Modelling the Reserve Bank of Australia's Policy Decisions and the Case for a Negative Cash Rate

• Published date: 01 June 2021
• Author: Timothy Anderson,John Hawkins
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/1467-8462.12406

The Australian Economic Review, vol. 54, no. 2, pp. 179–189 DOI: 10.1111/1467-8462.12406

Modelling the Reserve Bank of Australia's Policy Decisions and

the Case for a Negative Cash Rate

Timothy Anderson and John Hawkins*

Abstract

Taylor's eponymous ‘rule’models how central

banks set policy rates in response to inflation

and output. We estimate a Taylor rule for the

Reserve Bank of Australia (RBA), modifying it

to make it more realistic, while retaining its

simplicity. The model implies that if the Bank

responds to recent forecasts as it has on

average since 1995, the cash rate could have

briefly gone negative in 2020. But the RBA is

wary of negative cash rates. There are

grounds for caution; the economic outlook is

particularly uncertain and the economy's

response to negative rates is uncharted

territory.

1. Introduction: Taylor's Eponymous Rule

Taylor (1993) introduced his ‘rule’of how a

central bank policy rate relates to inflation and

output. From the start, the rule has had both a

positive and a normative context. Taylor (1993,

p. 195) describes it as both a ‘representative’

rule which ‘closely approximates Federal

Reserve policy’and a ‘good policy rule’.The

rule takes the form:

=+ + (−)+ ( −*

)

i r p 0.5 p p 0.5 y y

T

(1)

where i is the central bank's policy rate, r is the

medium‐term ‘equilibrium’or ‘neutral’real

interest rate, p is the inflation rate, p

T

is the

inflation target and y −y* is the deviation of

output from its trend. In the United States context

of his time (and wanting to keep to round

numbers for simplicity of exposition), Taylor

assumes 2 per cent for the implicit inflation

target, 2 per cent for the neutral real interest rate

and that trend output grows at an annual rate of

2.2 per cent. He notes that the neutral real rate is

closetothetrendeconomicgrowthrate.

This simple model ‘explains’well the rise in

the US policy (federal funds) rate in the late

1980s and its reduction in the early 1990s

recession. In Taylor (1999, p. 325) he argues that

the equation is consistent with a range of policy

regimes: monetarism, the gold standard and an

informal policy of ‘leaning against the wind’.

From early 1995, there have been frequent

references to the Taylor rule at the meetings

of the Federal Open Market Committee

* Anderson and Hawkins: Canberra School of Politics,

Economics and Society, Faculty of Business and

Government, University of Canberra, Australia.

Corresponding author: Hawkins, email

<John.Hawkins@Canberra.edu.au>. We are grateful to two

anonymous referees and participants at a seminar at the

University of Canberra for helpful comments.

[Correction added on 16 Feb 2021, after initial publica-

tion on 27 January 2021; the displayed quote in

Section 3.2 was initially omitted due to a production

error and has been reinstated.]

© 2021 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research,

Faculty of Business and Economics

Published by John Wiley & Sons Australia, Ltd