-way correct, and if the RBI persists with the 8.5 per-
cent rate for the rest of this quarter, then the RBI policy
for 2011 Q4 will imply a policy gap of 3 percentage
points i.e. the actual rate is a full 3 percentage points
above what it should be. At 2.1 percentage points above
in 2011 Q3, the Indian policy rate is the most hawkish
and extreme, ever. At 3 percentage points, it will be the
third highest excess quarterly policy rate in our entire
sample of non-high inflation economies for the last ten
years (800 quarters, 21 countries).
Table 7: Where are they now - 2011Q3?
Developed Markets Rank Current Repo Model Inflation Growth Excess Repo
Australia 8 4.5 IP 4.9 -10.3 1.8
Eurozone 6 1.5 GDP 2.9 2.7 -1.9
- Germany 7 1.5 GDP 3.0 4.0 -0.4
- Italy 5 1.5 GDP 4.0 0.3 -0.5
- France 3 1.5 GDP 1.7 2.8 -0.4
Japan 6 0.0 GDP 0.2 -5.4 -0.1
Canada 4 1.0 IP 3.3 -2.9 0.3
UK 2 0.5 IP 6.0 -3.8 -0.3
USA 1 0.3 GDP 2.5 0.8 -0.9
Emerging Markets
India 13 8.5 IP 9.6 6.0 2.1
Korea 12 3.3 GDP 3.1 5.5 0.8
Chile 11 5.3 IP 4.0 7.2 0.9
Israel 10 3.0 IP 4.0 2.0 1.1
China 9 6.6 GDP 7.0 5.9 1.3
Thailand 8 3.5 GDP 10.3 2.4 1.1
Malaysia 7 3.0 IP 3.7 1.8 0.4
Taiwan 5 1.9 IP 1.0 12.4 0.5
Mexico 5 4.5 GDP 1.5 4.2 -0.5
Philippines 4 4.5 IP 6.6 -10.8 -0.3
Singapore 3 0.4 IP 5.1 7.6 0.2
South Africa 2 5.5 IP 5.9 2.5 -1.5
Hong Kong 1 0.5 GDP 3.3 3.7 -0.6
Source: Oxus Research Database
13. Developing Trends | November 2011
Page 13
Growth and Inflation Costs of High
(Excessive) Interest Rates
Classical monetary economics would suggest that lower
interest rates, ceteris paribus, would result in higher
inflation and higher growth and high interest rates would
result in lower inflation and lower growth. This would
imply that the countries that are ranked higher (lower),
because of their lower (higher) interest rate residuals,
should have higher (lower) inflation and higher (lower)
growth in that period or in the subsequent period.
Tables 8(a) & (b) show the effects of monetary policy
on inflation and growth of the ‗loose‘ (represented by the
top ranked 6 countries) and the ‗tight‘ (represented by
the bottom ranked 6 countries) developing economies of
each period. The way to read table 8(a) is as follows—
the average inflation as measured by the GDP deflator
for the top ranked 6 developing countries (the ‗loose‘
group) of period 1 was 2.5% in period 1 and that of the
same 6 countries was 2.7% in the following period.
So countries who were ranked in the top half in period 1
registered an increase of only about 0.2% in inflation,
despite being ‗loose‘. Contrast this to the ‗tight‘ countries
of period 1 who went from being 1.9% to 3.3% in the
subsequent period - about 1.5% increase despite being
‘tight‘!
Table 8(a) shows the actual level and table 8(b) shows
the changes in growth and inflation for the loose and the
tight countries as they move from one period to the next.
For the second period the change in GDP Deflator
inflation in loose countries is 0.9% vs. 1.2% of the ‗tight‘
countries and for the fourth its 0.3% vs. -2.3%.Overall
the average change in inflation for loose countries is
0.5% whereas that for tight countries it is 0.2% - a
difference of about 30 basis points only for GDP deflator
measured inflation. For CPI inflation the same
difference is about 20 basis points. This indicates a very
low inflation cost, if any at all, of keeping interest rates
low.
“While there is almost no inflation cost of having low interest rates, there is a sizeable
growth cost of having too high interest rates”
Table 8(a): Growth and Inflation costs of high interest rates
Inflation
Monetary
Policy
Periods
1 2 3
Current Next Current Next Current Next
GDP Deflator
Loose 2.5 2.7 4.2 5.1 3.4 3.7
Tight 1.9 3.3 2.2 3.4 5.3 3.0
CPI
Loose 2.1 2.7 4.2 6.3 4.5 3.7
Tight 3.7 4.2 2.2 3.4 2.8 3.3
Output
GDP
Loose 5.8 5.9 3.8 -0.2 -0.8 5.8
Tight 5.1 4.3 5.9 -2.1 -0.7 5.9
IP
Loose 5.8 5.9 3.8 -0.2 -0.3 5.6
Tight 2.7 3.8 5.9 -2.1 -0.5 5.7
Notes: Only the Emerging Market Economies are taken into consideration, however the high inflation countries - Argentina, Brazil,
Indonesia, Russia and Turkey - have been left out.
Source: Oxus Research Database
14. Developing Trends | November 2011
Page 14
What about the cost to growth? Again by looking at output as measured by GDP (or IP) growth in Table 8
(b) we see that the average change in growth in the subsequent period of the loose economies is about
0.9% whereas that of the tight economies it is -0.7% - a difference of about 170 basis points against the
tight countries. Measured by IP, this gap is 90 basis points.
So while we observe almost no inflation cost of keeping interest rates low in this globalised world, we do
observe a sizeable growth cost of having high interest rates.
Table 8(b): Higher growth costs from excessively tight monetary policy?
Inflation
Monetary
Policy
Changes in Periods
Average
Change
1 2 3
GDP Deflator
Loose 0.2 0.9 0.3 0.5
Tight 1.5 1.2 -2.3 0.2
CPI
Loose 0.6 2.1 -0.8 0.6
Tight 0.5 1.2 0.5 0.8
Overall
Loose 0.4 1.5 -0.2 0.6
Tight 1.0 1.2 -0.9 0.5
Output
GDP
Loose 0.1 -3.9 6.6 0.9
Tight -0.7 -8.0 6.5 -0.7
IP
Loose 0.1 -3.9 5.9 0.7
Tight 1.1 -8.0 6.2 -0.2
Overall
Loose 0.1 -3.9 6.2 0.8
Tight 0.2 -8.0 6.4 -0.5
Notes: Only the Emerging Market Economies are taken into consideration, however the high inflation countries - Argentina,
Brazil, Indonesia, Russia and Turkey have been left out.
Source: Oxus Research Database
15. Developing Trends | November 2011
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Table 9(a): Country Snapshots, Argentina - Italy
Argentina*
Note the close correspondence of the repo and the predicted rate till the beginning of the crisis
period, 2008 onwards.
Australia
Worst performing central bank among the eight Developed Economies. Wide gaps (actual repo
vs. predicted) during 2002-2004.
Brazil*
Inflation gap has the maximum effect on repo rates (pass through coefficient a high 0.8). Large
deviations between 2004Q1 and 2008Q4. Closer to the Taylor predictions since 2009.
Canada
Output gap has the largest, but small, effect on repo rates – coefficient of only 0.06. Erratic
rankings; a middling central bank.
Chile
Large gap between actual and predicted repo rates until 2009. Note the explosive behaviour of
the actual repo rate since 2009; an average Central Bank.
China
All variables affect (inflation, output and exchange rates) the setting of the repo rate, but one of
the weakest performing Taylor models. On average, the worst EME Central Bank.
France
ECB bank rates, French data on GDP and inflation. All three variables affect the setting of repo
rates. Beginning second half of Period 3, convergence with Taylor rule.
Germany
Equal coefficients for inflation and output gaps – 0.35 and 0.32, respectively. An equal mandate
central bank – or that ECB policies best suited to Germany. ECB for Germany the third best central
bank.
Hong Kong** The market determined repo rate close to predictions. Not ranked.
India
Except for the crisis period starting Oct. 2008 (not before), performance compared to its peers
considerably below average. In 2011, the worst performing Central Bank, and by a wide margin
(see the explosive nature of the gap between predicted and actual repo rates).
Indonesia*
Nothing seems to explain the repo behavior – output gap, inflation gap, real exchange rate
changes – Not significant.
Israel
Inflation gap the most important – coefficient of 0.22. Follows the Taylor model most closely dur-
ing the financial crisis of 2008/09. The best performing Central Bank among EMEs.
Italy Among the three ECB countries, central bank “performance” the best.
Note: * Countries excluded from rankings because of presence of high inflation episodes. ** Countries that follow a pegged/managed ex-
change rate regime as a form of monetary policy. Therefore, short term policy rates are market determined and not set by the monetary
authorities as in other EMEs or Developed Markets.
The Country Snapshots in Tables 9(a) and (b) provide a brief description of how central banks have fared vis-à-vis
the Taylor rule between the periods 2002Q1 and 2011Q3.
16. Developing Trends | November 2011
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Table 9(b): Country Snapshots, Japan - USA
Japan Low inflation, low growth, what is a central bank to do?
Korea
All variables affect the repo rate, although output gap has the strongest effect – coefficient of 0.16.
Central bank ranking has become progressively worse since Period 1. Among EMEs, second worst
performing Central Bank.
Malaysia
Inflation gap is very important but coefficient a relatively low 0.06. The central bank went from being
the second worst performer in Period 1 to the best performer in Period 2. However, the perform-
ance has deteriorated since Period 2.
Mexico
Output gap has the strongest effect on the repo rate – coefficient of 0.13. An overall rank of 6;
erratic performance over the four periods.
Philippines
Inflation gap important with a largish elasticity (coefficient) of 0.29. A bad first period performer;
otherwise a consistent above average central bank.
Russia* Very low explanatory power for the repo model, and most coefficients have the wrong sign.
Singapore**
Exchange rate, not repo rate, the major monetary policy instrument. Deviations from predicted rate
have become smaller since Period 3. Not ranked.
South Africa Follows the Taylor model fairly closely during Period 3 and most of Period 4.
Taiwan None of the independent variables seem to explain the repo behaviour. Ranked 10th
overall.
Thailand
Inflation gap has the strongest effect on repo rates – coefficient of 0.12. Rankings volatile but in the
top half of EMEs.
Turkey*
Concern about high inflation reflected in the coefficient for inflation gap. For each 1 percentage
point increase in the inflation rate (over trend), the central bank has deemed it fit to raise repo rates
by 1.5 percentage points.
UK Only output gap affects the setting of repo rates – a small coefficient of 0.08.
USA
Only inflation matters – a “secret” inflation targetter? Inflation gap has a large coefficient of 0.9 –
almost a one-for-one pass through of inflation to interest rates. Note that the FED was the worst
ranked central bank in the growth boom period 2. But the best-performing central bank amongst the
developed economies.
Note: * Countries excluded from rankings because of presence of high inflation episodes. ** Countries that follow a pegged/managed ex-
change rate regime as a form of monetary policy. Therefore, short term policy rates are market determined and not set by the monetary au-
thorities as in other EMEs or Developed Markets.
17. Developing Trends | November 2011
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Some firm conclusions
Central bank policy-making can be explained by looking
at the behaviour of output and inflation. For a sample of
26 countries – eight developed and 18 Emerging
Economies – the Taylor model can more than adequately
explain the repo rate (overnight, Fed Funds, etc)
behaviour for the 26 central banks under consideration.
The model is estimated for each country for the period
2002Q1 – 2011Q3. For Developed Markets, inflation gap
and output gap play equally important roles in determin-
ing short term interest rates. The average output gap
coefficient for developed markets is 0.21, which suggests
that a 10 percentage point increase in the output gap
(actual output > potential output), necessitates a 2.1
percentage point increase in short term interest rates.
Inflation has a higher elasticity of about 0.4.
For the Emerging Economies, inflation gap is the more
dominant variable in determining short term interest
rates. The average inflation coefficient for an emerging
market is 0.26, which suggests that a 5% increase in
inflation necessitates a 1.3% increase in short term rates.
Central banks normally have a target of both controlling
inflation and sustaining growth. This research report
assesses their performance on both of these counts by
developing a performance index.
The period 2002 to 2011 is analyzed for four periods. In
the aggregate, the best performing central bank amongst
the Developed Economies is the United States, while the
central bank of Israel is the best performer amongst the
Emerging Economies.
The worst performing central bank in 2011 among the
Developed Economies is Australia, while the Reserve
Bank of India is the worst performer among the Emerging
Markets for this year.
Various tests suggest that too low interest rates do not
hurt in terms of higher inflation, however excessively high
rates do hurt in terms of lower growth.
The repo forecasts estimated from the Taylor rule suggest
that repo rates at present among some of the Emerging
Economies - Chile, China, India, Indonesia, Israel, Korea,
Malaysia, Taiwan and Thailand – are higher than where
they ideally should be.
What does this elaborate exercise of ranking central
banks tell us? Just the recognition of the ugly? No.
Contained in the analysis are some robust predictions.
Essentially, several emerging market economies have too
high interest rates. Given the emerging slow growth
scenario, interest rate cuts will be the big story in the
developing world in the coming 12 months.
