Reserve Bank Assistant Governor Karen Silk says decisions on the desired 'neutral' level for interest rates aren't likely to be made till next year

The Reserve Bank (RBNZ) says it is unlikely any decision on the 'neutral' level for the Official Cash Rate (OCR) will be made this year.

When announcing a fourth consecutive 50 basis-point hike for the OCR last week the RBNZ said its Monetary Policy Committee had discussed the possibility that neutral interest rates may now be higher.

"For example, market-based estimates of neutral nominal interest rates have increased over the past year. Staff will be undertaking further work to review their estimates," the RBNZ said.

The current 'neutral' level of the OCR is thought to be around 2%. While unobservable as such, the concept of 'neutral' interest rates is important because it describes rates that are neither stimulatory for the economy, nor restrictive. Neither too hot nor too cold if you like.

Our OCR has therefore been moved in the past year from highly stimulatory (at just 0.25% till October 2021) to a now restrictive 3.0%. 

Any changes that the RBNZ therefore makes to its perception of where 'neutral' sits have a direct impact on where it thinks the OCR should be at any given time. All things being equal, if the RBNZ now increases its view of where 'neutral' is, this should theoretically affect where it thinks the OCR should be raised to during this current hiking cycle. 

At the moment the central bank has a 'forward track' forecast for the OCR that sees it peaking at just over 4% by the middle of next year. 

Theoretically a change to the 'neutral' rate, making it higher, might suggest that the RBNZ would have to increase the OCR to somewhat higher than that current peak to achieve the desired restrictive levels to control inflation - last seen at an annual rate of 7.3% as of the June quarter.

The wholesale interest rate markets are currently just about pricing in a 4% OCR by the end of this year - and are now leaning towards an OCR peak of 4.25% by the middle of 2023.

News agency Bloomberg quoted RBNZ Deputy Governor Christian Hawkesby this week as saying there was a risk of the OCR climbing to 4.25%. Hawkesby said the RBNZ had “talked about a range of 2% to 3%” for the neutral OCR.

RBNZ Assistant Governor/General Manager Economics, Financial Markets and Banking Karen Silk told me that the bank had “discussed the fact that there are some market estimates out there that neutral nominal interest rates have increased over the past year".

“Reviewing that is an extensive piece of work, so, something that’s highly unlikely to be completed in this calendar year. But it is certainly being added to the agenda of work for the Reserve Bank to do.

“Any assessment of neutral rates is largely a historic one and at the time you do them they are obviously surrounded by reasonably high levels of uncertainty. And that really reflects that economics is an art it is not a science. The assessment of a neutral OCR whether it is two, two and a quarter, two and a half won’t make a material difference right now.

“We believe we have the OCR pitched into the more restrictive territory and we can see that it is slowing consumer credit growth and business investment and this indicates that current financial settings are restrictive and are starting to have an impact on demand and at least credit.

"So, we’ve got time to do that piece of work to understand whether neutral rates are actually higher than the historic assessment that we’ve had around where neutral rates sit. Its level of importance in terms of making the decisions that we need to make today is lower. It is however something we need to think about particularly as you get to the point where you are starting to see the turn in the cycle."

Silk, formerly a general manager with Westpac New Zealand, joined the RBNZ earlier this year and as a member of the RBNZ's Monetary Policy Committee (MPC) she's now sat in on three OCR reviews.

The MPC itself is still a relatively new thing, having been established in 2019 and changing the OCR decision-making process from one in which it was a decision make by the RBNZ Governor, to one made by the committee.

Silk said she has found the MPC process "very considered and inclusive" and "I think it has got a really strong learning bias built into it".

“I think what most people don’t actually understand is that the process is a 10-day process. It is not a quick two-hour meeting to decide whether we think things should move in one direction or another. Within the Reserve Bank there are multiple teams that are working for weeks before hand to prepare information for the Monetary Policy Committee to consider in its evaluation.

“It is a period of deliberation, discussion, reflection, risk assessment, and as I say it is very well considered and the decision is one where people don’t go in with predetermined outcomes it is a decision that is made on the final day in terms of confirming that this is the decision that we want to make. It is a very well considered process.

“The learning bias is something that really stands out for me. It shows up in a number of ways. It shows up in the degree of interest that exists in terms of understanding what high frequency indicators are saying alongside hard data. A lot of reflection on what has occurred versus what was expected at the time of prior decisions and what we can take from that when we are thinking about the current process and decision making and then a lot of looking forward at what are the areas of most concern that might want to delve into more deeply.

“So, when we finish on that Wednesday, the teams are picking up the pens on the Thursday to really start digging into the areas that the MPC want to know more about and as we are thinking into the future around where things may head from here."

She concedes the OCR decisions might get harder next year as the RBNZ approaches the peak of this current hiking cycle and has to decide how much is enough.

“Yes, I think it will get trickier, particularly as you are trying to interpret forward looking indicators at the same time as hard data. Collecting as much hard data as you can along the way.

“In hindsight it is always easy to pick when the turn was. When you are in the moment it is an awful lot harder to do. But the committee is well versed in having the need to make decisions and there is a need to make decisions based on the information that you have at hand at the point in time but acknowledging where future risks may lie."