What should the neutral interest rate be?

The RBNZ may lower its view of the neutral interest rate this week for the second time in two years

9th Sep 15, 5:01am by Gareth Vaughan

By Gareth Vaughan

Is the Reserve Bank poised to reduce its view of what a neutral interest rate is for the second time in two years?

This certainly appears possible on Thursday when the Reserve Bank issues its latest Monetary Policy Statement (MPS), where it's expected to cut the Official Cash Rate to 2.75% from 3%.

In a speech on July 29 Reserve Bank Governor Graeme Wheeler said; "The Bank’s analysis suggests that the neutral 90-day rate currently sits in the 4% to 5% range. The Bank is continuing to reflect on this issue as the very low level of global rates could mean that the effective neutral rate may be at the bottom end of, or below, this range."

In its June MPS the Reserve Bank set out what it means by the neutral interest rate.

"The neutral interest rate is an important concept in monetary policy. It represents the dividing line between where interest rates are stimulating or constraining economic activity," the Reserve Bank said.

Lowered after the GFC

In October 2013 Assistant Governor John McDermott explained that the Reserve Bank had lowered its neutral interest rate assumption following the Global Financial Crisis.

"The evidence and research we have accumulated does point to neutral interest rates being lower than in previous cycles. The neutral level of nominal 90-day rates looks to have fallen to around 4.5%, though there is a confidence band around that figure. Based on the uncertainty we’ve typically found in the past, the band might be in the order of half a percentage point each side of the central estimate. We have lowered the view of neutral 90-day rates in our forecasting framework in line with that. That estimate compares with figures in 2003 of somewhere between 5.5% and 6.25%," McDermott said.

He went on to say an implication of a lower neutral interest rate is that households and businesses will face lower interest rates "on average." However, this shouldn't be taken as a promise of lower interest rates all the time, McDermott added.

More recently, in April this year, McDermott said the Reserve Bank's estimate of the neutral rate was lowered following the Global Financial Crisis to reflect higher household debt levels, plus higher financing costs pushing up the spread between the 90-day rate and the interest rate on household mortgages. And in his 2013 speech McDermott said for Reserve Bank purposes the neutral interest rate is the rate consistent with inflation being steady at, or close to, the midpoint of the inflation target band (2%) and a zero output gap.

"In the Reserve Bank’s framework we have a view of neutral levels for both the policy interest rate, represented by the neutral 90-day rate,... and the interest rates that households and businesses pay, which we typically proxy by the neutral floating mortgage rate. To give an idea about the wide confidence intervals around neutral estimates, between 2000 and 2008 the Reserve Bank’s published research has offered estimates of between 3% and 6% for neutral real 90-day interest rates since the early 1990s," said McDermott.

So what should it be?

So now the key question is if the Reserve Bank's going to lower its view on what the neutral interest rate is again, what should it reduce it to?

ASB chief economist Nick Tuffley has weighed in with his view.

"The Reserve Bank has also recently acknowledged that the ‘neutral’ interest rate for the economy may be lower than previously assumed. Our working assumption is now 3.25%," Tuffley said in a preview of this week's OCR review.

Whatever figure the Reserve Bank settles on, how things have changed in a year. Last September, after the Reserve Bank had increased the OCR four times between March and July by a combined 100 basis points to 3.5%, Wheeler said further policy tightening was likely to be needed, with the OCR still "essentially about 100 basis points below neutral."

"So in that sense we're still acting in a stimulatory way in terms of impetus to growth even though we have tightened four times," Wheeler said back then.

One thing's clear. Whatever figure the Reserve Bank settles on, the ongoing low interest rate environment remains a borrower's, not a saver's, world.

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16 Comments

by MortgageBelt | 9th Sep 15, 7:22am 1441740149

It certainly is not 4 to 5%
. To cling on to that desperate belief shows how out of touch thinking and modelling is in RBNZ.
Anyway interest rate levels will have little effect in terms of stimulus anymore, NZ will need to start some form of QE or Govt spending to keep the economy propped up, as mass immigration, selling NZ property overseas, flooding universities with international students is reaching its limits now.

by Stephen Hulme | 9th Sep 15, 7:57am 1441742223

Yes indeed.

I understand the conceptions very well, as the dominant economic theory is something like “no pain, no gain.” In the words of many central bankers, almost in unison of not just intention but tone and even exact phrasing, there are costs to getting the economy moving forward. In Bernanke’s version, savers are to sacrifice in favor of financial redistribution that equalizes everything toward the back end – an eventual outcome that everyone easily recognizes as a robust and sustained growth period.

"This sounds very textbook-y, but failure to understand this point has led to some confused critiques of Fed policy. When I was chairman, more than one legislator accused me and my colleagues on the Fed’s policy-setting Federal Open Market Committee of “throwing seniors under the bus” (to use the words of one senator) by keeping interest rates low. The legislators were concerned about retirees living off their savings and able to obtain only very low rates of return on those savings.

I was concerned about those seniors as well. But if the goal was for retirees to enjoy sustainably higher real returns, then the Fed’s raising interest rates prematurely would have been exactly the wrong thing to do. In the weak (but recovering) economy of the past few years, all indications are that the equilibrium real interest rate has been exceptionally low, probably negative. A premature increase in interest rates engineered by the Fed would therefore have likely led after a short time to an economic slowdown and, consequently, lower returns on capital investments. The slowing economy in turn would have forced the Fed to capitulate and reduce market interest rates again. This is hardly a hypothetical scenario: In recent years, several major central banks have prematurely raised interest rates, only to be forced by a worsening economy to backpedal and retract the increases."

The point he was trying to defend was his view of an “equilibrium” interest rate. In his version of Wicksell, the Fed has limited influence almost all in the short run and must seek to harmonize “market” rates with the “natural” rate. Therefore, Bernanke was not necessarily “punishing” savers except as one avenue to accomplish why he believes his mechanical interest rate format is valid. Left totally unspoken is the “what if”; as in orthodox theory simply assumes this all works as directed. As you might surmise without much effort, nearly a decade following this formula hasn’t proved its usefulness as a real world tool so there has been far more of the “punishment” than of the eventual alleviation. Read the rest

by Roger Witherspoon | 9th Sep 15, 8:22am 1441743724

Duh. These central planners are pathetic. If NZ government bonds trade at 3% perhaps that is a suggestion that 3% is about the neutral rate. https://www.anzsecurities.co.nz/DirectTrade/dynamic/quote.aspx?qqsc=GOV…. Prices are evidence, theories are not.

The guys at the RBNZ and Treasury are deluded into thinking their models reflect reality. In reality it seems that reality is too complex to model.

by Stephen Hulme | 9th Sep 15, 8:59am 1441745974

Exactly - reality is unearthed by the actions of those wielding the power of price discovery - money.

A little-known New York hedge fund run by a former Yale University math whiz has been buying tens of billions of dollars of U.S. Treasury debt at recent auctions, drawing attention from the Treasury Department and Wall Street.

Element Capital Management LLC, led by trader Jeffrey Talpins, has been the largest purchaser in dozens of government-bond auctions over the past 10 months, people familiar with the matter said. The buying is part of an apparent effort by the fund to use borrowed money to exploit small inefficiencies in the world’s most liquid securities market, a strategy that is delivering sizable profits, said people close to the matter. Read more

PS - had to laugh at the stale ANZ quote time stamped in August - Wholesale bookie indication is currently 3.01%. And yet I believe over $200m traded last week.

by Roger Witherspoon | 9th Sep 15, 9:25am 1441747517

Surely there must be simple way for the RBNZ to allow price discovery for the overnight rate, so they can get out of the way except in emergencies. I mean we keep the fire engines in the station when there are no fires.

by Stephen Hulme | 9th Sep 15, 11:19am 1441754347

Yes, it's called Overnight Indexed Swaps - a hugely traded otc product. But you have to pay extraordinarily high subscription fees to see real time quotes ie Bloomberg, Reuters etc.

Funny you should mention fires - The World Bank is screaming "fire" from the rooftops.

Fed risks, and we quote, triggering “panic and turmoil” in emerging markets if it opts to raise rates at its September meeting and should hold fire until the global economy is on a surer footing, the World Bank’s chief economist has warned. Read more

by iconoclast | 9th Sep 15, 10:27am 1441751231

When a rescue mission lasts for 7 years, and the fire-fighters are still standing around with their safety nets, how and who decides what is a "surer footing"?

by steven | 9th Sep 15, 1:28pm 1441762103

A Neutral rate would be one where inflation is neither increasing or decreasing about the desired point? So if this is the case and we have dis-inflation and are below the desired point then clearly an OCR of 3% is way too high.

by Stephen Hulme | 9th Sep 15, 1:40pm 1441762836

Wicksell, throughout his career, was an unwavering advocate of the quantity theory of money. He argued that increases in the economy’s average level of prices were due to excessive increases in the monetary base, that is, increases beyond the increase in the economy’s overall output. Read more

by steven | 9th Sep 15, 2:56pm 1441767384

http://krugman.blogs.nytimes.com/2013/04/12/simple-natural-goodness/

"When I say that the rate is too high, I mean relative to the rate that would produce full employment, which is, as Brad reminds us, Wicksell’s “natural rate”."

As the piece also comments earlier,

"One of the baffling aspects of economic debate during this Lesser Depression, or so it seems to me, is the apparent urge of many economists to shy away from straightforward conclusions, the urge to make the simple complicated and the clear blurry. "

Seems to abound in here at times.

So the simple thing for me is if we have an inflation rate below the desired target and it there is dis-inflation ie that deficit is getting bigger the present OCR rate is too high.

This from my engineering is simple control theory. if you are too cold in a room the value needs to open to provide more heat to warm you up all else being equal, it seems simple really.

if you dont think it is, well simply explain why not.

PS an even better link,

http://krugman.blogs.nytimes.com/2015/08/29/artificial-unintelligence/

"how would you know if the Fed is setting rates too low? Here’s where Hicks meets Wicksell: rates are too low if the economy is overheating and inflation is accelerating. Not exactly what we’ve seen in the era of zero rates and QE:"

by steven | 9th Sep 15, 2:57pm 1441767453

oh and errr,

"The worrying thing is that, as I’ve suggested, crude misunderstandings along these lines are widespread even among people who imagine themselves well-informed and sophisticated. Eighty years of hard economic thinking, and seven years of overwhelming confirmation of that hard thinking, have made no dent in their worldview. Awesome."

by scarfie | 9th Sep 15, 9:04pm 1441789468

I haven't considered the natural rate of inflation before, so here is my first thought on the matter. The natural rate is exactly what they are. This is based on the fact that real control of interest rates happens regardless of central banks, they might control the rate but they don't control the trend. What is not considered is that money is created to pay interest, but that newly created money adds to prices without being available for production.

The natural rate is based upon the level of unearned income available. The maximum rate available being exactly what is extracted of course. Resources available are a part of this function.

by Ergophobia | 9th Sep 15, 1:04pm 1441760674

Watch as NZ terms of trade and growth remain robust and dairy prices improve - banksters, "economists" and their flunkies rbnz cry, drought, foreign wars, immigrants ... anything to keep the road to free money and a vandalized dollar open for vested interests.

by Ergophobia | 9th Sep 15, 2:22pm 1441765355

And this is where that "open road" is leading: http://www.dailymail.co.uk/money/news/article-3227008/Britain-sitting-1…
Britain is the real sick man of Europe, it's just better camouflaged with funnymoney (gilts).

by sharetrader | 9th Sep 15, 2:40pm 1441766411

welcome to the world of printing money

by steven | 9th Sep 15, 2:53pm 1441767196

they are all sick.