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.
*This article was first published in our email for paying subscribers early on Tuesday morning