Taylor Rule Versus a Depreciating Currency
The central bank of a small open economy has a policy rate of 4.0%, inflation at 6.8% against a 3% target, and an output gap of -2.5%. The exchange rate has depreciated 12% over six months; estimated pass-through to inflation is 0.35. The Taylor rule with a 2% neutral real rate, 0.5 weight on the inflation gap, and 0.5 weight on the output gap would prescribe a rate. The government wants lower rates to support growth and has called for a 100 bp cut. The central bank has inflation-targeting credibility but has missed the target for six quarters. Reserves are adequate, the banking system is profitable, and the capital account is open. The finance ministry argues that tightening will appreciate the currency and hurt exporters.
1. Calculate the Taylor rule rate and compare it with the current policy rate. What does the gap imply about the real policy rate?
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Using i = r* + π + 0.5(π − π*) + 0.5(y − y*):
- r* = 2.0
- π = 6.8
- π − π* = 3.8
- output gap = −2.5
i = 2.0 + 6.8 + 0.5(3.8) + 0.5(−2.5) = 8.8 + 1.9 − 1.25 = 9.45%.
The current rate is 4.0%, so the rule prescribes about 5.45 percentage points of tightening. That is a large gap. The rule is not a mechanical mandate, but it shows that the real policy rate is deeply negative: 4.0 − 6.8 = −2.8%. A negative real rate with inflation near 7% and a depreciating currency is a recipe for continued inflation and currency weakness.
2. Should the central bank raise rates given the negative output gap and the depreciation? Discuss credibility and pass-through.
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The negative output gap argues for caution, but inflation and the exchange rate argue for credibility. The 12% depreciation with 0.35 pass-through adds roughly 4.2 percentage points to inflation over time: 12 × 0.35 = 4.2. Waiting risks de-anchoring expectations. If wage and price setters begin to assume 7% inflation, the output cost of disinflation rises later.
A credible central bank should raise the policy rate, but perhaps in steps, and pair it with clear communication that the 3% target is not being abandoned. The government's demand for lower rates is understandable but would widen the inflation gap and likely worsen the currency. The trilemma is relevant: with an open capital account and a managed exchange rate, the central bank cannot set an independent low rate without intervention and controls. It should allow the currency to adjust while using the policy rate to anchor inflation. Credibility is the asset that keeps the output cost of disinflation finite.
3. What is the risk of tightening too much? Propose an alternative package that does not abandon the inflation target.
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Tightening too much could deepen the recession, raise nonperforming loans, and strengthen the currency sharply, hurting exporters. A 5.45-point hike in one move would be disruptive. A better package is: a credible 150–200 bp increase now, forward guidance that further moves depend on inflation expectations, macroprudential measures to contain FX borrowing, and fiscal support targeted at the output gap.
If the central bank has reserves, it can smooth disorderly FX moves without trying to fix the exchange rate. Communication should explain the trade-off: the negative output gap is temporary, but unanchored inflation is persistent. The central bank should not finance the government or cap rates; that would undermine the inflation target and invite a worse crisis. The goal is not maximum tightening but a believable path back to 3% inflation.