The Reserve Bank says the Official Cash Rate, at 4.25%, is currently still at a restrictive level and it estimates the long-term 'neutral' level of the OCR is between 2.5% and 3.5%. It says it will need to "feel its way" as the OCR gets closer to neutral.
The RBNZ has already previously indicated it will likely reduce the OCR to 3.75% at its next review on February 19, which therefore will mean the cash rate is getting much closer to the bank's estimate of neutral.
In a speech titled Beyond the Cycle: Growth and interest rates in the long run RBNZ chief economist Paul Conway said for the OCR, "our current estimates of the nominal neutral OCR suggest that we are still north of neutral".
"At 4.25%, the OCR is currently still restrictive, against Reserve Bank estimates of the long-term nominal neutral interest rate being between 2.5% and 3.5%.
"Easing domestic pricing intentions and the recent drop in inflation expectations help open the way for some further easing, as signalled in the November 2024 Monetary Policy Statement.
"Given uncertainty, we will need to ‘feel our way’ as the OCR gets closer to our estimate of neutral.
"We will continually cross-check our estimate of the neutral interest rate by comparing the proximity of the OCR to neutral against what we are seeing in the real economy.
"For example, if our estimate of neutral is too low, then we would see economic activity and inflation pressures pick up by more than expected, as monetary policy setting will have been less restrictive than originally intended. We also update our estimate of neutral as part of every policy round," Conway said.
He said that while prediction is difficult, "absent another large negative economic shock, a return to the ultralow interest rates seen during the early stages of the Covid-19 pandemic seems unlikely anytime soon".
Conway said the nominal neutral interest rate is the level of the OCR consistent with inflation being sustainably at target and the economy running at its potential output.
When the OCR is above neutral, monetary policy restrains demand and inflation pressures. Below neutral, it is stimulatory.
Without future shocks, the neutral interest rate indicates where the OCR is likely to settle to keep inflation at the 2% target midpoint.
The neutral interest rate reflects the balance between total savings and investment over time. For example, increased demand for investment funding or a lower savings rate would put upward pressure on the neutral interest rate.
The other significant subject of Conway's speech was New Zealand's 'potential output'.
Potential output is the level of goods and services the economy can sustainably supply without generating excess inflation or disinflation. It depends on the supply of inputs – capital and labour – and how productively they are combined to produce output. For example, if there are more people available to work, more capital to use, or better ways of doing things, then potential output increases.
"Potential output is the level of output the economy will gravitate to in the long run, once economic volatility due to the business cycle or one-off shocks has played out. We cannot directly measure potential output. Instead, we estimate it using techniques that separate out business-cycle volatility from the long-run trend.Our central estimate of potential output weighs up these different estimates. There is considerable uncertainty as to where potential output is at any point in time," Conway said.
"Over the next three years, we currently expect potential output growth to range between 1.5% and 2% per year. This is a lower economic ‘speed limit’ than in the recent past.
"This subdued outlook stems from expected ongoing weakness in productivity growth and lower net immigration. Of course, this is only a forecast (from our November Monetary Policy Statement), and New Zealand's potential output growth will depend on policy settings and private-sector decisions regarding investment, productivity, and migration.
"Notably, New Zealand’s productivity is now well below the OECD average and that of more advanced economies. This ‘productivity gap’ implies significant opportunity for New Zealand businesses to adopt existing technology and to ‘catch up’ to the productivity levels of businesses in leading economies."
Conway said the RBNZ does expect GDP growth to pick up over the next two years in response to less restrictive interest rates.
"However, this is a cyclical pick-up in growth. Our longer-term growth prospects remain modest, given weak expected potential output growth."
Conway said thanks to work by the now defunct Productivity Commission and others, there is a reasonable sense of what a pro-productivity reform agenda would look like.
"In short, such an agenda would emphasise strengthening international connections, fostering capital deepening (including infrastructure), enhancing competition in underperforming services sectors, and driving more effective innovation.
"...The last point I’ll make on improving productivity and potential output is that it is not solely the responsibility of the government and public sector. Ultimately, lifting productivity is largely up to the private sector and there are many ways New Zealand businesses can improve their performance (eg, adopt and adapt e-commerce). Individuals can also contribute to better productivity by shopping around for the best deal, particularly across businesses in the services sector."
We welcome your comments below. If you are not already registered, please register to comment
Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.