Taylor rules : Rneutral vs current interest rates

CFA Level III
#1

Can someone explain briefly what is the difference between R(neutral) and the current short term interest of the Central Bank?

For example

Rneutral=3.5%

RTarget=3.75%

Current Central Bank interest rates=5%

To compute the required change in interest, should it be based on Rtarget vs Rneutral or R(Central Bank) vs R target?

#2

Target - current is what should be changed

Neutral is how you derive the target.

#3

Ok,

Would it be correct to say that, if one expect both GDP to be on trend and inflation to be on target, then the Central Bank should decrease its interest rate to 3.5%?

#4

If one expects the forecast of both to equal the trend, then yes.

The equation is Rt = Rn + 0.5(GDPf- GDPt) + 0.5 (INFf- INFt)

If the second and third terms are zero, then the target should be the netural short term rate.

#5

ok thks

#6

The current should be adjusted down by 1.25%

#7

It’s used to derive the target, but isn’t neutral supposed to be the rate that is neither expansionary nor contractionary?

#8

It’s more of a spectrum. That’s around the average over several cycles, beats me how the original paper derived it.

#9

If the rate calculated using the Taylor Rule is greater than or less than the “Target” rate, why should the Central Bank tighten or loosen monetary policy?

Loosening monetary policy would mean lowering the rate to stimulate borrowing and increase consumer and business spending; but I could use some help in understanding how to arrive at the decision to loosen or tighten monetary policy based on the calculated rate vs the target rate.

#10

The target IS the calculated rate. You compare that to the current rate, which is different from the netural (base) rate.

#11

Thank you for the help. If the Target Rate is less than the Current Rate, what should the central bank do? Why? To bring the current rate down, the Central Bank should tighten monetary policy?