The Taylor Rule
The most famous guide for policymakers is the ‘Taylor Rule’ and is used to provide a reasonable explanation for why policy took the path that it did. At the core of the Taylor Rule is that inflation-targeting central banks have a trade-off between inflation and output. Above-target inflation puts upward pressure on the appropriate interest rate while a shortfall of demand relative to potential provides downward pressure.
In the original 1993 version of the Taylor Rule, equal weight was given to inflation and output shocks, but this itself depends on the reaction of the policymakers, and need not be constant through time.
A common mistake is to say that inflation or gross domestic product (GDP) growth is high and that the policy rate is therefore too low, but this is only true in a relative sense. An increase in GDP growth or inflation implies that the interest rate might need to be a bit higher than it otherwise would have been, but that is not the same as saying a change is needed.
According to Philip Rush, Founder and Chief Economist at Heteronomics, interest rate levels should always focus on gaps and levels, not the dynamic pace of the economy. “If the potential growth rate is also robust then demand may not be excessively stimulated,” he says. “Even with weak potential growth, if the level of output is a long way below potential, interest rates should be at low levels to stimulate demand back to its potential.”
Rush believes that failure to do this would leave disinflationary spare capacity that could cause a miss of the inflation target: “The value of the dynamic data here is their indications of the gaps and levels that matter, and they do so in a directly observable and less uncertain way than the various bits on the supply side of the Taylor Rule”.
Down to business
Interest rate risk can never be eliminated, and for many businesses, it is very much a centralised risk and must be managed. This can be done with accurate cash flow forecasts (see box), and by reviewing past trends for interest rates over both short and medium terms. It is essential that the risk profile of the company is adhered to, and that other legal requirements and documentation is in place so the proposed strategy can be executed.
Whatever the appetite for risk in any organisation, there are real opportunities for treasurers to earn improved returns on idle or investment cash balances. The ability to understand how any cash investment could be affected by a rising or falling interest rate allows treasurers to take immediate action. This will impact the current and future values of existing cash holdings, as well as influencing the relative attractiveness of different investment proposals.
As referenced in the Treasury Today’s September/October ‘Question Answered’, there are many different cash investment options available to treasurers, and each one varies significantly in its relationship to interest, and thus its capacity to mitigate risk. Of principal interest to treasurers are:
Overnight bank deposits. Rates offered on overnight bank deposits tend to track interest rates fairly closely. However, given the lessons learnt from the 2007/8 financial crisis, treasurers should always review counterparty credit risk associated with the depositary bank. With some overnight bank deposits, there is also the option of earning credits to offset fees, interest or both.
Time deposits. These can offer higher yields but tend to catch any rate increase with a lag, as they need to wait out the term of the deposit before being reset to a higher rate. Time deposits carry the same counterparty risk as overnight deposits but there is an increased liquidity risk. However, some minimum maturity time deposits can offer attractive yields and increased liquidity, versus longer term-time deposits.
Money market funds. Compared to overnight bank deposits and time deposits, money market funds (MMFs) have a significantly more diversified counterparty credit risk and yields are in line with market rates.
So, in order to better navigate the current interest rate environment, it’s critical for treasurers to design and deploy a robust investment strategy that recognises trade-offs in yield, safety and liquidity.