The Taylor principle or why should central banks raise interest rates actively
We can see the recent sharp increases in food inflation and CPI inflation. The raise in CPI inflation is a consequence both of demand pressures that have fueled core inflation and also of the shift the relative price of food that has passed onto other prices. The recent rise in the price of food is different from those short-term shifts caused by climatic factors because the recent rise is due to lasting changes in food habits in big emerging markets which, these changes are expected to last in the foreseeable future. During this raise in inflation, policy interest rates will increase either passively to offset the increase in inflation or actively to combat the increase in inflation.
What should central banks do? If they are to maintain price stability, they should stick to the Taylor principle. The principle is a key characteristic of the Taylor rule, named after John Taylor who formalized the behavior of monetary policy in the United States. According to the principle, every inflation increase must be met by a rise in the policy interest rate which is larger than the increase in inflation (to be more precise, the rise in the policy interest rate must be equal to 1.5 times the increase in inflation). Failure to stick to the Taylor principle, namely, rises in interest rates that are smaller than the increase in inflation, result in a spiral of higher inflation, drop in real interest rates, higher demand and higher inflation.
Figure 2 (with data up to June 2006) shows that the recent increase in inflation has taken place at the same time as decreases in real interest rates. But according to the Taylor principle, if central banks are to give inflation an anchor, policy rates must at least keep up with inflation. In addition to the Taylor principle, it is widely accepted that central banks should combat at least the effect on inflation expectations of shocks such as increased food inflation, the so called second round effects.
To conclude, if inflation from now on is not to increase without anchor, the region’s central banks should raise interest rates actively and respect the Taylor principle. The recent 75 basis points increase in interest rates by the Banco do Brasil is an example of good monetary policy. In July inflation increased 50 basis points to 6.1%. The increase in the policy rate in July was exactly what the Taylor principle prescribes.