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S. Balakrishnan

Research has discovered that the Fed's actions in the last decade and more, knowingly or otherwise, conform, more or less, to Taylor's rule and avoided boom-bust economic cycles.

The feeling that the price of oil has nowhere to go but up is becoming more and more widespread. Talk of $100 oil is increasingly common. While this should give the shivers not only to major developing country oil importers like India, first world economies too will undoubtedly feel the chill — if they are not having the symptom already.

How, in these circumstances, should monetary policy react? Should it be restrictive or accommodative? It is the billion-dollar question facing all central bankers.

At first glance the answer seems obvious. Higher oil prices mean higher inflation. An expansive approach in this situation carries the risk of sparking off an inflationary spiral. The first priority must be to slow down economic activity and that necessitates raising interest rates.

Can one be sure that it is right? After all, crude prices have risen sevenfold from the depths of sub-$10 a barrel in the second half of the nineties but US inflation — as well those of the major economies of the world — has just inched upwards. The Federal Reserve commenced its series of rate increases only in mid-2004, much after energy prices started shooting up. Clearly, there is much more to all this than meets the eye.

At least two countervailing factors have been at work — the shift in production and service locations to low-cost countries such as China and India and the surge in productivity in the US economy. They have combined to dampen inflation to the point of harmlessness.

China's biggest export is, in fact, not cheap goods but deflation. And when inflation is low, there is no reason for the central bank to adopt an aggressive monetary policy stance. This has been the story of the Fed in recent times.

Straightforward rules

What central bankers need badly is straightforward rules to decide where interest rates should be. They can look for help to the US economist, Mr John Taylor. Taylor's rule is as easy as they come.

The Fed Funds rate should be the sum of the real (i.e., inflation-adjusted) interest and long-term inflation rate targets. Thus, if the real interest rate goal is 3 per cent and inflation limit is 3 per cent, in the base case the rate would be 6 per cent. This is moved up or down depending on actual inflation and GDP.

For example, when GDP is below potential and inflation is below 3 per cent, rates would be lowered and vice-versa, allowing dynamic responses. The beauty of Taylor's rule is its simplicity. It also meets the tests of intuition, reason and common sense.

What is more, research has discovered that the Fed's actions in the last decade and more, knowingly or otherwise, conform, more or less, to Taylor's rule and avoided boom-bust economic cycles. The right formula for all seasons and central banks?

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Monetary puzzle: Is Taylor's rule the answer?

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