Concern about the health of the world economy has risen in recent weeks. Widespread declines in leading indicators of economic activity, particularly of PMI indices, suggest that the second half of 2010 could be one of a severe weakening in the pace of economic recovery. At the moment, the decline in some of the leading economic data do not suggest that economic growth at a global level will go negative but the risk is certainly higher. For the advanced economies, the risk of a collapse into recession is even greater.

Taking into account the sovereign debt crisis in Europe, the widespread tightening of fiscal policy by a range of European countries and signs of renewed weakness in the US economy, the point at which official interest rates will rise in the advanced economies has almost certainly been pushed back. Financial market expectations of interest rates in the US, UK and Euro area have all fallen back in recent weeks, see chart a. But what does a more objective measure suggest that interest rates should be in these economies?

Chart A

Using the Taylor rule – based on actual inflation relative to target, the history of economic growth and real interest rates – we calculate where official short-term interest rates should be for the US, Euro area and UK. One benefit of this approach is that it is based on actual data, and the historical links between the variables that make up the rule, so it seems to stand the test of time. As a result, the Taylor rule is a good guide to actual changes in official interest rates. But this does not mean it does not throw up odd or surprising results from time to time. In this case, the UK Taylor rule outcome seems at odds with the evidence of what is happening in the actual economy.

Table 1 shows a summary of our calculation of the Taylor rule for the second quarter of 2010. On the face of it, the results for the US and Euro area seem strange, suggesting that interest rates should be negative. However, with price inflation very low in each economy and growth just turning positive, current trends suggest that to get price inflation back to target, actual interest rates would have to be negative.

Table 1

In one sense, central banks are actually doing this via unconventional measures that put additional liquidity into the economy. To that degree, the Taylor rule is offering support for a continuation of these unusual measures and, at the very least, for these policies not to be withdrawn at this time. It also supports the recent move in financial markets to mark down expectations of official rate rises in these economies.

For the UK, the Taylor rule is, on an initial reading, surprisingly suggesting that official interest rates should be increased to 6% on one measure and 4.5% on another that has been adjusted for indirect taxes. To be sure, it still seems strange that even adjusting for the fact that indirect taxes have pushed up inflation to well above its long run average, the Taylor rule is still predicting that official rates should be raised. But the fact is that annual UK price inflation is high historically, at 3.4% on the CPI measure, and 5.1% on both the headline retail price measure and the RPI excluding mortgage interest rates.

So, the Taylor rule is quite correctly suggesting that to rectify this actual interest rates should be raised. What would been surprising is if the Taylor rule had been suggesting UK interest rates should be negative. Chart d shows that the implied Taylor rule rate for the UK is well above that of the US and Euro area. That said, however, we do not think that UK rates should be raised to this level. After all, with an economy growing less quickly than that of the US or the Euro zone, it would be a brave central bank that raised rates, see chart e. Truth is, the Taylor rule should be ignored in this instance as it is not designed to take into account some of the factors affecting UK inflation at this time.

Chart D

Chart E

UK inflation is high because of the lagged impact of the 25% drop in sterling’s trade weighted value in 2007-2009 and the knock on rise in import costs. It has also been boosted by higher fuel prices and tax changes. These influences, however, are likely to be temporary. In addition, fiscal policy is being tightened and the economy could weaken further. However, the challenge for the central bank is that, with VAT set to rise to 20% from January next year, price inflation will likely remain high and above target on official measures.

These challenges will make the MPC’s job of setting Bank rate even harder as the year progresses. Some MPC members may wish to see higher interest rates, but at this time such an outcome would likely prove extremely destructive for the real economy and likely tip the UK back into recession. Hence, such an action seems extremely unlikely. We expect Bank rate to remain on hold well into 2011.